The Paradox of Housing
Peter Schiff
Jun 23, 2006
As real estate prices spiraled upwards over the last ten years,
artificially low interest rates and lax lending standards were
not the only factors helping to maintain housing affordability.
Just as important were the expectations of future price appreciation
and the suppression of the rental market. With these two factors
largely reversed, the housing market is much more vulnerable
than most people understand.
Given that many people expected to extract money from future
appreciation, which could help pay mortgages, taxes, maintenance,
and insurance, houses actually seemed cheaper to buy, despite
soaring sticker prices. On the other side of the coin, without
offering the bounty of free cash, the rental market suffered
a multi-year torpor. Flat rents anchored a rock-bottom core
CPI, which allowed the Fed to keep rates low and the cheap mortgages
flowing.
Now that house price appreciation is slowing, or in some cases
reversing, buying houses is paradoxically becoming much more
expensive. An example is in order:
Assume a home buyer purchased
a condo for $500,000 using a zero-down, no-doc, interest-only
ARM. Let's assume that his interest rate was 4%, with taxes,
insurance and maintenance adding another 1% per year. The annual
cash cost would be $25,000, or just over $2,000 per month. However,
if the buyer assumed an annual appreciation rate of 10%, creating
the potential of $4,000 per month in equity extraction, the expected
monthly cost becomes negative $2,000. (In a survey last year
the typical Los Angeles homebuyer expected an annual appreciation
rate of 20%) In other words, our condo buyer actually expects
to be paid $2,000 per month as a result of his purchase. So
even if he had monthly income of only $3,000, he would have no
qualms about assuming a mortgage equal to almost 70% of his actual
pretax income and lying about his income to qualify for the loan.
Now assume the interest rate
on a zero down $500,000 interest-only mortgage rises to 7%.
Assuming taxes, insurance and maintenance still add 1%, the annual
cost is now $40,000, or $3,300 per month. However this 65% increase
is actually just the tip of the iceberg. If the borrower, now
more modest about his expectations, assumes an annual appreciation
rate of only 5%, his expected annual cost is now only reduced
by $25,000, resulting in an expected annual net cost of $15,000.
From the buyers perspective a house which once paid its owner
$2,000 per month to live in it now costs $1,250 per month to
own. Therefore the true increase in cost is not just 65% but
3,250%! Of course, if housing prices remain stable or fall,
the real cost is far higher. Since the $1,250 per month represents
over 40% of the buyer's pre-tax income, these higher mortgage
payments will now be a difficult burden to bear, even with the
diminished equity extractions. Without the cash outs, affordability
would be impossible.
As the slowing housing market increases the perceived cost of
buying, renting becomes a far more compelling option. However,
due to all the recent condo-conversions, the supply of rental
housing is somewhat constrained. As higher interest rates increase
the debt service expenses of landlords, many of whom financed
with ARMs themselves, they not only have a strong motivation
to raise rents, but the means to get away with it.
Rents and the CPI
Rents make up 40% of the core CPI, and are by far the index'
largest component. For the reasons outlined above, a softening
housing market eliminates the financial advantages of buying
and increases demand for rental properties. Recent data shows
that national rents are increasing at a rate not seen in more
than five years. This has begun to show up in the core CPI,
which will continue to grow with the surging rental market.
Just as rising home prices paradoxically suppressed the core
CPI, falling real estate prices will now do the reverse. A more
rapidly rising core CPI will force the Fed to continue raising
rates, putting even more pressure on home prices, and initiating
a particularly nasty spiral.
The Fed of course now has a
real conundrum on its hands. It either plays down the significance
of the core, possibly excluding rents entirely as they now do
food and energy, or continue to raise rates even as housing prices
collapse. The former, which amounts to a version of "heads
I win, tails you loose", risks exposing the Fed as hypocrites.
The loss of any remaining faith in the Fed will cause a run
on the dollar and even more inflation. On the other hand, to
continue raising rates will surely tip the economy into a recession.
My guess is that the Fed is
already preparing the markets for a pause even as core consumer
prices continue to rise. The spin will be that peaks in core
consumer prices historically occur with a lag relative to the
end of a tightening cycle. This will likely buy the Fed a little
extra time until the markets finally notice that rather than
peaking, core prices just keep on rising. Therefore, the greatly
anticipated, highly illusive pause will not be the least bit
refreshing.
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Peter Schiff
C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.
1 800-727-7922
email: pschiff@europac.net
website: www.europac.net
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Mr. Schiff is one of
the few non-biased investment advisors (not committed solely to
the short side of the market) to have correctly called the current
bear market before it began and to have positioned his clients
accordingly. As a result of his accurate forecasts on the U.S.
stock market, commodities, gold and the dollar, he is becoming
increasingly more renowned. He has been quoted in many of the
nation's leading newspapers, including The Wall Street Journal,
Barron's, Investor's Business Daily, The Financial Times, The
New York Times, The Los Angeles Times, The Washington Post, The
Chicago Tribune, The Dallas Morning News, The Miami Herald, The
San Francisco Chronicle, The Atlanta Journal-Constitution, The
Arizona Republic, The Philadelphia Inquirer, and the Christian
Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg.
In addition, his views are frequently quoted locally in the Orange
County Register.
Mr. Schiff began his investment career as a financial consultant
with Shearson Lehman Brothers, after having earned a degree in
finance and accounting from U.C. Berkley in 1987. A financial
professional for seventeen years he joined Euro Pacific
in 1996 and has served as its President since January 2000. An
expert on money, economic theory, and international investing,
he is a highly recommended broker by many of the nation's financial
newsletters and advisory services.
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