So What Will Happen To Real Estate?

So what is my prediction? After all, I'm deliberately staying out of the real estate market, so why am I making this decision. The first question is how are people able to buy at all, with prices so high? With the example 2 bedroom condo requiring over $3000 a month in cash flow, and over $2200 a month in tax-neutral cashflow, how can anyone afford anything?

Of course, people aren't paying quite this much. The buyer of a house looks at the monthly cost more than the total value, and the monthly cost is greatly reduced through the use of adjustible rate mortages, especially ones with interest-only or negative amortization. And the statistics are showing that these have become increasingly popular. Yet even with those options its not a good deal to buy: at 3.5%, the tax neutral nonsavings is still no cheaper than renting.

And these mortgage carry a price: uncertainty. If interest rates on the ARM jump from 3.5% to 4.5%, thats an extra $200 in tax-neutral cost per month for my example. And long-term interest rates are unnaturally, incredibly depressed: Roubini and Setzer argue that interest rates are artificially lowered by 200 basis points, 2%, because of asian central bank currency intervention. So if George Bush gets his way and China floats its currency, say hello to a large interest rate jump.

Assuming Roubini and Setzer (and numerous others) are correct, and that the currency situation can't last forever, or something else will cause interest rates to rise, why get an ARM? If you are going to sell in 2-3 years an ARM is the way to go as the long term uncertanty isn't significant for a short-term loan. But this is the classic bubble assumption: prices keep going up (and it has to go up at least 6% to cover transaction costs when selling). Otherwise, to reduce payments for a longer time, its a huge gamble: If interest rates go up to 6%, its tied, and beynd that, its a catastrophe. Given long term interest rates so historically low, why take the risk?

Whats worse is that people are using these alternate mortgages in order to afford a house at all. If someone is squeeking by, leasing their car and with an ARM on their house, leveraged to the hilt, what happens if interest rates jump? If the economy goes south? There is now a huge number of people with no margin for error.

So what is my prediction: Well, interest rates are going to go up a little and the market will freeze: Buyers will stop buying as their monthly costs go up, but sellers won't lower their price. Taking my example, to have the same tax-neutral cost/month, a rise in interest rates from 6% to 8% requires a drop from $450,000 to $395,000 in the sale price of the condo. So a 2% rise in interest rates in my example requires a price drop of 12%, even with buyers willing to spend the same amount as they currently are.

Now a flat market for a few years would be a nice, best-possible hypothesis. But I worry that the soft scenario won't happen. Rather, what I believe will happen is that after a year or two of freeze, with interest rates going up (and the economy shrinks as the refinanced-driven spending disappears), is that the crisis will hit: some small number of people will be forced to sell, yet buyers will be unwilling to pay more per month than they currently are. With a drop of 10% or more, this might end the bubble-mentality.

The worst case scenario, with a 200 basis point (2%) or more rise in interest rates, would thus be a huge collapse in price, as the bubble assumption is proved horribly false. And the collapse may be severe: Given 8% interest rates, the selling price to have rent-equivelent tax-neutral nonsavings cost for my example (observed over 4 years) would be $250,000, a nearly 45% drop in prices!

Of course, I hope (even as a non-homeowner) a tokyo-level collapse will not happen, and would be very unlikely (I hope). Yet a 15% drop seems certain, and a 30% drop would not be out of question. If prices dropped 30%, even with higher interest rates, then I'll probably buy a house: it gives a huge hedge against inflation, the value will go up if interest rates go back down, and the price won't be so obscenely out of line when compared with renting.

(note, minor edits for clarity)