Sunday, July 18, 2010

Real Estate: The Original Pyramid Scheme

Today I'm skipping the humor and going with a serious post.

I'm not in real estate, nor do I have a background in economics or finance. But as an observer and participant, I have to ask: Is real estate really a glorified pyramid scheme playing out before us in slow motion?

According to Wikipedia, "a pyramid scheme is a non-sustainable business model that involves the exchange of money primarily for enrolling other people into the scheme, without any product or service being delivered."

Personally speaking, I think residential real estate is heading towards non-sustainable. A product is clearly delivered (your house) but can only have value if there is someone willing and able to purchase that property when it's time to sell.

A pyramid scheme relies on people paying money in, and then recruiting lots of other people to pay money in. The people at the top of the pyramid (the first in) make money and everyone else gets screwed. Simple math shows the pyramid will collapse quickly with the exponential growth required to sustain it. I encourage you to read the Wikipedia article for examples.

Real estate requires cash in for a down payment and closing costs, and enough income to sustain the mortgage loan, home owner's insurance and property taxes - all percentage based on the value of the property. The higher the price, the more cash down and income needed. I won't bore you with reiterating how we got into the last financial mess when it came to sustaining mortgages.

As housing prices continue to grow, are we truly pricing out new buyers in the long run? In other words, if buyers don't already own real property or have a large enough bag of cash, how will they get in? And if they can't get in, how will sellers get out? Do you see the analogy of the pyramidal dilemma?

Sure, people will inherit real property over time, but if that eventually becomes the only way in, it cannot sustain this model.

Housing prices are set based upon a number of factors: comparable sales in the vicinity, marketplace averages, and most importantly by the gut of those who make a percentage-based commission selling your home - a commission often shared between two agents (selling and buying), and unless completely independent, those agents must share their commission with their individual agencies. The incentive is to keep the prices high. Now I'm not knocking real estate agents or their services. It's a complicated process and their services are valuable and worthy of compensation. My issue is compensation based on a percentage of the selling price instead of a flat fee - a debate for another time.

Money Magazine just named Columbia/Ellicott City, MD, #2 of 10 in its recent Best Places to Live article. I live in Ellicott City and work in Columbia and am pleased we made this list. But the article mentioned "homes are affordable -- by Northeast standards, anyway." That's what prompted this blog. I contend homes are not "affordable" by any standard.

If you chose to stay with me, here are some details:

In 1999, the median annual household income in Maryland was $52,850 ($74,150 in Howard County). In 2009 it was $70,050 ($100,100 in Howard County).

In 1999, the median home price in Maryland was $131,913 ($174,900 in Howard County). In 2009 it was $256,217 ($340,000 in Howard County).

So, in Maryland, median annual household income rose about 35% in the last 10 years while median home prices rose 94%. Just let that sink in for a minute.

[FYI, I'm grabbing home prices from the Maryland Association of Realtors here and Maryland Median Income from the Maryland Department of Planning here. I used the PDF called "Median Income in Current Dollars for Single Years 1989 to 2009."]

I don't know about you, but my paycheck has not been growing "in this economy." Granted, home prices are not increasing like they were but these housing booms with price wars and massive price jumps are not easy to recover from. There's no such thing as a "reset". People aren't going to renegotiate or return money.

A buyer today who wants a $340,000 home in the #2 Best Place to Live according to Money Magazine will need $6,800 for a 2% down payment for an FHA-type loan or $68,000 for a 20% down payment for a conventional-type loan. Property taxes will run around $5,000/year and homeowner's Insurance close to $1,000. And then he/she will need a bunch more cash for the miscellaneous closing costs that are tacked on by everyone who can make a buck, I mean offer a professional service.

Using an example of a 5% APR 30-year fixed-rate mortgage for that $340,000 home, Principal and Interest (P&I) will run about $1,790/month for the FHA loan (remember only 2% was put down), or $1,460/month for the conventional. Even with home prices flattening, if loan rates jump, say to 8%, you'd be at a P&I of $2,445 and $1,995 respectively.

"Affordable" is a relative term. When mortgage interest rates go back up, this pyramid will grow in mass.

I guess my point is that real estate is a dangerous, if not shaky, model that our economy, both personal and national, is heavily reliant upon. It's based on personal price setting (we always deserve every penny coming to us - it's an investment) and speculation. And affordability and sustainability is based on personal income that does not keep up with housing prices and is largely out of our personal control. This adds up, to me at least, to ultimate financial disaster. Many people suffered in the last housing fiasco; many, many more will suffer if a true housing collapse occurs in the future.

If ultimately people can't afford to buy in to this scheme, the demand goes down. The people holding the property can only sell to each other. That can only work for so long. And as homeowners die off, they'll bequeath property to family who will have few to sell it to.

So what do we do about it? Excellent question. I need to give this more thought.

Perhaps we sell while we can in typical pyramid fashion and take care of ourselves. But we'd need buyers and where would we go? Maybe we telecommute from more affordable areas. I like to believe we aren't all in it for ourselves.

Perhaps home ownership no longer becomes the primary financial goal or symbol of status for Americans. I don't care if you rent or own, why should anyone else?

Perhaps Corporate America starts sharing more of the profits with its employees instead of the shareholders and executives so personal income can match living expenses. Or subsidize employee housing. Yeah, I don't see that happening any time soon. But if the work force can't afford to live within commuting distance, eventually Corporate America will have to do something.

I'd also like to see the unnecessary complications taken out of real estate. Prime example: title insurance and searches. When you buy a house, you spend money on having the title searched to ensure no one else has legal claim to the house. OK, I get it. When you refinance your own home, you must pay for this all over again. Really? I need to pay to ensure I haven't unknowingly deeded my house to someone else in a drunken act of desperation on I don't think so. Closing costs are typically outrageous and one more unnecessary hurdle to gaining home ownership.

So when pricing your home for sale, remember it's not just a return on your investment or passing along costs to the next guy. It's setting the bar long-term for your kids, grandkids, great grandkids and your fellow humans. Think about that.

Oh, I passed my house along in the divorce and kept the 401K. So I'm counting on the goodness of people to correct this course so the future isn't so scary for me, and my kids, grandkids, great grandkids and fellow humans. What do you think?