Why buying at the peak was a brilliant move

If you bought a house in L.A. in the summer of 2007, paid peak prices and have watched your home's value drop by 33%, you have to admit: You made a really bad financial move, right?

Er, wrong, according to a contrarian opinion piece in today's L.A. Times that argues that buying L.A. real estate in 2007 -- even at peak prices -- was "a smart investment."

The author, and proud peak buyer, is Chris Ayres, who lives in L.A. and writes for the Times of London. He argues, "Those of us who purchased nonspeculative property from 2004 to 2007 for the gratuitously self-indulgent purposes of raising a family and investing in our neighborhoods will ultimately have the last laugh."  The words "cheeky Brit" do come to mind.

Ayres' logic: Peak buyers got easy financing on good terms. Interest rates were low. Inflation -- possibly a bigger factor in coming years than in the recent past -- means the value of of his home in dollars will someday rise, while his loan payments will become relatively cheaper.  Perhaps the biggest advantage, he argues, is "the glorious all-American instutition that is the home mortgage interest tax deduction." 

His back-of-the-envelope math on savings from the peak purchase of a $1.2 million home (not necessarily his home, just an example Ayres chose):
--$20,000 per year in income tax savings, for $200,000 over the next 10 years.
--Another $200,000 over 10 years by getting a lower interest rate on his bubble-era loan.
--Another $700,000 in savings and equity that 5% annual inflation will ultimately add to the value of his home and increasing affordability of his mortgage.

He concludes: "The penalty for having bought at the height of the worst real estate bubble in history adds up to a potential $1.1 million gain."

My two cents: He's trying to have it both ways on rising interest rates and future appreciation. If interest rates do settle two points higher than they were last summer, as Ayres argues, home prices will take an even bigger hit, and his home will not increase as much in value -- regardless of what inflation does.

Off topic but tangentially related: Ayres is a journalist, a trade with a glorious history and a questionable future income stream. Salaries for journalists are not likely to keep pace with inflation over the next 10 years. If you haven't noticed, free content is putting downward pressure on the cost of paid content. An era of 5% inflation will not be kind to journalists.

--Peter Viles
Your thoughts? Comments?
Photo Credit: Home of the Week from this week's L.A. Times, by Charmaine David.

Comments

[sandiegan]

Ayres writes:

"the glorious all-American instutition that is the home mortgage interest tax deduction."
--------------

True. True.
But he misses one of the biggest advantages to owning in CA--Prop 13.

Love it or hate it, Prop 13 is probably the greatest middle-class tax relief legislation in the history of the world--over the long term.

Just the ability to accurately forecast your maximum property tax burden far into the future, even if that burden was at a higher rate than Prop 13's 2% per year, is probably worth an extra 10-20% on the purchase price for those planning to own for the long haul.

Just ask any of the geezers in Santa Monica that have lived there since 1959 and are paying $900/yr in property taxes.

[mspromt]

Mr. Ayers is probably in love with his new house and his mind is likely at ease knowing that he and his family are properly nested. But from an objective standpoint, he could have saved a lot of money had he waited to buy: less money down, less in taxes, lower monthly, etc. And while I'm no math whiz it sure seems like the smarter financial move is to buy low even if higher rates prevail. For instance:

A million dollar home, $200K down at 5.5 percent is $5,583 per month. The prop tax on that is $12.5K

OR, the numbers if you waited to buy after the 30 percent drop in value and rates (presumably) go up 2 points:

That million-dollar home is now $700K, the down becomes $140K, the rate is 7.5 percent and the monthly is only $4,703. The prop tax is only $9,450.

That's a savings the first year alone of $155K. Add that to the 10-year profit projections of homeownership and it seems like at the end of that period, even with higher rates (which might be refinanced to a lower rate at some future point) you'd be further ahead than if you bought high.

IMHO, the inflation argument doesn't work, at least not in the near term. Housing is falling faster than inflation is rising so during this margin of shift , the buyer who waits wins. Plus, if the dollar continues to fall or holds its own, interest rates won't keep going up. The Fed is busy keeping Wall Street happy so they are unlikely to raise rates. Also, what about the 1.25 percent property tax Mr. Ayers is paying on that inflated price tag? That won't ever go down.

Lastly, if Mr. Ayers needed to buy at the highest point of the largest bubble in the history of the world because his biological clock was telling him to, fine, but I really don't think that justifies his smug crack about gratuitous self-indulgence. Rather, that sarcastic comment makes him sound defensive. I'm sure he is happy with his purchase and can afford the luxury of buying what and when he wanted. But his example is probably an exception. For most of us, I think it would be a dumb move to buy high.

[Lancho Fieri]

A journalist buys a whopping 1.2 million dollar home? And now in complete denial about losing his shirt? Seems like there is another BIG source of income and financial resources at play here. I'm glad Lord Ayres knows how to ignore reality because he's not gonna get much sympathy when he sells at a loss.

[gman]

How can anyone who's worked that hard to post-hoc justify their overspending be wrong? :o)

Under current conditions he's consoled himself with a fine balance of issues that can change pretty quickly. He's essentially made himself very vulnerable to changes in those assumptions. He's also vulnerable to any change in his circumstances. Job move, illness, etc.

With respect to inflation, I think you have it right. His wages have to keep up for it to make sense. That's not a likely scenario. As people in the late 70's and early 80's if they felt like their wages kept up with inflation. Also, the commodities market is taking a dive so the inflation spike is probably not sustainable on a year-to-year basis. Further, inflation often leads to deep economic downturns. He's at risk of losing his job in an already unstable industry.

As far as all those tax deductions go, those can change and the AMT can creep up to bite you. You need to analyze any AMT effects. There are a lot of new changes in the current housing bill. Further, if Obama gets elected, million dollar homeowners will be the first to see their deductions cut in some manner. I saw no consideration of those risks.

Rent increases have been fairly modest lately. In fact, I live in OC and the rents have been going down because of the buildup of inventory that's unoccupied. I think the assessment that rent is going up is not a good one. Plus, if things get bad you can always switch to a less-expensive place. Sacrifice a bedroom and save 30% a month. In a long-term mortgage, you're stuck with the same payment.

As far as the tight credit conditions, those aren't going to last but a few years. If they continue, his value will continue falling. If they don't, people will get the same mortgage but on a house 30% cheaper. I'd always rather borrow less money at a higher percent than more at a lower percent. There's the chance of refinancing later and you can more easily pay down the principal.

Finally, renters can take the extra savings per month and invest it in the down stock market. Even at mid single-digit return rates, you'll find that excess cash far outstrips the increase in rents.

Overall, I suppose if he stays there fore 30 years and pays his loan off, he'll be fine. But, I would hardly regard the current trend as a fortunate circumstance.

So, I say, keep patting yourself on the back. After you lose your shirt, the direct skin-to-skin contact will be even more reassuring.

[gman]

Oh, and I forgot that his maintenance and fees will just go up with inflation. Anyone who's owned a home remembers the shock of landscaping costs, fixed roofs, replaced water heaters, repairmen, etc. Stuff you don't pay for when renting. Utility costs are often lower also since people tend to rent smaller places than they buy.

[Dan]

With accounting like that, if journalism is no longer a viable career, he has a bright future in movie finance.

[LA-renter]

Mr. Ayres' editorial was an entertaining read at breakfast.

I loved Ayers' description of Peter Hong's "How we cashed in before the crash": "...set a new standard for the sheer quantity of smugness that can be contained within a mere 2,000 words." (Spoken, or written, like a real Brit.)

Ayers then gives us a PH impersonation of a bubble buyer.

I'm still unsure whether Ayers is being serious: "I have regrets. Like wishing I'd borrowed more money..."

As Peter wrote, his math and logic seems to be faulty. For example, he says that inflation will decrease his million dollar loan to ONLY $600,000 over the decades. Isn't he ignoring the interest paid on that principle? The loan principle is one million but Ayers' payment is significantly more than that. Otherwise, why would anyone loan money?

Why do people feel compelled to convince others that they're smarter than thy neighbor. I could care less. Housing is NOT an investment (to make a killing), It's just a necessary expense.

[Brad]

He ranks on other journalists for being smug...a wee bit of the pot/kettle syndrome don'tcha think? And how many journalists are in the 33% tax bracket unless he's married to, like, a lawyer?

Boom-time buyers not yet in default still may be the majority, but they're on the endangered species list. It would be interesting to read a follow-up from this guy once all the toxic Alt-A's and Option ARM's begin to go critical en masse.

And let's hope he has enough left over each month to afford decent private school for his children after "investing" his property taxes in LAUSD...

[Rational Renter]

1. Timing interest rates is less important than timing prices. You can always re-finance to a lower interest rate later. You can't re-finance yourself out of overpaying by $400,000.

2. The Mortgage Interest Tax Deduction is the biggest straw man argument. Even with it, you could always rent for considerably less than buying during the peak of the bubble.

3. Has he thought about how he could have bought one year later (today), when mortgage rates are still pretty low (less than a point higher), and saved a bundle of money? Enough money to put his kids through college?

[Dan]

Seems to be a bit of self-reassurance. If he's happy with it, that's fine, but the reality is that home prices will continue to tumble until 2011. We're a long way from the bottom.

The whole thing about "well I got cheap money" has a slight thread of validity to it, but what happened is that the cheap money fueled an artificial inflation of home prices, which fueled a desire for even cheaper money.

People 3 years from now will be buying homes at much more reasonable prices, with money that is still pretty cheap.

[Pat]

How does a journalist buy a $1,200,000 home? That would indicate at least a $300,000 annual income.

[Laura in L.A.]

My thoughts exactly, Peter!

Chris, honey, that's quite a nut to come up with every month! In these uncertain economic times, good luck with that.

[Ed Sanders]

Unless there is significantly more to Ayers piece, he is obviously too stupid to be trusted with any real financial responsibility. Did he bother to do the "opportunity cost" part of the calculation regarding what he spent on purchasing relative to renting? Did he bother to look at the cost/expense ratio of a similar home purchase a year later? If he doesn't have something to compare his "gain" against, how does he know he has any gain at all? I would also guess that the back of his envelope didn't have room for recalculating those numbers for a $900K house. in 08. Let's not even talk about what he is spending on maintenance and upkeep.

I fear for his family.

[Brian]

I have a few problems with Mr. Ayres' reasoning and his math. I'm not sure where he came up with $700,000 in equity gain. He himself calculates that a $1.2 million purchase is currently worth $800,000. In 10 years, assuming his 5% per year inflation, that would put the value at $1.3 million. That's a gain of $100,000, not $700,000. This also assumes that prices have bottomed out, not a likely scenario. He also claims $200,000 in savings from getting a lower rate. but that's not how I calculated. Using his example, a million-dollar mortgage at 6.25%, after 10 years would have resulted in interest payments of $581,000, with a balance remaining on the mortgage of $842,000.

In contrast, the same purchased today, at $800,000, with the same $200,000 down payment, but with an interest rate of 8.25%, would result in the payment of $4500 a month, and after 10 years, total interest of $470,000, and a balance remaining on the mortgage of $529,000.

By my calculations, he would have paid $111,000 more in interest, and owe $313,000 more. Hard to see where he comes up with advantage to over paying at the peak.

And his comparison should be against renting, rather than purchasing at a later date. Using a million-dollar mortgage at a very low 2005 jumbo rate of 6.25%, we come up with a monthly payment of 6157. Housingtracker.net reports that the ratio of mortgage payment for a median priced home in Los Angeles to the equivalent three-bedroom rent is 1.6. That means that the equivalent rent would be $3848 a month. The annual difference between rent and mortgage payment is about $27,000 a year. If you assumed a 7% return on stock invested money, that would give approximately $405,000 at the end of 10 years. Further, if we took the $200,000 down payment, and invested the same way, we would come up with another $390,000. That's $795,000 cash.

That might help tide him over during the coming newspaper downsizings. Perhaps he might use the money to study basic economics.

[formerlahomeowner]

Ayre's argument assumes that the peak-bubble house buyer can mentally handle paying ~$10K per month on a devaluating asset, even if he can afford it. The recent trend shows that people are walking away from their properties even if they can afford the mortgage. Additionally, say "buh-bye" to that $200K. $1.2 million gain in 10 years - welcome to LA LA Land. Wishful thinking at best.

[Rational Renter]

I would also like to know if the author has thought about how long he will have to live in the house before it recovers its full value. I guarantee you he is underestimating it.

I think there is very little chance that we will see 2007 prices again before 2017. Very little. If you bought at the peak of the last bubble, 1991, you couldn't sell for that 1991 price until 1999. That's eight years. And this bubble is more than twice the size as that last one.

[desmo]

You can see why newspapers readership is dropping off a cliff like the value of " Errors" house. A totally useless bunch of BS to try a prop himself up, "look at me everybody I'm smart". lol, I will get satisfaction each month as this guy writes a huge check for nothing.

[GEAH]

"If you haven't noticed, free content is putting downward pressure on the cost of paid content."

Or, it puts upward pressure on the journalist to increase the value of his content.

For example, the reporters at the National Enquirer have done just that with the Edwards story. Equivalent reporters at the LA Times have shown themselves to be hardly worth more than nothing.

[Sitting Out]

thank god for suckers like Ayers

he's gonna let me buy his house for cheap when he loses his job

[Nick]

I would personally be pretty happy with an era of 5% real inflation, actually; that's substantially lower than virtually everyone is expecting, I think. Real inflation just hit 9% as of the last BLS report, and I don't think people are expecting it to decline much over the next 5-10 years, especially with the Fed holding rates low and lacking the fortitude to fight it. I don't agree that buying at the bubble peak was a good move, but the expected double-digit inflation over the next decade or so should soften the blow for homeowners.

PS: If anyone doesn't know the difference between real inflation and the completely bogus CPI numbers, go read www.shadowstats.com and stop being ignorant. Seriously, the more people that refuse to even acknowledge the utter BS CPI and just talk in the real numbers, the sooner everyone will see the CPI for the complete manipulated lie it is. Help the country be less ignorant, use the real numbers.

[Chuck]

Mr. Ayres asks: "...if you ever meet someone who brags about having gotten out when times were good, ask them what inflation's doing to their rent, how much tax they're saving on that home-office deduction (a few hundred bucks, woo-hoo!) and, more important, where they parked all that filthy boom-time lucre they made."

Well...
a) Rent remains unchanged.
b) I'm saving quite a bit by paying NO property taxes.
c) I parked the money in Vanguard's Inflation-Protected Securities Fund.

[dan of bubblepedia.net.au]

This is cognitive dissonance at work is it not. I bought a house which was worth 500k on a cash flow basis with a loan for 1200k.

I am a clever guy, I make only good decisions, I wasn't thinking it was a good idea because of the magic capital gains to be made from owning your own home like all those silly heads, I was thinking it was a good idea to loose a million dollars over twenty years because I would save 200k in tax, and I will save 200k in tax, you just watch how clever I am you showoffy rich renters.

Come in spinner.

dan of bubblepedia.net.au

[alvin]

Despite the fact that Chris makes some broad, and as Peter points out, not necessarily congruous assumptions about future inflation, rates and prices, his math makes no sense.

First, he is happy to use inflation to inflate the value of the home to 2018 dollars, and deflate the value of the mortgage to 2008 dollars. Of course these don't match. In 10 years, the mortgage balance (which is interest only in his example) will still be $1mm, and the home will be worth $1.3mm (per his assumptions), so with the $200k down, that leaves a net gain of 100k in 2018 dollars - not the $700k he estimates.

And he is also mixing and matching pre-tax and after-tax numbers. His example "saves" $200k after taxes over 10 years thanks to the tax deduction on the 6% mortgage, and then adds another $200k in savings PRE tax because the mortgage is 2% lower than current rates. But the AFTER tax difference would be less - only about $134k using his numbers.

BUT, if he is gonna use today's rates to compare "savings", shouldn't he use today's home price too? Someone purchasing a home today for $800k with the original $200k down would only need to borrow $600k, which nets to $32k a year AFTER taxes, or $8k LESS per year than if they'd borrowed $1mm at 6%. They would also save thousands a year in property taxes too.

Also the buyer who paid $800k today, again using his assumptions, would have a $500k capital gain in 10 years, $400k more than the buyer who paid $1.2mm.

It's touch to argue that buying at the top was "brilliant", at least when you want to compare it with buying today, or probably even the foreseeable future.

[sterling argument]

Well this explains why the UK has a housing bubble every bit as bloated as hera in the US!
Chris's arithmetic is a little misleading - for example he says the homedebtor would recieve a 20k per year interest deduction for a total of 200k over ten years BUT this is in future dollars - the actual saving in current dollars is much smaller when applying his estimate of 5% CPI inflation.
He also suggests that we will see an average of 5% house price inflation over the next ten years from 2007 prices! This means they would have to more than double from today's prices as they have already declined about 20% from 2007. In simple terms, if house prices were to stop plummeting today they would have to staedily appreciate at 8.2% to accomplish this feat!
As they say in blighty "you're having a laugh mate!"

[Tony]

I must confess he will save a lot of money in the long run... After his ARM explodes in his face, he can easily go a year without making house payments between the NOD and NOT, then he can stall the foreclosure another 3-6 months by declaring bankruptcy at the last minute, then add another 6 months by hiring an attorney to demand a physical title/deed in court, and another year during the confusion if his lender goes under.

Not a bad strategy provided he doesn't care about his credit score.

The only negative is his timing. If he did it a year ago he could have re-fied and vacuumed out some cash to play with.