To Buy or Not to Buy...A Home

Story first appeared in The Wall Street Journal.

It's been a scary few years for the housing market. But at some point, the nightmare has to end (please?). Is now the time? Should first-time home buyers consider jumping into the market?

After all, home prices have fallen 34% from their 2006 peak and mortgage rates are hovering at or near record lows.

On one side are those who argue that homes are more affordable than they have been in decades, based on how much monthly income a mortgage consumes and whether owning is less costly than renting.

An uptick in home buying by investors already is under way, they say—an indication that those who wait may miss out on a good buying opportunity.

On the other side, pessimists insist that the housing slump is far from over, and that prices will continue falling—perhaps as much as 20% or more.

Excess inventories, they say, are the problem, and some estimate it could be four years before the market absorbs all of that extra supply.

The chief economist at money-management firm RBC Global Asset Management Inc., says this is a remarkable time to be a first-time home buyer. The president of A. Gary Shilling & Co., an economic consulting firm in Springfield, N.J., says buying now is a terrible idea.

Yes: It's a Rare Opportunity

This could be the best time in a generation to be a first-time home buyer.

Cheery views such as this are out of vogue and easy enough to dismiss as the ravings of a serial optimist. And yet this opinion isn't based on any heroic economic assumptions. To the contrary, it is constructed upon a more curmudgeonly foundation: In my estimation, the stock market probably underestimates Europe's woes, U.S. economic growth may fall short of expectations, and—of greatest relevance—the overall housing market is likely still several years from normality.

Nevertheless, this is still a remarkable time to be a first-time home buyer. Affordability is the best it has been in 30 years, thanks to the combination of a 34% decline in prices since the 2006 peak and a historically low 4% average rate for a 30-year, fixed-rate mortgage.

The two affordability metrics that truly matter are how much monthly income a mortgage consumes, and whether this is less costly than renting. On the first count, I calculate that home prices are now an astonishing one-third cheaper than the historical norm. On the second, real-estate website Trulia figures that buying is cheaper than renting in 98 out of America's 100 major markets. That is practically a clean sweep.

Rock-Bottom Rates
Investors get this. While households dither, investors ramped up their home buying by 64% across 2011. They understand that this is the mother of all buyer's markets, and won't last forever. The prospect of making a profit by flipping these properties is still rather distant, so they lay in wait for an eventual rebound and in the meantime make money by renting out their properties for more than the monthly mortgage payment.

Yet most people are sitting on their hands, frozen not by the fundamentals but by psychology. For those able to overcome their phobias, a blazing contrarian opportunity exists.

Here's a dirty little secret about recessions: They aren't bad for everyone. They can even be downright beneficial if played right. Roughly one in 30 Americans is unemployed as a result of the financial crisis. The rest have sidestepped this blow, and what's more have been given the gift of extraordinarily low interest rates.

The long arc of history reveals no other sustained period of real interest rates this low. It is mind-bending that American home buyers can now borrow for 30 years at a cheaper rate than either General Electric Co. or the Australian government. And unlike their counterparts in most other countries, Americans can lock in today's borrowing costs for the full life of their mortgage, enjoying perfect certainty about future payments.

The finances of most households have had a rough go over the past several years. Many were ravaged by financial markets. Others are trapped beneath an illiquid and possibly underwater home.

However, the situation for first-time home buyers is different. They largely skated through the past few years. They weren't yet in the housing market, and so escaped that devastating hit. And with an average age of 30, they hadn't yet accumulated sufficient assets to truly suffer when markets fell.

A significant part of this cohort's savings has been generated in just the past five years, and while markets have been enormously volatile over that period, a monthly savings plan would have generated a 26% return in equities and 22% in bonds. First-time home buyers may not be so hard up for their down payment after all.

Heck of a Deal

But is it wise to take the plunge in this era of economic uncertainty? While the economy remains very fragile, it has become less so since the fall. Still, say the worst happens—you buy a home and then immediately lose your job: The foreclosure backlog provides breathing room, and there is ample evidence that the newly unemployed are regarded preferentially by employers over the poor souls in long-term unemployment purgatory.

Could home prices fall further? Yes they could. The home-inventory overhang is still quite large and credit availability remains poor. Home prices are unlikely to bloom in earnest for quite some time. But inventories are finally shrinking and mortgage availability has at least stabilized, and if you wind up buying a house on sale for one-third off its fair value instead of discounted by 40%, you still got one heck of a deal.

Arguably, the bigger risk is rising interest rates, which could erode affordability and snuff out this buying opportunity.

What if you are presently unemployed, or a grim-faced banker has rejected your mortgage application? Alas, your decision has been made for you. But for viable first-time home buyers—those with a stable job and a preapproved mortgage—this opportunity is ripe for the picking. Investors are already eating your lunch.

No: The Fall Isn't Over

Don't buy your first house now unless you're willing to lose 20% of its market value in the next several years. Maybe more.

It will take a 22% drop to return median single-family house prices to the trend identified by Yale University that stretches back to the 1890s and prevailed until the housing bubble began. (It adjusts for inflation and the tendency of houses to get bigger over time.) And corrections usually overshoot on the downside just as bubbles do on the upside.

The problem is excess inventories. They are the mortal enemy of prices, and experts have calculated an excess of two million housing units, over and above normal working levels of inventories of new and existing homes. That is huge, considering that before the housing market collapsed, about 1.5 million new homes were being built annually, a figure that shrank to 568,000 in February. At current rates of housing starts and household formation, it will take four years to work off the excess inventory, plenty of time for those surplus houses to drag down prices.

Excess inventories, of course, were spawned by the earlier housing boom, which was driven by a host of factors—including low interest rates, almost nonexistent lending standards and government attempts to put even those who couldn't afford chicken coops into four-bedroom houses. But most of all, the housing bubble was driven by the conviction that home prices never fall—they hadn't on a nationwide basis since the 1930s—so any bad purchase would eventually be reversed.

As such, the homeownership rate expanded to 69.3% by late 2004, from the earlier norm of 64%. But now, homeownership has retreated to 66% as foreclosures mount, lending standards stay tight and many worry about their jobs and/or the responsibilities of homeownership. Everyone knows that house prices can and do fall.

Pushing Up Inventories

The optimists will tell you that home inventories have stabilized, but their thinking is flawed.

Our estimate of two million excess homes takes into account those on the market as well as hidden inventories, such as foreclosed homes not yet listed for sale and those withdrawn from the market because owners couldn't stomach the bids they received. A U.S. Census Bureau category that measures such hidden inventories has leapt by one million units since 2006.

Additionally, our inventory estimate doesn't even include future foreclosures, some five million of which are waiting in the wings. The 49% drop in new foreclosures since the second quarter of 2009 is a mirage, and was partly due to the Obama administration pressuring mortgage lenders to try to modify troubled mortgages to keep people in their homes. (They were largely unsuccessful.) Then lenders refrained from foreclosing to avoid even more bad PR during the robo-signing flap that highlighted inadequate foreclosure procedures.

Now that mortgage servicers have reached a $25 billion settlement with Washington and state attorneys general, foreclosures are likely to roar back. That likely will trigger the additional price decline, since the National Association of Realtors says foreclosed houses sell at a 19% discount to other listings, and sizable sales of real estate owned by lenders drag down the entire market. The total peak-to-trough decline in single-family house prices then would be more than 50%.

If those foreclosed out of their abodes move to rentals, they're occupying other housing units, so there is no change in overall inventories. But if they double up or move in with their parents—as statistics show they have been doing—even more excess inventory results.

A Disastrous Investment?

Sure, the always optimistic National Association of Realtors tells you that based on mortgage rates, incomes and house prices, single-family houses have never been more affordable. But according to their index, that was also true in December 2008, and prices have fallen 9.2% since then. Ugh! Home prices may have dropped 34% since the peak in early 2006, but that doesn't make them cheap if prices continue to decline.

Many have realized that an abode and a great investment are no longer combined in a single-family house. Instead of straining to buy a house, young families should rent until their kids are old enough to really need a single-family home.

Yes, apartment rental rates are rising and vacancies are falling, but by past standards, house prices remain high relative to rents. But even if homeownership was cheaper than renting, as some claim, buying a house now would be a disastrous investment if prices fall another 20% or more.

The homeownership dream of an appreciating asset and huge ATM has been replaced by the nightmare of a liability that is expensive to own and falling in value. Act accordingly.

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