April and Adam Nichols are suffering from sticker shock. The newlywed New Yorkers would love to get out of their cramped one-bedroom rental in Manhattan, which costs them $2,325 a month, and buy a starter condo. But everything theyâve seen in their under-$500,000 price range is horrible. One place they looked at in Hoboken, New Jersey, was a fifth-floor walk-up with a view of an ugly brick wall. Another in the Bronx was in a run-down building populated by folks fifty years their senior. And as for buying in pricey Manhattan itselfâwell, unless youâre Donald Trump himself, fuggedaboudit.
So what are the Nicholses planning to do? For now, nothing. âItâs hard to throw money away on rent, but weâre going to be patient,â says Ms. Nichols. âPrices are bound to come down.â
Itâs hard to sit on the sidelines when every day, the news profiles hairdressers, truck drivers, and schoolteachers making thousands flipping properties. And itâs harder still when the air-waves are crammed with home-fix-up shows, and when bookstores are filled with books on how to make millions as a real estate investor.
But to every thing there is a time and a season, and thatâs as true for home buying as it is for everything else. The people who win big in the real estate game are the ones with the courage to sit out the manias as markets reach their peaks and buy during the busts. As Shakespeare wrote: âRipeness is all.â
The trick is to be contrarian and recognize where you are in the real estate cycle. When Doug Duncan, chief economist for the Mortgage Bankers Association, moved to Washington, D.C., in 1988, the local real estate market was sizzling and buyers got caught up in bidding wars at open houses. He decided to rent. Soon, the market took a nosedive. Five years later, he decided it would be a good time to buy. He paid about a third less than the previous owner, whoâd lost his home in a foreclosure. âYou have to use caution,â he says. (Weâll show you how in Chapter 6.)
Understandably, not many real estate brokers share this opinion. An ad sent to clients by agents of the New York brokerage Prudential Douglas Elliman pushes ownership hard, even in todayâs hair-raising market. It points out that real estate prices, unlike stocks, adjust slowly, and that predictions that the New York market would crash after 9/11 didnât come to pass. It also tells first-time home buyers that they have to âget in the elevator to ride to the penthouse,â and asks: âWhy do you work so hard? To live in a crummy rental for the rest of your life waiting for a bargain to emerge?â
But the real worry today isnât that youâll be stuck in a rental for the rest of your life, but that youâll buy at the peak and be stuck in the property for an entire real estate cycle, which can last for years, waiting for prices to recover. To come out ahead as investors, we need to buy low and sell high, but this gets forgotten in the emotions of buying a home.
So how often do busts occur? The Federal Deposit Insurance Corporation (FDIC) has identified 21 cities that experienced a housing bust over the last quarter-century. In the mid-1980s, the victims were cities in Texas, Louisiana, Oklahoma, and other places that depended on oil prices. In the early â90s, cities in the Northeast and California, which had experienced big, unsustainable home price run-ups, were hit. Scattered throughout the country were other places that experienced price declines when they lost major employers or became overbuilt. After too many developers invaded Honolulu, for instance, the city had six straight years of price declines, ending in 2001.
Although the FDIC notes that booms donât always end in bustsâoften, there is simply a period of price stagnationâthe agency adds that the number of boom cities increased by 72%, to 55, in 2004, mostly near the coasts. More than half of these places had never experienced a boom before.
How genuine is the danger of price declines today? Some economists like David Lereah, chief economist for the National Association of Realtors, argue that weâre not in danger at all, because current long-term fundamentals are sound. In his recent book Are You Missing the Real Estate Boom?, Mr. Lereah points to a number of factors that he thinks will keep the boom propped up indefinitely, including healthy job growth, tight supply, and continued demand by retirees, foreigners, Baby Boomers, and their children. He predicts prices will rise 9% this year nationwide, with even greater gains in markets on the coasts. âThis real estate boom has wings,â he writes.
But though nominal prices havenât fallen since the 1930s, real home prices have tumbled from time to time, typically after a big run-up like weâre seeing today. In the early â80s, real home prices fell 10%. It would take a sharp and unlikely contraction of the economy to repeat that scenarioâa doubling of current mortgage rates and a halving of home salesâbut if oil prices remain high, such a contraction is possible, according to Lawrence Yun, a forecast economist also with the National Association of Realtors.
After all, oil prices affect everything from how many workers a company hires to how much consumers pay at the pump. Given that the United States currently holds less than 2% of the worldâs oil reserves, and is faced with diminishing supply in places like Prudhoe Bay, itâs likely that weâll have to ramp up imports. Analysts expect prices, which recently touched $60 a barrel, to remain high by historical standards over the next year or two.
Other factors are troubling, too. Americans are deeper in debt than ever before, many from risky interest-only and negative amortization loans they took out to take part in an all-night real estate party, which weâll discuss more in Chapter 2.
And the same herd mentality that has influenced manicurists to try to become real estate moguls could also swing the other way. One big bump-up in interest rates, coupled with a few local downturns, is all it would take to create a stampede for the exits. The effect could be devastating and widespread. In 2000, when the stock market fell, a third of the accumulated stock wealth was in the hands of 1% of investors. Today, the top 1% of home-equity holders control only 13% of the nationâs housing wealth. When the housing market turnsâand it always does, eventuallyâthe manicurists and the moguls are going down together.
A TIME TO BUY, A TIME TO RENT
What should you do in these uncertain times, buy or rent? Thereâs no one-size-fits-all answer, since it all depends on where you live, your income, your stage of life, and how often you plan to move. Generally speaking, people tend to rent when their income is the lowest, when theyâre young and old, and to own in-between. However, thatâs not always the case, especially today, when some young people are forgoing pricey cars and weddings to make down payments, some older people are opting to suck the equity out of their paid-off homes through reverse-equity mortgages, and some mid-career couples are renting in luxury condos in the city rather than buying a McMansion in the âburbs.
A number of Web-based calculators can help you decide whether itâs best to rent or own using data such as your salary, the cost of the home, the interest rate and term of the loan, and other factors. But bear in mind that many of these calculators are being offered by lenders who have a vested interest in your buying a home. One of the best calculators on housing affordability from a neutral source is on the Web site of Jack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania. He also has other excellent calculators to help you determine the best ways to handle other mortgage scenarios, like comparing loans and fees, refinancing, consolidating debt, making extra payments to principal, terminating mortgage insurance, and figuring out the best loan terms. His Web site is www.mtgprofessor.com.
Letâs look at the cases for owning and buying, so you can decide what best fits your current circumstances.
The Case for Owning
Uncle Sam wants you to own a houseâbadly. And heâs willing to give you all sorts of incentives to convince you to do it. According to the Office of Management and Budget, homeowners currently get $76 billion annually through the mortgage interest deduction on their federal income tax returns and $14.8 billion through deductions for state and local property taxes. The agency says that mortgage interest deduction also saves owners an additional $29.7 billion on taxes on income that otherwise would be paid as rent.
Whatâs more, if you sell your house after living in it for two out of the last five years, you get a tax-free gain: $250,000 for an individual, and $500,000 for a couple.
Because itâs seen as a way to encourage responsibility and invigorate communities, homeownership is one of the few issues that truly enjoys bipartisan support. President Clinton introduced an initiative to increase the level of homeownership a decade ago; President Bush says he wants to create an âownership society.â
Under both administrations, the idea of renting has been given short shrift, even with populations that typically have rented, such as those with low incomes and shaky credit. âTheyâre getting the message that theyâre losers if they donât buy,â says Arlington, Virginia, housing economist John Tuccillo.
The Department of Housing and Urban Development currently gives home-buying help to low-income households through the American Dream Down Payment Fund, Self-Help Homeownership Opportunities Program, Section 8 Homeownership Vouchers, and the Section 32 Public Housing Homeownership option. HUD and the Neighborhood Reinvestment Corporation also counsel renters who have the potential to become home buyers and encourage them to buy.
Uncle Samâs push toward home ownership has had its intended effect. Over the past decade, 10 million new households bought homes; now seven out of 10 American households live under their own roofs. Thatâs certainly helped increase the average familyâs net worth at a time of stagnant wages and a lackluster stock market. Since the boom began in 1996, homeowners nationwide have amassed over $5.2 trillion in home equity.
More money means more choices, of course. Homeowners can take out their equity and use it for any purpose whatsoever, from paying for their kidsâ college education to subsidizing their Harley-Davidson habit.
Ownership also banishes many worries renters face about whether the landlord will raise the rent, withhold the security deposit, sell to Landlordzilla, or turn the building condo.
Plus, the politically sanctioned push toward homeownership, coupled with low interest rates and easy money from lenders, has caused builders to flock to for-sale housing and neglect the rental market. The supply of rental apartments is declining, as some are demolished due to age, and others are converted into condos. Construction of new rental housing fell to a 10-year low in 2004, as multifamily builders turned in droves to more lucrative condos.
Although rents are currently a bargain in some of the hottest housing markets (see âThe Case for Renting,â below), as supply tightens, that may soon change. Itâs happening already in some sizzling markets like south Florida, where condos are sprouting like kudzu, but long-term rentals are becoming as rare as jungle orchids.
In 2004, rents rose 4.2% after three years of stagnant growth of only 1% annually, according to Deerfield Beach, Florida, housing consultant Jack McCabe. Occupancy rates in Palm Beach County rose to 92% from 86.6% three years ago. Just a few years ago, a tenant could get concessions ranging from free rent to signing bonuses, but if you ask for them now âagents just laugh at you,â Mr. McCabe says.
The Case for Renting
For those who already own a home, have built up equity, and live in the nationâs hottest and most precarious housing markets, now may be a very good time to rent.
With price increases reaching the double digits in many metro markets, housing has become increasingly unaffordable. The National Association of Realtorsâ Housing Affordability Index was 132.6 in 2004, down from 138.4 the year before. By the second quarter of 2005, it had declined to 120.8.
In some markets, the flight to homeownership, spurred by low interest rates, has left units vacant, forcing landlords to make deals. In Atlanta, for instance, itâs common to see giveaways of a monthâs rent. In Chicago, you can get two monthsâ free rent and a $500 signing credit.
Overall, according to the National Association of Home Buildersâ Multifamily Market Outlook, the real rent index, adjusted for inflation, declined for the first four months of 2005 to 107.2, the lowest itâs been since February 2003.
And in some of the most expensive for-sale markets in the country, rents have been falling even longer. Rents in San Francisco, for example, have fallen 19% since 2001, to $1,300. For that monthly rent, you currently can get a one-bedroom apartment on toney Nob Hill, with hardwood floors, a built-in china cabinet, and a courtyard with gazebo and built-in barbecue grill. Meanwhile, buying a similar place costs about $530,000, or about $2,366 a month at a 5.34% interest rateâand thatâs assuming you put down $106,000, or 20% of the purchase price.
Renting to Buy, Buying to Rent: Alyson Dutchâs Story
A decade ago, Alyson Dutch, a public relations professional, moved to Malibu, California, to escape the pain of a divorce. She lived in a cramped place near the beach with her dog and cat until she spotted a charming compound of three homes under a canopy of ancient oaks. The three-bedroom main house was the residence of a former professional ballet dancer and his family; the apartment over the garage served as the ownerâs office; the one-bedroom guesthouse was for rent for the then-steep price of $2,000 a month. Ms. Dutch negotiated the rent down to $1,750, âupped my clients fees a bit, held my breath, and moved in.â
What Ms. Dutch really wanted to do, however, was to buy the entire compound. And it turned out, the owner wanted to sell. But the $1 million price tag seemed hopelessly out of the reach for Ms. Dutch, at that cash-poor point in her life.
But bad timing can be overcome with a little ingenuity and seller help. The owner offered to give Ms. Dutch a note for 25% of the purchase price, at rates slightly higher than what a bank would charge, to use as a down payment. She financed the rest of the loan conventionally.
Ms. Dutch quickly found a renter for the main house. With the fresh cash flow, within two years she was able to refinance the property at a more favorable rate and pay off the ownerâs note.
Although her financial life is now in order, Ms. Dutch still lives in the guesthouse, uses the office over the garage, and rents out the main house. âThe tenantâs rent pays my entire mortgage and my taxes,â she says, âso basically I live here for free.â
Despite its apple-pie image, homeownership has other drawbacks, too. Because renters typically pay less, they have more money to put in the stock market, businesses, and other investments, which helps not only them, but the economy as a whole. Renters also have flexibility, and can move without incurring heavy settlement costs, which typically run between 2% and 6% of the purchase price of a home.
By contrast, upscale owners in rising markets sometimes feel trapped in their homes by market forces. In Los Angeles, real estate broker Anthony Marguleas says that high prop...