« on: May 08, 2007, 02:53:28 PM »
Great article until you take a closer look.
-House prices and rents have been closely linked throughout history, with both increasing at the rate of inflation, or about 3% a year since 1900. A house, after all, is an ordinary good. It can't think up ways to drive profits like a company's managers can. Absent artificial boosts to demand, house prices will increase over long periods at the rate of inflation, for a real return of zero-
The author then goes on to list the two reasons for recent artificial boosts
1)Government subsidized housing that relaxed borrowing standards where downpayments are as low as 3%
2)A reduction in the Fed Funds rate and thus an overall reduction in interest rates.
While classifying these as "artificial boosts" maybe somewhat accurate, the author does not address the fact that these factors are likely here to stay i.e that there has been a fundamental change in the mortgage market. The days of a 40% downpayment for a home are over. Imagine what the difference in demand (and thus mkt value returns)would have been if downpayment were always 3% or lower rather than 40% up until the mid 1900's. We can no longer classify these factors as demand-driven artificial factors when in fact they now make up part of the structure of the mortgage market.
Now for the author's example:
-If you have $300,000 and a choice between spending it on a house or shares, you'll pay $6,000 a year in incidentals if you buy the house or about $15,000 a year ($1,250 a month) in rent if you buy the shares. But the shares will return $21,000 a year after inflation while the house will return zero. (My numbers work out even better than these. I pay a smidgen less than $1,250 a month for rent, while house prices in my neighborhood are far higher than $300,000.)
Accurate, yet misleading. The author is leaving out the biggest driver of the returns on real property, LEVERAGE!
Here is a more representative example:
If you want to purchase a $300,000 home you are not going to pay cash, you're going to pay a 3% downpayment of $9,000. You'll pay $6,000 a year in incidentals (per the author's example) plus $2,000 in mortage (24,000 per an) for a total of $30,000 a year. Subtract from this what you WOULD be paying in rent, ($1,250 per month per author) $15,000 per year, and that leaves a $15,000 higher payment for mortgage vs rent. But wait, if we assume a 3% appreciation (see author above) then the house will return $9,000. Remember your initial investment was only $9,000, so rather than a 3% return your actual return is 100% on your invested funds.
Also, we now only have a net annual outlay of 4,000 ($15,000 mortgage/rent differential minus $9,000 return on investment). But wait again, the author assumed we had $300,000 in cash, but we only paid out $9,000 for downpayment, we still have $291,000 that we can invest. We get to own equities AND own a home and provided we stay away from homebuilding stocks we end up with a much more diversified portfolio with comparable returns and a lot less overall risk.