Monday, January 02, 2006

Housing irrationality

Winterspeak reader MP sent in this article which argues that the price of housing has not gone up because monthly cash payments have decreased (due to lower interest rates). Based on a month-to-month cash basis, the cost of housing is about the same as it was back when prices were lower and interest rates were higher.

I don't buy this because I don't think the cost of financing should impact the value of an asset. For example, would you buy if it were trading at $100/share? Suppose I offered you a margin account with generous rates -- would you buy it then?

[Note -- a margin account is a brokerage account that let's you borrow money to buy stocks, just like a mortgage lets you borrow money to buy a house].

The answer is that the rates on the margin account have no impact on whether or not I think is a good deal at $100/share. If I think is fundamentally overvalued -- that the profit it makes now and is likely to make in the future don't justify a $100 share price -- then I don't care how cheap the financing is, I just won't want to buy it.

There is a link between interest rates, the amount the bank charges you for a loan, and discount rates, the amount you need to be compensated for delaying accepting money in the future instead of today, however, and that is that the two are meant to be kind of the same thing. If you value being paid in the present much more than being paid in the future, you will demand a high interest rate for postponing payment. If you don't care much between being paid today and a year from now, you will demand a lower interest rate for postponing payment. Most of what you buy when you a buy a house is the right to live in it in the future, and if you don't need to be compensated particularly much for waiting, then that does justify a lower discount rate and hence a higher purchase price today.

But I don't think that people have a fundamentally longer term perspective toward home ownership today than they did in 1995, I think they are looking at cash-in/cash-out on a monthly basis and doing whatever they can to make mortgage payments. In essence, they are being offered at $100/share and asking what their margin requirements will be before buying. I don't think this is the right way to think about buying a stock, and I don't think this is the right way to buy a house.


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