Ken Melvin on Housing Prices

Reader Ken Melvin sends along some thoughts on housing prices:

Speculation in housing:

Much of the speculation in houses is due leveraging. The buyer puts down 10% on a $500,000 home, first year; price of the home goes up 10% to $550,000. The buyer sells and voila, makes 100% on his 10% down. Hell of a deal. Next buyer puts down $55,000, price goes to $605,000. Next buyer puts down $60,500, house goes to $665,500, … Another year later; $732,050. Getting ridiculous, so it begins to slow a bit. Say increases drop to 5%. Buyers say, still not too shabby, in fact, we’ll gladly settle for a mere 50% return. So, they plunk down $73,205, prices goes to $768,600, houses sell, and the buyers makes 50% return on their investment.

How best offset the speculative force of leveraging? No help from the world of finance here. They’re getting a cut. Given that I think that speculation in housing is bad and think that this can easily be proven; we can; put a high tax on residential real estate gains, fifty per cent or better – make it high – make it mean something, and, keep assessments current.

Why the lender should be partner:

Guy builds a bunch of condos in Bayland planning to sell them for $550,000. Oops, sub-prime crisis – has to sell these condos for $350,000; a price that still affords the developer a decent return. So, the price is whatever the market will bear. If the condos in Bayland ha been completed and were sold a couple years ago, when the market price for such was $550,000, the developers would have stuck an additional $200,000 per in their pocket, a small ton of money, and, by now, all them would be running for US Senator. The lender would have packaged the $550,000 loans as ‘financial instruments’, sold them, then, with new and better reserves, loaned more money to buy more overpriced condos. So: The developer will sell their product for anything between a reasonable mark up and whatever the market will bear. The buyer doesn’t have anyway of knowing what the units are really worth. But, the lenders and the builders do. If the lenders were partner to the purchase, they wouldn’t give anymore than they had to give. If the lenders were partners to the purchase, they would have said we’ll lend no more than 90% of $350,000. This way, the buyers don’t get stuck owing $495,000 (assuming they paid 10% down) on a condo worth $350,000, aren’t bankrupting themselves making payments on overpriced condos, and, more people will be able to afford housing.

At a selling price of $350,000, the buyer puts down $35,000 and owns 10% of the condo, while the lender owns the remaining 90%. Price goes to $400,000 in two years, condo sells, lender nets $45,000, buyer $5,000. Little speculative force due leverage here.

Conversely, say price goes down to $300,000 over two years, condo sells, lender loses $45,000, buyer $5,000. If the price goes down to $300,000 and there’s no sale of the condo of the example, the condo’s worth about what the buyer owes (~$300,000), so chances are the buyer would hang in there and continue making payments. Compare this way of financing housing to what we have now.

A footnote on an associated aspect of housing prices – interest rates and housing prices: In short, housing prices are a function of the payments a typical homebuyer can afford and thus are a function of interest rates. If a buyer can afford payments of $3,000/mo and interest rates are 6%; the buyer can afford to pay $500,000 for a house. If interest rates go to 8%; the same buyer can only afford a $370,000 house. Whether houses are built is determined by the difference (margin) between what potential buyers can afford and their building costs. The sub-prime loans skewed the (initial) payments the buyer could afford.

This post was by Ken Melvin.