Wednesday, January 26, 2005

Residential Real Estate - Is It a Bubble?

Yesterday a client of mine called and told me her son was purchasing a home in Arizona. 4 bedrooms, 2000 sq. ft with a front and backyard, basically brand new. The price of the home.......$200,0000 (up from the $170's just last year). The same type of home where I live, sunny Southern California (Orange County) would go for at least $600,000 and have nearly $10,000 in real estate taxes annually to boot. That is a pretty big difference. With no money down you are looking at a payment with taxes of $4,334 per month in Orange County (assuming 30 year fixed), but only $1,218 in Arizona. Orange County is 3.6 times higher priced on a monthly basis. The question becomes "is living in Orange County (or many other expensive areas) 3.6 times better than in Arizona?" The answer is that I don't know. Perhaps Orange County isn't overpriced, Arizona is just underpriced.

What I do know is that from an investment standpoint the Orange County home doesn't look like a very good deal. If you were to put 20% down (mortgage of $480,000) your payment with real estate taxes would be about $3,558 monthly, yet you would be lucky to get $2,400 in rent per month (I currently pay about $1,900 for such a home in rent). Even on an after-tax standpoint you aren't breaking even cash flow wise, once you add in the cost of housing maintenance and vacancies (another $200 monthly minimum) you don't have an investment, you have a speculation. You are speculating that either the price of housing will continue to rise, or that rents will rise quickly enough to make your cash flow work. Now, the Arizona property probably won't cash flow either, but the difference is much less and long term the risk is much less - you don't require that prices go up considerably to make money.

In my opinion residential real estate prices are too high in many, but not all areas. There are many factors involved in this that would take too long to explain here (see my links below). My advice is to be very aware of the risks that you are taking when purchasing a home in these expensive areas, don't fall into the mindset of "Real estate can't go down" or that "this time its different." I am not saying don't buy real estate, I am saying be sure it makes sense for you and that you understand all the risks going in.

What follows are some links to recent articles in Money magazine that I think you will find interesting.

The Schiller Interview
Irrational Exuberance - Again
Bang for the Real Esate Buck

Until next time...........