Depreciation Delusions: Why Falling House Prices Don't Matter

There are a few folks out there writing headlines about another down leg in housing prices.  Here is one from HousingWire:

Home prices could dip another 6% to 7%, before hitting rock bottom in early 2012, according to analysts at JPMorgan Chase.

If that is the case, prices will fall about 37% from peak levels reached before the 2008 housing meltdown.

For obvious reasons, this kind of headline puts a lot of prospective buyers on the sidelines while they wait for some good batch of housing news to come about.

The questions I ask is: If the market is going to fall another 7%, can it be to anyone's advantage to buy today? Or can anyone make money buying real estate today if it will be worth less tomorrow?

The answer is an emphatic YES!  How? The key is buying the right property.  There are two kinds of properties in the real estate market 1) RETAIL which is your sparkly shiny homes that are at full market value and 2)WHOLESALE which are the scratch-and-dent bargain bin properties that are typically bank owned, short sales, or estate sales.   

Fortunately, wholesale properties can be purchased for anywhere from 90% to 50% of Retail market value depending on condition.  What does this mean?  Well, it means that you can still pick up a lot of equity in a home in today's market and still keep a majority of that equity even if the market slides 7% or even 15%.


Let's say that you purchase a wholesale property today for $65K.  The retail value of the home is $95K.  You have $30K equity.  Now lets say the market slid 10% over the coming year.  Your equity position is reduced to $20.5K.  Yet, your net worth is still $20.5K better than it was before you purchased the property.  If you waited to buy the property after the market slid you could have purchased it for $58K  and its retail value would be about $85K.  You would have about $27K equity.  The questions one has to ask themselves is: What is the opportunity cost of waiting a year to net a possible $7K in additional equity?  Would that time have been better spent by acquiring additional bargains rather that waiting for the "perfect" property at the perfect moment?

Obviously, if you were going to just purchase one property in your entire life and you had the luxury of purchasing whenever you wanted, timing the market exactly right would be to your favor.  However, if you are interested in creating wealth through real estate acquisition, this is an unreasonable proposition.  Instead, wealth builders look for opportunities as they arise in any market.

Wealth builders and smart home buyers look to the wholesale real estate market for such opportunities.

Another fallacy out there is that owning real estate is not good if there is an overall trend toward lower home prices.  House prices are a product of supply and demand with an overlaid component of household income.  If population levels are declining like they are in Russia, Iran, Japan and Detroit, you can expect house prices to decline as demand declines and existing structures maintain supply.  If economic malaise arrives and wages decline, house prices will decline too.  That is what we have experienced as a nation over the last several years.

Keep in mind though, that over the long term that if house prices decline, typically so will the price of milk, clothes, and every other thing that has a price attached to it.  We call this deflation.  If you own rentals and the rents have declined because of deflation, typically it won't matter much because the cost of living will have declined as well.  Your standard of living will be unaffected...that is, unless you have mortgages on your property.

To beat the deflation effect you have to be out of debt on your properties and have little debt elsewhere.  This is why I advocate aggressive amortization or sizable down payments on property when possible.

A couple years ago I wrote We're Turning Japanese! and explored this scenario.  Here are the charts I put together:

 
Click to enlarge.  The point of this chart was to show where equity was in a financed retail property if long term deflation were to occur.

The other chart I put together shows what happens with a 10% downpayment:

As you can see, it would take a catastrophic hit to house prices over a sustained period to affect equity in retail homes with 10% down payments.  Otherwise, equity is sustained and grown over the long haul regardless of long term declines in value.

The way to make this situation even more favorable in the long term is to shorten the mortgage time to 15 years.  However, Utah has never and likely never will experience protracted price declines like you see illustrated here.  Population growth and limited supply of land will moderate our prices on the downside.  Even the worst housing collapse since the Great Depression has only knocked about 15% off Utah's house prices while the U.S. has suffered a 37% decline on average.

The bottom line is that house prices can't go down much more.  Even if they do, the wise investors and wealth builders will be pocketing the bargains while they are available now in today's market.  Why make money tomorrow when it can be made today?

Bargains abound.  Call me and I will show you where they are.