Monday, February 7, 2011

Irrational Exuberance to Irrational Pessimism

I was going to go to a few stores to gather some $ per gram food stats to add to my continuing tables but went house hunting with my wife this weekend. Since about 2006 my view of houses has been that I don't want to buy one and that taking on the debt wouldn't be worth it. I use all of my ready available cash at higher edge anyway so it never really made much sense for me to buy. In addition I had read Robert Shiller's excellent book Irrational Exuberance in 2006 and agreed very much with his views(that basically the housing market was overpriced). This was rather funny at the time because my wife worked for Barret Homes(a huge property developer)in London. I remember her telling me about their model for purchasing land(which was made for them by Pricewaterhouse Cooper). When she described most of the assumptions I laughed because I believed it failed to capture the crux of the home builder’s dilemma, which is that at some point you're going to build too many houses. They moved into the FTSE100 that year as Britain's biggest home builder. Later of course when the bubble burst they nearly went bankrupt.

So when my wife decided to start looking for houses this year I always found myself playing the skeptic to her "I want a nice house with a garden for our daughter to play in" enthusiasm. So I went along and expected very much to play the skeptic again. Surprisingly this is not what ended up happening. The houses that I looked at seem undervalued and in some cases even the monthly payments seemed to offer a very large edge. Of course my wife ended up being pessimistic about all of them because they weren't ideal but I was seeing something different and something in my head switched. When I came back to our apartment I was the optimist and she the pessimist. I even started crunching the numbers. It helped to my form my new view that individual houses if evaluated correctly can be great buys right now, especially if you can get a short sale/foreclosure from a bank. Certain niche houses within the overall market are in recovery. They are those that capture the shifting dynamics between a very old choice which has additional factors that you can read about in a recent Star Tribune article about the local rental market here. So without further adieu her is my take:

Rent or Buy the home buyers dilemma

                 P     EMP MOP FF RHC VORH % Edge

House 1 86700 656   360  100 1300  544    196.43%
              99700 710   360  100 1300  490   176.93%

House 2 154900 998 360   70   1350  282     65.54%
              128000 998 360   70   1350  282     79.31%

House 3 240000 1512 360  70   1000 -582    -87.30%

House 4 398000 2735 360 140 2013  -862    -77.97%

P = Price
Expected Monthly payment(via a mortgage calculator)
Months of Payment = 360 for a 30 year mortgage
Fudge Factor(inc Electric/heat/association fees etc)-extra expenses above current expenses
Replace housing cost(i.e. Rent)- How much is it to rent a similar place which brings us to
Value Over Replacement Housing(VORH) = Rental price-Mortgage payment
% Edge = (VORH*360) / Price

                TG       YV     TSVBP   CRPD CD   T $/gal to NE EEW

House 1 663840 22128  88094.92   50     20     13.6             2027
              644400 21480
House 2 587520 19584 136869.64  50     20      7.05             2019
              587520 19584 113100.8    50     20      7.05

House 3 150480 5016    212064     50      20       N/A             N/A

House 4 414360 13812   351672.8  50     20        N/A             N/A

Total Gain(TG)= Monthly Edge +Savings Value

yearly value(YV)- Total gain/30

Turnaround Sell Value Breakeven Point(YSVBP)- price you'd have to get it for to buy it and turnaround and sell it for the list price to breakeven Price*.94*.94(seller’s commission)

Commute range per day- distance to metro area

Commuting Days/month = 20

Transport $/gal to negate edge= what would gas prices have to be for it to more profitable for tenants to live in a closer commuter town?

expect edge window-gas prices were half their current price 8 years ago so I expect them to double in another 8 years(this is probably the worst part of the model)

So how does this explain why my views have shifted?

House 1 and 2 we both toured this weekend

House 3 I lived in 3 years ago

House 4 was a higher priced home currently on the market I used to illustrate that there is not a full recovery.

So the numbers tell me that Houses 1 and 2 are offering not only saving advantages(as houses have always done) but are offering monthly cost savings. Needless to say I presented this all to my wife and pushed hard for house 1 but alas our closing date appears too far out for the bank to accept. We may take a shot at house 2 or wait for something better. In this market who knows. Hopefully there will be some more and I can use my model again to evaluate.

I think it was warren buffet who said it best "The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."

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