Thursday, September 4, 2008

One Part Shelter + One Part Investment = Crash

Mr. Housing BubbleSo what do you get when you start adding to, and then increasing, an investment component in houses? A recipe for a real estate crash, according to well-known investor Peter Schiff. In an article this week, Schiff talked about how during the housing run up people paid increasing prices for homes not because of the shelter piece that they offered, but rather for investment purposes. He offered a rough estimate that during the peak, a $500,000 house might have offered a $250,000 shelter component and a $250,000 investment component. According to Schiff, the shelter portion represented the utility and desirability of the house and the investment side represented the future appreciation. Needless to say, the investment portion is in serious question right now, and since houses still offer the same utility, the investment side is the one that is losing value.

Without the prospects of enormous appreciation like we saw during the bubble expansion, home values still have a ways to fall. If we figure that Schiff’s estimates are accurate, and that at the height of the bubble half the value was shelter and half was investment, then prices could fall as much as 50 percent. Right now they have fallen around 20 percent, which would mean we could be facing up to another 30 percent in declines. Granted, I seriously doubt we will remove the investment piece entirely, so at least in my mind, another 30 percent in declines is probably unrealistic; another 15 to 20 percent, though, wouldn’t be out of the question.

If you want get the full scoop on the other reasons why Schiff says real estate is still not ready to recover, read his article: It’s Time to Get Real about Real Estate. But I do want to point out one other point he makes at the end of the article. Many people think that this housing correction is just one big doom and gloom scenario, and that the people writing about it are simply pessimists. In reality, however, this news isn’t bad for everyone. The fact that housing is becoming more affordable is great news for the millions of people who were stuck renting because they didn’t want to take on an outrageous mortgage payment. It is also great news for all the young people out there who are trying to buy their first homes. If this correction did not happen, it would be nearly impossible for many of these people to ever buy a home, so the fact that homeownership is now a possibility for them has to feel good. Sure, for existing homeowners who are seeing their values decline this news is hard to swallow, especially considering that most of them mortgaged their properties to the hilt, but it most certainly is not bad news for everyone.

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2 comments:

September 5, 2008 at 3:05 PM Jay said...

"If we figure that Schiff’s estimates are accurate, and that at the height of the bubble half the value was shelter and half was investment, then prices could fall as much as 50 percent. Right now they have fallen around 20 percent, which would mean we could be facing up to another 30 percent in declines."

Your math is inccorect - the decline will be even greater.

example
500,000 house declined 20% to 400,000. if it is going to decline to 250,000 then it would decline NEARLY 40% (-$160,000) to get to $240,000. probably 39% in reality.

but the point is that it's more than 30%.

people often make these math errors. if something appreciated by 100%, remember it only takes a 50% decline to return to normal. (e.g. 500k house doubles to 1,000,00. 50% of that is $500k. that could be 10% a year for 5 years...and seem very gradual. plus it doesn't factor in the lack of keeping up with inflation...

September 5, 2008 at 4:06 PM Eric Ames said...

Thanks for the comment Jay. I appreciate you clarifying this point. I was referring to another 30% from the original ($500,000) not from current pricing, but reading the post again I could see how that might be confusing.

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