Dispelling Myths About The Real Estate Market

To lay the groundwork for my next prediction, let me first summarize and dispel a few commonly-held misperceptions about home ownership.

Myth #1: Real estate prices never fall.

In fact, housing price busts are extremely common. For some examples, take a look at the graph below, which shows real housing prices in several different states in the US since 1975. (Note: data is from the Office of Federal Housing Enterprise Oversight.) It’s evident that house prices can fall as well as rise, despite the overall upward trend.

To provide a broader picture of house price busts, the IMF published a couple of papers about asset price bubbles and crashes last April (available here). They studied 52 stock market busts and 20 housing market busts that have happened in the last 30 years. Among the numerous interesting points they made were:

  • Whereas only about 25% of stock market booms are followed by busts, about 40% of housing booms are followed by busts.
  • On average, when there is a bust in the housing market, real prices fall by an average of about 30%.
  • The bigger the price boom in the period leading up to the peak, the bigger the fall in prices after the peak.

Myth #2: Owning is always preferable to renting, because at least you build up some equity with your monthly payments.

While it is true that you build up equity when you own a home, there are other factors to consider.

  • During the first 5 years of the typical mortgage with 10% down, about 85% of your mortgage payments go straight to the bank’s pockets as interest payments.
  • If the price of your house falls by just 5% during those first five years, your equity in the house will be lower than your initial down payment, so you will have lost money despite the fact that you were supposedly building up equity.
  • If your monthly payments to buy a house are 15% more than your monthly payments to rent something similar, you could rent at the lower monthly rate, save the difference in a money market account, and still come out ahead (in the absence of capital appreciation) by renting versus buying.

Myth #3: It’s okay to pay a high price for a house right now because interest rates are very low, reducing the monthly payments.

Actually, interest rates are not particularly low right now in real terms. The following graph shows the average interest rate on 30 year fixed mortgages, adjusted for inflation. Yes, nominal interest rates are very low right now, but that’s simply because inflation is very low. Real interest rates are about average for the past 15 years.

What does this mean? It means that while low nominal interest rates make monthly payments on a mortgage look cheap, it also means that the burden of your monthly payments won’t be eroded over time by inflation as much as it would if inflation were higher. Effectively, this means that you pay off less of your loan now, and more of it in the future. But the house is not any cheaper because of low nominal interest rates any more than a car is cheaper when you repay your car loan over 5 years instead of 3 years.

The fact that these commonly-held conceptions are wrong does not mean it’s never worth buying a house. In fact, it almost always still makes sense to buy a house if you’re going to be living there for several years. And even if it’s more expensive to own versus renting, there are non-monetary benefits to home-ownership that are not trivial. However, the points made above are important to understanding my next prediction…