department of finance, insurance and law how real estate affects people financially joe trefzger,...

Department of Finance, Insurance and Law

How Real Estate Affects People Financially

Joe Trefzger, Illinois State University

Central Illinois ChapterSociety of Financial Service Professionals

April 26, 2013


DisclaimerThe ideas expressed in the following presentation are those of the speaker alone, and may not reflect the views of Illinois State University or any sensible individual.

Data cited are from sources believed reliable but not personally verified.


Outline• Observations on current state of

the market Increased sales numbers and higher prices have

been seen Inventory and financing problems remain

• Real estate fallacies: ownership issues• Real estate fallacies: financing

issues


State of the MarketCauses for Optimism

Experts say a housing recovery started just about a year ago. Houses nationwide in value by 7 – 10% on avg. from early 2012 to early 2013 (one estimate pegs at $1 trillion).

Economists predict increases of 6 – 10% in 2013.

Sales of new homes in March by 18.5% over March 2012.Sales existing homes in March by 10.3% over March 2012.

First Q 2013 B/N local sales by 28% over first Q 2012, with new houses doing well.



Construction is up (permits, starts) to address low supply, interest rates at historic lows.

Time on market needed to sell is down, builders in hot areas receive multiple competing offers.

Nat’l median new home price at about 2007’s level ($247 K).

Home building co. stocks sell at avg. P/E ratio of 24 (vs. 18 for S&P 500).



Income property also doing well. REITs have outperformed stock market over past 4 years. Vanguard’s equity REIT index fund 15%/share since November (from $63 to $73).

Some serious money out there thinks real estate is a good investment – if not in absolute terms, at least relative to some other choices. Land prices in some areas have soared (farm, timber, building sites).



Less expensive homes’ prices have risen despite tough borrowing standards, and high-end buyers have paid increasing prices – paying cash or using investments as loan collateral.

Modest houses have gotten price support from small and large investors (sometimes paying cash) who, earning nothing on savings, became landlords, renting to those who got burned by easy credit and now want to be tenants.



Higher rents have made houses more desirable as investments but also made it more attractive to buy so you don’t have to rent.

Some observers say it can’t be a bubble b/c lenders are lending very cautiously, and b/c many sales have been with the buyers’ own cash.

People who defaulted at least three years ago are again eligible to get FHA loans. (“Boomerang” buyers.”)


State of the MarketCauses for Concern

Worries over economy and employment raise questions on what is driving/sustaining the “recovery.”

New home sales activity above recent historic lows, but still considerably below high years of recent past.

March 2013 sales consistent with 417,000 units/yr (vs. 2011 273,000 units, 2005 1.4 million units).



Avg. prices still far below 2006 highs. Higher prices also fed by fewer houses for sale, from reduced recent construction & “underwater” owners reluctant to sell. Much of new “housing” construction is apartments.

Nat’l median price of existing homes sold was up from $165 K March 2012 to $184 K March 2013, but still far below $230 K peak in July 2006.

Case-Shiller index showed some small price declines in a few market areas from December 2012 to January 2013 (but winter is always harsh on home sales).



Some economists fear further price could contribute to inflation, also give millions of “underwater” owners positive equity might sell, increase supply & dampen subsequent gains. 21.5% (10.4 million) of people with mtg. loans were underwater at end of 2012 (better than 25.2% at end 2011).

“Shadow inventory” of properties banks have avoided foreclosing on might also reach the market now that alleged foreclosure abuse cases have been settled. In late March RealtyTrac@ data firm reported banks were foreclosing on/already owned, almost 1.5 million houses nationwide (but less than the 2.2 million at peak in late 2012).



Supplies also could as 2009/2010 first-time home buyers can sell without losing income tax credits they claimed.

Foreclosures down (IL particularly high though down from a year ago), but short sales are up. Lenders, borrowers, nearby owners all prefer cleaner short sale route. House sold short less likely to sit vacant, attract vandals.

Data firm Core Logic showed short sales closing at 24% discount to an objective value measure, foreclosures at 64% discount.



While relationship between home prices and household incomes in line with historic averages, prices and rents have risen faster than incomes.

We’ve spent $188 billion of taxpayer money on Fannie and Freddie (have also received dividends of $58 billion, but that is not an especially high rate of return).

Wall Street is again getting into issuing mortgage-backed securities – started with commercial a while ago, now residential also; some see it as return to the old risks.



Comm’l property fundamentals still struggling, rents and vacancies down, not much construction, though banks are again lending on commercial buildings. Shiller calls entire current U.S. housing market “artificial” most purchase loans ultimately provided by fed. gov’ t (FHA, Fannie Mae, Freddie Mac) at astoundingly low interest rates. (He sees mini-bubbles in some hot market areas.)

Share of purchase loans held/guaranteed by a U.S. gov’t agency from 30% in 2006 to 90% today.



Fed encourages this artificiality by buying massive quantities of securities these loans are bundled into – banks aren’t making loans at those rates to collect interest on.

Lenders face new restrictions as of January 2014.

Dodd-Frank requires lender to estimate in good faith that borrower has “ability to repay,” or else can later be sued by struggling borrower.

Protect selves by issuing only loans that meet “qualified mortgage” standard.



“Qualified Mortgage” Loan (804-page description by CFPB): • No high fees (generally ≤ 3% closing and related costs)• Must verify borrower’s income and assets• Total monthly debt payments ≤ 43% of monthly gross income• Loan maturities must be ≤ 30 years• Generally no prepayment penalties• No balloon pmnts (negative, zero, partial amort. loans gone)• ARM’s probably gone (no teaser rates, CFPB calls ARM’s “risky”),

at least unless interest rate is fixed for 5 years

“Qualified Residential Mortgage:” one that can be sold in secondary market without retaining default risk.


State of the MarketMy Take

Don’t get too excited in short term over specific numbers in this artificial mkt. Some of what is reported seems curious (Stockton, CA is market with too few homes avail. for sale??)

Real estate may become more attractive to cash-hungry taxing bodies at all govt. levels sole asset class that cannot be moved away/hidden. When “QE” ends will see whether prices have only b/c of financing benefits capitalized into prices, and perhaps belief that real estate (incl. housing) was sensible asset choice in an environment of dismal savings returns, fears over inflation.


State of the MarketMy Take

If you can afford a $1,500 monthly payment, the amount of loan you can service is

$204,000 at 8% annual interest rate




Real Estate FallaciesMisconceptions that many observers of the financial and real estate landscape seem to hold. Paraphrased or twisted a bit in places to tell a good story.

“Big picture” thoughts about role real estate plays in people’s lives, esp. with respect to personal financial planning. Some are loan-related, others value/ownership-related.

With apologies if any of these points seem totally incorrect or totally obvious in the current environment.


Real Estate Fallacy #1Fixed rate mtg. loans are best for borrowers;

adjustable rate loans only benefit greedy lenders.

Not true. Pmnts fixed in nominal terms tilt problem. Int. rate includes an inflation premium. Borrower pays now for sins (inflation is big concern) that may occur much later. PLAM: Pmnts fixed in real terms. Adjust for actual inflation after the fact. Great in theory, not seen (yet) in practice.

Borrow $102,132.32 for 30 years at 3% int. (monthly pmnt. $430.59). At end yr. 1 still owe $100,000 under original plan, but there’s been 6% inflation. Balance owed to $106,000.


Real Estate Fallacy #1Yr. 2 payment now based on 29-yr. amortization of $106,000 at 3% interest.

New $456.43 pmnt. is about 6% higher than original pmnt, should be equally affordable – in real $ terms – if borrower’s income has kept up with inflation.

ARM: The practical compromise. Borrower assumes some, not all, risk of rates rising due to inflation (or other issues). Interest rate starts lower than with FRM, we adjust for expected inflation before the fact.


Real Estate Fallacy #2If mortgage interest deduction were eliminated,

home buyers would be hurt.

Not true. Buyers would pay lower prices. Home sellers who had paid high prices b/c of deduction would be hurt – lose deduction and sell for less after unforeseen change.

Benefits capitalized into prices buyers offer; fewer benefits lower offers.


Real Estate Fallacy #2But impact might be less than it looks on the surface, because fewer people itemize deductions than own houses.

So a lot of home buyers already would seem not to capitalize the marginal value of deductibility into their offering prices.

More likely an issue with high end houses. So ultimate impact seems uncertain, but probably with parties other than buyers being the ones hurt. Brokers, builders, lenders, local gov’ts would be hurt – & likely will lobby to keep the benefit.


Real Estate Fallacy #3If you have a sizable mortgage loan,

“the bank owns your house.”

Not true. Bank is a lender, you are the owner. We too often ignore (don’t understand?) what “ownership” means. Consider: buy for $200 K, $40 K down/$160 K borrowed. Prices quickly by 15%, sell for an extra $30 K. How much of that gain does the lender get?


Real Estate Fallacy #3Consider: buy for $200,000, $40 K down/$160 K borrowed. Prices quickly by 15%, sell for $30 K less. How much of that loss does the lender absorb?

Ownership is claim on residual value. True of all assets, but becomes especially important with real estate b/c purchases so often are financed with considerable debt.

Peculiar terms: “own outright,” “pride of ownership.” (Another peculiar/overused term: “mortgage.”)


Real Estate Fallacy #4Real estate you manage yourself gives better

investment returns than if professionally managed.

Not true. Issue is return on capital vs. return on labor. When you manage real estate you own, you are combining financial investment with part-time job. Pay $200 K for small rental building. Year 1 rent receipts, net of out-of-pocket operating costs (quite low since do so much mgt/repair/maintenance work yourself), total $28,000. At end of year, property still worth $200 K.


Real Estate Fallacy #4What has been % rate of return (pre-tax) on invested dollars during first year of ownership? $28 K/$200 K = 14%?

Let’s say you contributed avg. 16 hrs/week x 52 weeks = 832 hours of labor. If could earn $20/hour doing some other job, must look at 832 x $20 = $16,640 of the $28,000 as return on labor.

Other $11,360 is return on the $200 K investment; $11,360/$200 K = 5.68%.

(Owner/mgr. doesn’t face agency problems; that is a benefit.)


Real Estate Fallacy #5The best time to buy real estate is when interest rates are low.

Not true because when rates are low people are willing to pay more for asset itself (capitalize financing benefits into price).

Person who buys when rates are low may have to pay top dollar, then never gets to refinance out at a lower rate.

Person who buys when rates are high is likely to get a break on the price, then later gets to refinance to a lower rate.


Real Estate Fallacy #6You should pay off mtg. loan early/you should borrow against home’s value to invest in stock

market.

Not necessarily true. Differing views.

David Myers: Pay added principal to save on interest

Solid point: fewer interest dollars paid over timeNot so solid: gets rid of cheapest financing


Real Estate Fallacy #6Bob Brinker: “No-brainer”

Solid point: keeps risk levels equivalentNot so solid: mtg loan may be basis for itemizing

Ric Edelman: Have a big, long-term loan

Solid points: cheap financing, liquidity (definitely fund IRA) Not so solid: housing vales rise, invest at higher rate

Issue is crossing risk classes. Can’t create a money machine, but one can emerge around you.


Real Estate Fallacy #7It is sensible for home builder or real estate

agent to live in a really expensive house since he/she

knows mkt. & has cost advantage in the purchase.

Not true. Issue is one of portfolio mgt./diversification.

We think of “portfolio” as consisting of stocks, bonds, other traditional investments. But someone’s portfolio also includes “human capital,” skills that allow them to produce income.

Builder/broker’s hum. capital already tied to strength of local RE market. Like person whose IRA is all in employer’s stock. (Of course portfolio concerns may not be only consideration.)


Real Estate Fallacy #8There is no free lunch anywhere, and certainly not with real estate.

Not true. Live in a cheaper house in a given jurisdiction, pay less in property tax, still get same use of public amenities.

Consider buying least expensive house you can be happy & comfortable in.

Also limits downside risk if prices fall in your local area due to poor economy, high property taxes.


Real Estate Fallacy #9You should expect your house to increase in value over time.

Not true. Home is wasting asset. Can maybe sell today for ˃ paid years ago, but proceeds won’t buy newly-built house with similar features. Nominal value can if land value , & if construction labor and material costs , like gold jewelry when gold prices .

But older house worth less than newly built one with similar size and features on equally valuable land suffers physical deterioration, might lack amenities today’s market expects.


Real Estate Fallacy #10If you own a house you should want

local real estate transaction prices to rise.

Not true generally speaking – replacement house you want also in price (pay higher prop. tax, too). Issue deals with general trend in local home prices, not an individual property. Rising nominal value does provide for potential leveraging: •$200 K house, $40 K down/$160 K borrowed, prices quickly by 15%, sell for $230,000 and net $70 K.

•Use $70 K to make 20% down-payment on $350,000 house (would have sold for $304,350 before the rise).


Real Estate Fallacy #10But monthly payments also go way up; this outcome useful only if the down-payment is the only constraint.

Any actual economic benefit would have to relate to relative price increases in different geographic areas.

•$200 K house in B/N, $40 K down/$160 K borrowed, prices quickly by 15%, sell for $230,000 and net $70 K.

•Move to Indianapolis, where prices by only 8%. $230 K buys what would have sold earlier for $213 K.


Real Estate Fallacy #10So get real upgrade for no added cost – unless in home prices is connected to observed inflation that has also increased interest rate you must pay on new loan.

You probably do (don’t) want your house to rise (fall) in transaction value if independent of local trend.

•Bad if due to poor maintenance, negative externalities.•Good if due to striking oil, getting rezoned.


Just for Fun: Fallacy #11Land zoned commercial should be worth more

than land that is zoned residential and is similar in general location & features.

Not true. Why should value of something depend on what it is to be used for? Should comm’l vs. residential matter?

Does landscaping co. pay more for Toro Personal Pace 3-in-1 lawn mower (comm’l use) than home owner does (residential use)?

Issue would seem to be one of politics rather than economics – allocating too little land for comm’l use so its unit price .


Just for Fun: Fallacy #12Market value is fair compensation if

governmental unit takes your property under eminent domain.

Not true. Your real estate is worth more to you than brick & mortar “market” value. Three issues:

•sentimental attachment to that unique property•“social contracts” with parties relative to unique location•special improvements the typical buyer would not value

Think in terms of “Steven Spielberg” value.


Just for Fun: Fallacy #13If you spend $30,000 improving your kitchen, it

[will] [can not] add $40,000 to value of your home.

Not true. It’s uncertain. Seems at first glance that a buyer could call a contractor as easily as I could, so spending $30 K could add no more than $30 K to value. “Law of One Price.”

But I’ve come to believe this relationship:

Addition to Resale Value = D + C + A – O


Just for Fun: Fallacy #13

•D = direct cost of construction (if efficient, appropriate) •C = value of convenience of having job completed ($6 K) •A = value of assurance that job could be done well ($9 K)•O = lost value options select style/material/colors ($5 K)

So you recoup more than direct dollar cost if (C + A) ˃ O .

Here, ($6 K + $9 K) – $5 K = $10,000 in resale value.


ThankYou!!

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