house prices, and why everything you hear is wrong
In the past couple of days I was interested to read comments from a friend about the recent real estate market collapse in much of the USA. 140 characters has a tendency to reduce discussion to less than the bare bones, but the comment was along the lines of "big fall in house prices: good for buyers, bad for sellers". This may, to many, seem like a common sense statement of truth. In fact - at least insofar as I or anyone else with whom I've discussed this has been able to illuminate - it's not true at all.
Rising house prices
We've all heard how rising house prices are the sign of a strong economy and help to generate wealth for everyone. This is a pernicious myth, and I believe does a great deal of damage: while it may be the sign of a confident economy, it may do more harm than good to the vast majority of people living in that economy.
why they're bad for buyers
This one should be fairly obvious: when house prices rise - as most cities in Australia have seen in recent years - they tend to do so considerably faster than incomes. This is partly due to the shared delusion that rising house prices are good (therefore a lack of any concerted opposition to rising house prices, and government policies that help drive them), coupled with the fact that the people who are in charge of paying other people's incomes tend to fight increases tooth and nail. If you have to buy a house that is 25% more expensive using an income that has only increased by 2.5% in the same period, then it becomes much more difficult (or impossible) to afford adequate housing.
why they're no good for owners
Many people are under the impression that it helps them when their house increases in value. This is almost entirely spurious: the "value" in your house is completely tied up in the house. You can't take a few bricks and sell them to realise a portion of said value. When you took out the loan to buy the house, that became the only meaningful value, and it's the value of the liability of the loan. You have to keep making repayments to keep the house, so your income versus the required repayments are the only relevant parts of the equation. Unless and until you become a net seller (see below), the current price for which your house might sell is utterly irrelevant. Some people also believe that equity is a good way to generate wealth. For a lucky few this might be the case, but for most people it doesn't work out that way.
why they're bad for sellers (owners who want to move)
Most of the time, when someone wants to sell a house, it's because they want to buy another. And in most of those cases, the other house is something more expensive: a bigger house, in a better area, etc. Even if it is simply a comparable house somewhere else, the seller who wishes to buy another house will be worse off if the value of their house has increased... and here's why: it's never just your house. If you managed to pull off the trick of buying a house which increased in value far more than every other house in the market, then (very) lucky you. But in general, housing markets rise and fall on broad trends: if your house has increased in value 25%, then chances are good that the next house you want to buy has also increased in value by 25%, or something similar. At that point, if it's a like for like trade, you're worse off, because you lose 25% more in real estate agent's fees, stamp duty, and any other cost that is charged as a percentage of the sale price of your house. If you're upgrading, it's even worse, because the difference between the sale price of your current house and the purchase price of your next house has also increased by 25%... so that's 25% more money for the difference that you have to find from somewhere else (e.g. savings, loan, etc).
Falling house prices
This situation is supposed to be the opposite of all the good things we're told about rising house prices... but it's really not all it's cracked down to be. In general it is symptomatic of broader economic problems - and those problems may well have negative impacts - but the falling house prices themselves are not a bad thing (except for a very few cases, most of whom are big enough and ugly enough to look after themselves).
why they're good for buyers
As the converse of the above, this should be pretty obvious: unless you lose your job or have some other large drop in income due to a broader economic collapse, falling house prices make housing more affordable.
why they're not bad for owners
As discussed above, the only meaningful price of the house is the one that you took out your loan to pay: you made (or should have!) a determination back when you took out the loan that you could afford to pay off the loan over the coming decades, using income you have (or could realistically expect to have). It matters not one bit whether the house is now "worth" $100,000 more or $100,000 less than it was when you took out the loan: the current value of the house doesn't change the nature of your commitment to the loan. And provided you want to keep living in a house that you "own", you have to keep your side of that commitment.
why they're good for sellers (owners who want to move)
This, once again, is the converse to the example above. If you're moving to another house of comparable value, then if both houses have decreased in value, you save the percentage by which they've decreased on agent's fees, stamp duty, and any other percentage costs of selling. Even better, if you're upgrading, the amount of extra money you need to find for the upgrade has also decreased.
So... who actually wins when house prices go up?
Surely, if rising house prices were actually bad and falling house prices were actually good, we wouldn't have governments making policies to drive rising real estate prices and real estate agents telling us all the time about how great the rising value of real estate is, would we? Well, no... not unless they had reasons that served their enlightened self-interest to do so. Someone must stand to gain from a rising real estate market: the question you should ask is, who?
real estate agents
Real estate agents work day-to-day in a fickle, deceitful, at times desperate market filled with people who mostly don't know what they're doing and mostly believe that all kinds of tricks, lies, and psych-outs are necessary means to the end of getting a roof over ones head. Sadly, this is a self-fulfilling prophecy much of the time: hardly anyone is ever honest with a real estate agent, so in turn the "information" they churn out is a conglomeration of all the lies and nonsense they've been told. However, there's one thing they know for sure: the more houses sell for, the better off they are. This is because most of the fees they charge are based on a percentage of the sale (or rental) amounts of the houses for which they provide service. If a house sells for 25% more money, their cut also increases by 25%. However, the amount of work they did to sell that house, and cost of all the things involved in the process (advertising, staff hours, printing, etc. etc.) stayed effectively the same. The increase in the commission they take is pure profit.
governments
In the current political environment, where anything and everything is about serving the economy, there are plenty of reasons for a government to maintain the illusion of a strong economy, and there's no doubt that - because of the misconceptions I'm attempting to debunk here - rising house prices are perceived the be a good sign of such an economy. However, there are big reasons why governments benefit directly from rising house prices: land tax and stamp duty. Although the names of these taxes, and the manner in which they're levied, varies from state to state, most states either take a cut of the value of a house when it is sold, or tax property on an ongoing basis, or both. In either case, the amount of that tax is almost always a percentage of the nominal or actual value of the property. The more a given property is worth, the more money they make from those taxes. Indeed, there are recent cases of people being driven out of houses they owned outright in southern California, because the nominal value of their houses had increased so much that they could no longer afford to pay the land tax. This is a perfect example of the delusional nature of "wealth" as tied up in the nominal value of the house in which you live, set against the very real gains made by government in a skyrocketing housing market.
banks
Banks, you'll be surprised to learn, are not charities. They exist to make money, which they do by taking one person's money (deposits) and lending it to someone else (loans), and charging the latter a higher rate of interest than they pay to the former. Banks actually create money this way (I swear I'm not making this up). One of the biggest and most reliable reasons to loan money to people is to enable them to buy a house in which to live. This is a great situation for a bank to be in, because they know that if someone can possibly afford to pay their home loan, they will do so (even if they have to scrimp, reduce, even default on other debts) because they don't want to lose their house. So it's a fair call to say that a bank will loan you as much as they can if they think you have any chance of continuing to make payments. They may even loan you more money than they think you can afford to keep paying off, provided they think your house will be worth enough when you finally default, get kicked out of your house and declare bankruptcy, that they'll be able to recover all the difference by selling what you briefly imagined to be "your" house.
It is beyond the scope of this blog to discuss the practice of loaning money to people who clearly never had a hope of paying any of it off (the infamous NINJA loans)... but it's my opinion that we the taxpayers of the west have been awfully kind to spend billions bailing out so many banks while still allowing them to keep profiting privately. As far as I'm concerned, we paid for 'em, we should have bought 'em.
Anyway, the upshot of the above is that banks are quite happy for house prices - and therefore home loans - to keep increasing in value: the more money they have loaned out for people to buy their homes, the more money they make in interest payments, month after month, year after year.
net sellers
There is one group of private individuals who genuinely lose out in a falling real estate market, or who generally gain in a rising one. This is the relatively very small group of people who already own more property than they want to keep - property which they acquired before the market inflates. Some real estate investors are in this category (although a lot of real estate investors do more to pay the bank CEOs' bonuses than they do to increase their own wealth - interest-only loans are a good example: these bet more than 100% on the hope that the real estate prices will go up for the investor to make any money, but the bank will turn a tidy profit regardless). Some empty-nesters and retirees are also in this category, selling the big family home to move into something smaller... although due to demographics, often the demand for the "something smaller" where they want to buy it is high enough that they don't get much change from the big family home, in which case see comments about "like for like" sellers, above. A very few people have real money to make by selling out of some of their current stock of real estate, and there's no question that these people will be better off if real estate prices are high.
But I'm betting you, dear reader, are not one of them.
Common misconceptions about house prices
when property I own increases in value, I have more equity that I can use to generate wealth
This is one of the better pieces of marketing achieved by the banks in recent years, and essentially the story goes like this. We, the bank, will loan you extra money based on the increased value of your house (see! your increasing wealth is real!). You should then go and invest it to make even more money. Isn't that brilliant?
Except, of course, if investing it to make more money than the interest they'll charge you were that easy, the banks would just go and do it themselves. It is possible to outperform the interest you pay to the bank by investing elsewhere, but in general that's only possible by accepting a greater risk. It's possible you're a professional stock trader, or have some other way to generate strong earnings from borrowed capital... but if not, you're probably not going to out-earn the interest you'll pay in the long term, or at least not by much.
One person I know (who is utterly convinced of the reality of his increased wealth from the increased value of his home) had this comment when I discussed the above with him in mid-2009, specifically with regard to making more money from investments than paid in interest: "yes, I could... well, until this year". To which I say, "exactly".
if my house is worth less than I borrowed to pay for it, then I'm in financial trouble
This is, in layman's terms, complete bollocks. Let's say I take out a $250,000 loan, which I have determined I can afford, to buy a $275,000 house. I buy that house, and move into it. The next day, the real estate market crashes, and my house is now "worth" $150,000. Provided I can continue to make payments on the loan, I keep my house. The fact that it has decreased in nominal value does not make the house worth any less: it's not like someone has come in to my house and cordoned off the bathroom and half of the kitchen. I still have all of my house, and I still have the loan to pay off. And for all the reasons discussed above, even if I later sell the house to buy another, the fall in the real estate market has not hurt me one bit. You could say I'm worse off than if I bought the house a month later, but that is nonsense: this is like saying I'm worse off if I fail to win the lotto. I am worse off than plenty of imaginary scenarios, but they're all imaginary, and none of them happened. What did happen is that I bought a house and now live in it, and have to pay off a loan to continue to own the house.
The only way that the fall in nominal value of the house has any significance is if you cannot afford the loan. But in that case, you're in financial trouble anyway. If the house is worth more or less than what you paid for it, when the bank repossesses and sells it because you've defaulted on the loan, you're either out of the house with no money and bankrupt, out of the house with no money but not technically bankrupt, or out of the house with some money but not remotely enough to give you any chance of getting back into the housing market... because of course, the only reason you'd have some money left over is if the housing market went up a lot in the mean time, in which case the money you've now got doesn't make a dent against the decrease in affordability of the market overall.
real estate values double every seven years, so it's a great investment
Looking at long-term history rather than short term history, this simply isn't true: people will always pay pretty much all they can afford to live in the best dwelling they can afford. That premise has one pretty solid conclusion: house prices will, in the very long run, be proportional to income and inflation in general. Recently (by which I mean the past 50-100 years, but moreso in just the past couple of decades), house prices have broken away from that relationship, because we're living in inflationary times, and changes in the availability of housing finance have allowed for house prices to take off all on their own. We're now in a situation where the median house in Sydney or Melbourne costs more than nine times the median annual household income. This is absurd. Here's a simple set of calculations showing why it's absurd:
Let's say Dr & Mr Median buy the house at number 1 Median St, Medianville. To keep the numbers simple, let's say the median household income is $100,000, that median house costs $900,000, and interest is 7%. Interest alone costs $63,000 per year. Pay off the principal over 30 years, and you're adding another $30,000 per year in repayments. That's $93,000 per year out of a $100,000 income. Never mind about tax, living expenses, incidentals, etc.
Buying property can be a good investment, because it is enforced saving: you cannot choose not to keep investing, because you've made a commitment and you can't pick and choose which bits of the commitment to keep - it's all or nothing. This is unlike almost any other form of saving: you can always decide not to buy more investment shares this month and spend the money on a holiday instead... but it's very hard to do that with a property loan. But for anyone with the means and self-discipline to invest regularly, there is nothing magical about real estate.
It is true that in recent years, house prices have gone up quickly, and if you were lucky enough to own something before they went up, you might win big. However, the fact that they have recently gone up extremely rapidly does not provide either any guarantee, nor any justification that they should continue to do so, any more than the rapid gains observed in shares in the 90s provided a guarantee of continued skyrocketing growth.
A lot of pundits have been quick to proclaim "this time it's different". Back when the dot com bubble was in full swing, plenty of experts were also happy to say "this time it's different". How much do you want to bet that the real estate pundits are right this time? Would you bet your house on it?