Last week I discussed housing valuations — how expensive local homes are in comparison to their historical relationship with rents and incomes.  To sum up the conclusions, San Diego homes in aggregate are right in the middle of the valuation range that has prevailed for the past thirty-odd years.  However, due to super-low mortgage rates, monthly payments on San Diego homes are substantially below their typical historical levels.

This article will deal with whether it makes sense, financially speaking, to buy a home in a market characterized by middle-of-the-road prices alongside dirt-cheap monthly payments.

The answer, as you might imagine, is that it depends on whether you care more about future change to prices or to monthly payments.  Below I’ll discuss different circumstances under which buyers might care more about one or the other.  But first, I actually want to describe prospective changes for each.

The Future of Home Prices

In the article on housing valuations, I wrote the following:

When it comes to predicting the future path of home prices, we should look to the price-based valuation ratios (the first and second graphs).  There is an inexorable pull to the center in these ratios — a “reversion to the mean,” as we numbers nerds call it.  When the ratios get too high, they want to go lower, and when they get too low they want to go higher.  This is exactly what we would expect, because moves away from the center in the price-to-income or price-to-rent ratios indicate that housing is becoming either too expensive or too cheap in comparison with the fundamentals.  And markets always come back to their fundamentals eventually.

This passage illustrates the tremendous importance of looking at valuations as a starting point.  Values have their ups and downs as varying psychological and economic factors come and go.  But if you can assume that home prices always eventually gravitate back toward their intrinsic value — and both logic and the graphs accompanying the prior article indicate that you can — then valuations at the time of your purchase can provide a good indication of how an investment in housing is likely to perform over the long term.

If homes are substantially undervalued, you have what we in the investment business call a “margin of safety” (a phrase coined by investing legend and Warren Buffett mentor Benjamin Graham).  The premise is that if you can buy something sufficiently below its intrinsic value, the upside you can expect as the asset returns to its fair value provides a margin of safety against other factors that might otherwise negatively affect your investment.  Another way to put this is that if you buy something cheap enough, a lot of bad stuff can happen without necessarily harming the investment’s price, because a whole lot of bad stuff was already “priced in.”

Conversely, if you buy a home at a price substantially higher than its intrinsic value, the cards are stacked against you.  The economy can grow and it can continue to be the case that “everyone wants to live in San Diego,” but that good stuff has already been priced in, or possibly more than priced in.  The inevitable pull back towards fair value will be a drag on home prices regardless of how well everything else goes. 

Of course, it’s possible to do well over a certain time period in an overvalued market because (as we saw clearly in the housing bubble) valuations can go from really high to really, really high.  But that’s not so much making a good investment as getting lucky, and (as we later saw in the bust) this kind of luck runs out eventually.

So if you are at a valuation extreme, it’s not necessary to make forecasts about future positive and negative influences on the market.  If homes are cheap enough, it’s pretty safe to buy, as whatever ills may befall the market will probably be offset by the move back up to intrinsic value.  And really overpriced homes are inherently risky because any positive economic developments are likely to be neutralized (or worse) by the move down to fair value.

But what if valuations are right in between?  Well, then it’s a lot tougher.  In this case, you are in the unenviable position of trying to predict the future.  Will shadow inventory start to be a more negative factor?  Will the government come in with another round of interventions?  Will employment finally start to come back strong?  Will wages inflate?  Will the recovery strengthen or fizzle out?  Will our country’s foreign creditors continue to throw money at us hand over fist?  Will mortgage rates go shooting up?

These are the issues you need to worry about if you buy a home now and you are dependent upon the home’s price going up (or at least not going down). 

Personally, I think that there are enough structural headwinds facing our economy and the housing market that valuations are likely to decline further in the coming years, meaning that nominal (non-inflation-adjusted) prices are at risk for stagnation or decline over the next several years.  But that’s just a guess, of course.  People who are considering buying a home, and who require home prices to do well in order for it to have been a good investment, need to make guesses of their own.

The Future of Monthly Payments

Wouldn’t it be nice to not care about what happens to home prices?  Well, in some cases, this is exactly what buyers should do.

Thanks to ultra-low, government-subsidized mortgage rates, monthly payments on San Diego homes in aggregate are very near the lowest in comparison to rents and incomes that they’ve ever been over the thirty-plus year course of available data (the very lowest was in mid-2010).  As of year-end 2010, the monthly-payment-to-income ratio and the monthly-payment-to-rent ratio were respectively, 39 and 32 percent below their historical medians.

That is what we call a margin of safety.

Could payment ratios go lower?  Of course.  If you want to speculate that the lowest-yet ratio will go even lower, be my guest.  But hopefully you can see that you are taking a bit of a gamble.  Successful investing over the long haul does not come from timing exact peaks and troughs, because it is impossible to do so reliably.  It comes from knowing when something is “close enough” in terms of over- or undervaluation, acting accordingly, and being ok with the possibility of missing out on the final part of the move towards the peak or trough.  (By the way, would-be trough-waiters should note that mortgage rates have already risen since the December 2010 snapshot discussed in these articles).

Simple reversion to the mean suggests that mortgage rates will at some point move upward.  Fundamentals suggest that they will do so, and then some.  I am of the opinion that deficit cutting pillow-talk notwithstanding, the US government under either party is going to push the envelope on borrowing until our foreign creditors have had enough.  And were foreigners to take away the national credit card, interest rates could rise very substantially.  (That is, at least, if the decline in demand for our debt were not offset by the Federal Reserve putting its “quantitative easing” program into dangerous levels of overdrive — but that would cause a host of other problems, and the long-term result would most probably be higher rates anyway). 

Yes, these are more guesses.  But I think they’re good ones.  For what it’s worth, I am a lot more confident about higher interest rates than I am about home prices going in any particular direction.

As to when this all might happen, well, timing has never really been my thing.   But pursuant to the idea of being “close enough”: if I’m looking at close-to-all-time low monthly payments against a fundamental backdrop that suggests a potentially very large rise in rates at some point, I’m thinking it’s a good time to take out a fixed-rate mortgage.

Should You Care About Price or Payments?

It follows from the above two sections that whether or not now is a good time to buy a home depends substantially on whether you are more concerned with the future of prices or of monthly payments.  So who should care about which?

Any potential buyer who might want to or be forced to sell the home any time soon should be primarily concerned with prices.  It doesn’t matter what your monthly payment is — in this case, the success or failure of your investment will be determined by the change in the price of the house over the time period that you own it.  Unfortunately there is no easy way to quantify how long this period is.  My gut feel is around the 10-year timeframe, but that is yet another guess, and is based partly on the fact that it’s hard for me to believe that nominal prices would be lower that far out.  All I can say for sure is that the longer your ownership timeline, the less you need concern yourself with price changes.

The other type of buyer who should be more concerned about prices than payments is the person buying with cash or a very large down payment.  Low mortgage rates don’t help you much if you don’t have much of a mortgage, because it’s monthly payments, not purchase prices, that are cheap.  (I’m assuming for the purposes of this discussion that money not used toward a down payment will be invested wisely.  If you use the freed-up down payment money to buy a speedboat or walk-in humidor, you’re kind of defeating the purpose).

But if you are in for the long haul, you’re getting a fixed-rate mortgage, and you aren’t making a big down payment, you really don’t need to care all that much about future price movements.  Compared to the fundamentals, you are locking in a historically low monthly payment for your home.  Further home price declines will not change that reality.  In fact, nothing will change that reality — regardless of what happens to rates, wages, rents, and other prices, your payments will be forever the same.  If I’m right about inflation and interest rate risk, a decade hence you will have a good hearty laugh about how your low-to-begin-with mortgage payment has remained unchanged while the price of practically everything else has increased enormously.

Make Sure Your Home is Reasonably Priced

By necessity I look at data for San Diego in aggregate.  But we should never lose sight of the fact that the San Diego housing market consists of many sub-markets that vary substantially in valuation.  Since San Diego as a whole is roughly at “fair value,” the analysis above assumes that you can find a home that is at fair value compared to its neighborhood’s typical relationship with rents.  (Unfortunately, that’s not a terribly easy thing to determine, but one is well served to try).

If you seek to buy in one of the valuation outliers, your margin of safety may vary.  In those neighborhoods that have remained fairly overvalued, your monthly payments may not be at such rock-bottom levels even despite the low rates.  Conversely, the areas that have been really slammed can provide a little margin of pricing safety and payment ratios that are even better than those suggested by the aggregate charts.  Zooming in even further, individual deals within a neighborhood can be better or worse based on seller motivation and a host of other factors. 

So if you are considering a home purchase, make sure to consider whether the price is reasonable in a historical context and to adjust your calculations accordingly.

It Makes Sense To Buy — For Some

To sum up the past few sections, rock-bottom mortgage rates have pushed monthly payments so low that it may make sense to buy a home if you meet the following conditions:

  • You are buying a home that is reasonably priced on a historical basis compared to area rents.
  • You are very confident that you will be willing and able to keep the home for a long time (hopefully 10 years or more).
  • The bulk of your purchase will be financed with a fixed-rate mortgage.

It is, of course, a possibility that further significant home price declines could take place.  But given that valuations are at their historical norms, this is certainly not guaranteed.  And were interest rates to rise out of the abyss at some point — an eventuality that I consider quite likely — the increase in rates could more than offset any price declines as far as monthly payments are concerned.

Therefore, a case can be made that a buyer in the above circumstances should just go ahead and lock in these historically low monthly payments and be done with it.

For other potential buyers, it’s a different situation.  Those who would buy homes in significantly overvalued areas wouldn’t be getting the historically low payments described in the prior paragraph.  And those who would resell a property any time soon or pay for a home with a lot of cash wouldn’t be substantially benefitting from the huge subsidy provided by lifetime-low mortgage rates.

In these cases, future home price changes would likely dictate the success or failure of a housing investment.  So what will home prices do?  I shared some thoughts and forecasts on this topic above, but with neither serious over- nor undervaluation to be our guide, the future is fairly unknowable.  Those who depend on a specific path for home prices do so at their own risk.


Please contact Rich Toscano at rtoscano@pcasd.com and follow him on Twitter at http://twitter.com/richtoscano.

Rich Toscano

Rich Toscano has been observing the housing market for Voice of San Diego, with the occasional prolonged absence, since 2006. Follow him on Twitter at...

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