High End Home Market Still Has Further to Fall

We have been enlightened to a rather public person's Real Estate dilemma; Timothy Geithner.

He, along with his wife, bought a NY house in 2004 for $1.602 million. Currently, they owe $1.25 million in 2 mortgages on that house.

Now that he works in Washington, in February, he put his NY based home up for sale at $1.635 million.

After dropping the price to $1.575 million hoping to attract a buyer, it still did not sell. They now rent the house for $7,500 a month.

At $7,500 a month, they'll get $90,000 in rent revenue. The property taxes are $27,000 a year. Hey, the house is in the "Welfare State."

That leaves $63,000 for interest on the mortgage and any other repair costs to maintain the property they... I mean, the bank owns.

Let's assume the mortgage has an interest rate of 5.25%. Owing $1.25 million at 5.25%, that equals $65,625 in interest to the bank.

The rent does not even cover the interest and property taxes when the mortgage is $1.25 million. ($65,625 + $27,000 = $92,625 - $90,000 in rent = $2,625 loss)

Let's say you bought it for $1.25 million cash and rented it out for $7,500 a month. You would only yield $63,000 after property taxes, which comes out to be about 5%. You still have to pay property insurance, maintenance, etc.

5% yield for an investment that has considerable risk is not prudent. The renter may lose his job and not be able to pay their mortgage anymore like the 1 in 8 current mortgage holders in America not paying their mortgage today.

For me, I would want at least a 12% return on my investment given the risk I'd be taking in today's housing market. If my net cash flow comes out to be $60,000 a year, at 12% rate of return on my capital, I would put the value at $500,000 for Tim and his Wife's house.

This tells us that the high end housing market is still way over valued. I'm currently short Toll Brothers (TOL) for clients because their average home is expected to sell for $590,000 to $620,000 per home for 2009 putting them in the camp of high end home market where I expect to see considerably more declines.

Disclosure: Short TOL.

Comments

[t-bird:]

Very good article. Most people do not see nor do they comprehend what you are saying in this article. I have built or renovated eight homes over the last 32 years. From my first home in '77 @ $30,500 to the last house I sold in '05 for $2.4M...many people felt that by selling real estate they were ENTITLED to a positive return on their investment.

This as we all know now is no longer true and will become painfully evident to many as time passes...

Jun 04 08:24 AM

[2houndz:]

Even the NAR economists are saying now that there is a 4 year supply of homes priced over $750K. And keep in mind that the NAR spins everything to the most positive direction they possibly can.

Jun 04 09:10 AM

[Jon Smirl:]

There aren't very many people willing to rent $1.5M+ houses at $7,500+/mth. Most people with $7,500/mth simply buy the house. Since there aren't very many renters in that price range discounting is heavy since the alternative is no renter at all. I have friends that are currently renting a house that was on the market for $2.7M for $7,500/mth. But that's just because the house they own is being remodeled.

His interest rate is much more likely to be at 6.5% or higher for the jumbo and a second. He also had the pay the realtor a month's rent as commission on the rental.

High end rental markets are not liquid. They should not be used as a proxy for value. How many people do you know who with throw away $90,000/yr on rent? I think he did quite well to rent the house at $7,500, it could have easily gone down to $5,000.

The high end housing market is extremely local, I don't think you can draw conclusions from this. Moving a high-end house a half mile can take a million off from it's value.

Jun 04 09:17 AM

[30yr RE Vet:]

John is right. While this is an interesting argument, the fact is that this thesis has *never* proven true in the residential single family housing market. People traditionally buy and then rent out homes for the tax shelter and the upside on increase in value.

If you want to be short on the homebuilders, and you may be right on that count, there are plenty to go around. I'm not sure I would have picked TOL, though. They are one of the better companies.

I am a homebuilder for 30 years and a real estate investor. I have no affiliation with TOL.

Jun 04 09:46 AM

[Jason Tillberg:]

The only conclusion I draw from your arguement is the Tim's house is worth less than $500k based on getting even less rent as you suggest and also that he's losing even more money if his interest rate is higher. This house purchase is proving disastrous for Tim and his Wife.

But hey, the rental market is not liquid and his location must be good so that makes it a prudent investment. (sarcasm)

This idea of location and supply is the biggest falsehood. This is what everyone was saying in 2005 how location would keep home prices at ridiculous premiums to investment value. I always fired back saying "Tell that to the guy who bought his condo 20 minutes from downtown Tokyo in 1989."



On Jun 04 09:17 AM Jon Smirl wrote:

> There aren't very many people willing to rent $1.5M+ houses at $7,500+/mth.
> Most people with $7,500/mth simply buy the house. Since there aren't
> very many renters in that price range discounting is heavy since
> the alternative is no renter at all. I have friends that are currently
> renting a house that was on the market for $2.7M for $7,500/mth.
> But that's just because the house they own is being remodeled.<br/>
>
> His interest rate is much more likely to be at 6.5% or higher for
> the jumbo and a second. He also had the pay the realtor a month's
> rent as commission on the rental.
>
> High end rental markets are not liquid. They should not be used as
> a proxy for value. How many people do you know who with throw away
> $90,000/yr on rent? I think he did quite well to rent the house at
> $7,500, it could have easily gone down to $5,000.
>
> The high end housing market is extremely local, I don't think you
> can draw conclusions from this. Moving a high-end house a half mile
> can take a million off from it's value.

Jun 04 10:00 AM

[Vito Boscaino:]

Since high end homes are typically not held for investment income purposes, I don't think you can extrapolate "implicit value" based on the cash flow being generated. The reality is that he was very, very lucky to find someone to rent this home as other posters have commented. Whether or not Geithner invested in this property and assumed that he would generate a "return" is a question only he can answer. Based on the timing of his purchase though I would imagine that in 2004 he saw more upside opportunity on future value for the home then he did downside risk. The one takeaway that we can observe here is that if he was attempting to "time the market" and exit that property at the peak of the market, he overshot and held onto the asset too long. I guess my question would be what does this activity tell us about Geithner's ability to predict any kind of economic or market activity? My takeaway would be that he is probably not the sharpest tool in the shed.

Jun 04 10:51 AM

[Jon Smirl:]

You are making a key assumption that is ignored repeatedly in renter equivalent arguments. The renters are going to get evicted when a buyer comes along. It is guaranteed that Tim is losing money on this rental and he would be a fool to sign a 30 year rental contract on these terms. The renters are getting a temporary deal because supply is high; they'll pay the price when they have to leave. But they know that and it is part of the deal.

There is a core difference between a house being temporarily rented while buyers are being sought vs permanently putting the house into the rental market. Some people I know are paying a house sitter to live in their $10M houses that is on the market. Does that make the house worth a negative amount? If so, I want to buy it.

The floor under high end housing is set by replacement costs. It is impossible to replace Tim's house for under $1,000,000. Don't confuse liquidity with value.

There have been times in history where replacement cost didn't hold, but those times are rare. For example, after the initiation of the US income tax many wealthy people lost their mansions in the Northeast. During the Great Depression these mansions were even abandoned. There has not been sufficient personal wealth again to trigger building houses of the magnitude seen in the Gilded Age. But Tim's house is far from being a Gilded Age mansion.

Jun 04 10:58 AM

[Graham and ...:]

In the final analysis, a house is only worth what a renter (actually a group of renters over the years) is willing to pay to rent it. Put another way, the price of the houses should be the discounted present value of future rent payments minus expenses.

Any non-economic argument about the "strategic" value of a house holding or "psychic" income from say, the view, doesn't hold water. If ownership were so strategic, or the view so compelling, it would be reflected in the rent.

Jun 04 10:59 AM

[Jon Smirl:]

Renting has an implicit option contract built into it that is held by the property owner. Property owners will force the renters out when it is in their advantage. Stocks don't have the equivalent option - you can't directly compare.

Jun 04 11:35 AM

[billp37:]

"It’s not until May of 2010 that the next wave really hits. From there to October of 2011, the resets will be coming fast and furious. That’s 18 months of further turmoil in the housing market, and the beginning is still nearly a year away! (Although the months in between are likely to be no picnic, either.)"

www.contrarianprofits....

Jun 04 11:39 AM

[Brent Ritte...:]

While a person's house is certainly an asset, I don't think people should view it as an investment. A house is a place to live. You need it for shelter. I can understand that people bought into the housing bubble because it looked like a great way to make money, however, house flipping seemed like a bad investment to start with. There are only a little over 300 million people in this country. If you consider the average family is 3 people (two parents and a child), that means a total of about 100 million homes are needed. Does anyone have numbers on how many homes actually exist in the United States? Does anyone have numbers on the amount of homes that are destroyed (both through natural causes and standard replacements)? It would be interesting to compare the amount of homes built versus the actually need for homes.


On Jun 04 08:24 AM t-bird wrote:

> Very good article. Most people do not see nor do they comprehend
> what you are saying in this article. I have built or renovated eight
> homes over the last 32 years. From my first home in '77 @ $30,500
> to the last house I sold in '05 for $2.4M...many people felt that
> by selling real estate they were ENTITLED to a positive return on
> their investment.
>
> This as we all know now is no longer true and will become painfully
> evident to many as time passes...

Jun 04 12:23 PM

[sticktoitiv...:]

So his house is trading below NOI. He can augment it with his rather large salary. If all else fails he can extort the money from any bank he borrowed it from. Would you like to foreclose on the treasury secretary? As for its current value you would have to look at the comps and replacement value too. There is a good chance that there is a more value laden use for the property.

Jun 04 12:42 PM

[Jason Tillberg:]

www.bloomberg.com/apps...

That article sums up much about how many homes in the US.

130.8 million homes in the US. Some 19 million of which are vacant.


On Jun 04 12:23 PM Brent Ritterbeck wrote:

> While a person's house is certainly an asset, I don't think people
> should view it as an investment. A house is a place to live. You
> need it for shelter. I can understand that people bought into the
> housing bubble because it looked like a great way to make money,
> however, house flipping seemed like a bad investment to start with.
> There are only a little over 300 million people in this country.
> If you consider the average family is 3 people (two parents and a
> child), that means a total of about 100 million homes are needed.
> Does anyone have numbers on how many homes actually exist in the
> United States? Does anyone have numbers on the amount of homes that
> are destroyed (both through natural causes and standard replacements)?
> It would be interesting to compare the amount of homes built versus
> the actually need for homes.

Jun 04 12:44 PM

[John Wake:]

As an Arizona Realtor I don't know the New York market from Adam. I do know, however, that New York was pretty much the last market to join the falling prices party.

In a falling market you want to sell ASAP. The fact the Geithner barely moved on the list price guarantees that he will chase the market down.

He's not alone, of course. Most home sellers in a declining market are in denial. There is an amazing amount of emotion and self image tied to their home's value and they've already spent the profit in their head many times over.

A price reduction to the average home seller feels like a death in the family. So they don't reduce the price, they don't sell the home but they do ride the market down.

Rationally, he should reduce the price until he finds the highest price at which it will sell.

There is a huge amount of emotion tied to money. When it comes to money, even economic rocket scientists like Geithner make irrational decisions.

(To be fair, he may have decided that if he got his (unrealistic) price he would sell, otherwise, he would hold on to it for when he moves back to New York. Financially, however, he would have almost certainly been better selling sooner rather than later.)

Jun 04 01:26 PM

[optionsgirl:]

That's right. According to the stats I have been reading, we can expect to see a huge wave of jumbo mortgages wind up in foreclosure, through 2012-- especially ARM's.


On Jun 04 11:39 AM billp37 wrote:

> "It’s not until May of 2010 that the next wave really hits. From
> there to October of 2011, the resets will be coming fast and furious.
> That’s 18 months of further turmoil in the housing market, and the
> beginning is still nearly a year away! (Although the months in between
> are likely to be no picnic, either.)"
>
> www.contrarianprofits....

Jun 04 01:33 PM

[PlanetHead:]

Sometimes perception is more important than reality. Most folks are not to that bright when it comes to buying a home. First thing never believe the brokers they always rep the sellers. Turbo Tim bought at the top. His best bet is to move back in four years or ask the gov for a bail out.

Jun 04 01:33 PM

[j_remington:]

good analysis...unfortunately a short squeeze does not follow logic

Jun 04 01:39 PM

[mallarde:]

Even if the house loses money on a cash flow basis, don't you also have to take into account that the outflow of cash -- at least in part -- is adding to his equity in the real estate? That has some value, correct?

Jun 04 02:14 PM

[Steve in TN:]

Geithner has nothing to worry about. When his stint as Treasury Secr. is over he will be well compensated by his new employer:
Goldman Sachs
The revolving door keeps turning.

Jun 04 02:30 PM

[margel:]

I think your numbers do not make sense. Geithner is not a landlord. Plus you are missing the income tax effects of depreciation. In any case, only slum lords expect a 12% cash on cash yield on rental property. Most rental income property yields about 3-5% cash on cash. Income property owners want some cash yield but their main investment goal is appreciation.

Jun 04 03:29 PM

[MDLGTO:]

Here's a little schadenfreude from a former NY Homeowner (moved to Mexico)--Our tax load on our home increased from 9k to 20k (based on market value) from 2004-2006 and did not decrease (sold in dec 2008). I'd imagine with budget shortfalls and bloated local governments (grown fat from the bubble years) taxes will not go down probably will increase. Also, maintenance on homes in the NE are huge-I'd guess at 10k average a year (painting every few years, landscape care, HVAC/systems, et)-more if it's a country home.

Jun 04 05:51 PM

[Fighting Yoda:]

Yes, Timmy’s plight is much too common.

Prime and Alt-A are the next big shoes dropping per MBA (Mortgage Banker Association) Latest MBA survey:
Delinquencies and Foreclosures Continue to Climb in Latest MBA National Delinquency Survey May 28, 2009

MBA is suggesting worse of subprime is likely over, now we are going to start the foreclosure on Alt-A and prime loans - a much larger market.
"Prime fixed-rate loans now represent the largest share of new foreclosures. In addition, almost half of the overall increase in foreclosure starts we saw in the first quarter was due to the increase in prime fixed-rate loans."

Jun 04 06:36 PM

[mlonz:]

Timmy's house is as much of an "investment" as a Corvette or Jaguar. It is a consumption item with some moderate tax write offs included.

However I do agree that the $800k-1.2M is the most vulnerable part of the market going forward due to many of the reasons discussed.

-Vagaries of Jumbo Loan Markets
-Property Tax burden
-Job cuts are moving from entry level employees (Already let go) to mid and upper management.
-These markets have dropped the least so far, my eyeball estimate is 8-12% from peak, at least where I am.

Jun 04 07:04 PM

[Just Say Whoa!:]

"The bigger they come, the harder they fall--one and all."
--Jimmy Cliff

Jun 04 08:01 PM

[Rhino Realty:]

Jason - good article...I agree with your valuation methodology. I purchased a house in SC in 2004 for 1.85 M. I lived in the house for 3 years and sold the house back to the builder in 2007 for 1.3 M. After walking away from a few hundred thousand dollars, I am now thrilled that I got off the ship. That same house is now worth 1 M or less....also, I agree with the 12% figure...you can purchase an investment grade leased building with minimum 15 year lease term at 7.75% (Walgreen A+) to Dollar General 9% (B+).....I would say that 12% would be a minimum risk adjusted return for a non credit renter considering the alternative single tenant investment properties just referenced. In summary, your article is right on target and all readers should consider that the safest real estate investment today are in necessity branded single tenant buildings, not residential real estate properties. :)

Jun 04 09:10 PM

[OptimizedPrime:]

@ Jon Smirl -- Your right and wrong. Wrong in the sense that smart people with enough money absolutely DO rent in times like these no matter how much money they have. Where I live we have LOTS of renters renting houses in the $2m+ range for ~$6k per month. These people are getting the deal of the century as they are "renting" a $2m asset that is losing value for only $72k/year.

Now you are definitely right in the sense that most people--high-end and low-end--who could afford a house in the last ten years in fact did so since they saw houses as an investment that only went up and never went down ("in the long run" or some such bullshit).

They are self-fulfilling prophecy in reverse. They are now to blame for an absolute crash in the high-end because upwardly mobile folks now are under water and will spend decades digging out and saving enough for a down payment on the next level. As such, there's nobody left to buy anything on the high-end since most of these sales were driven by (short or long) flippers.

So the smart rich will rent (will have rented) and the dumb rich are stuck paying off a huge mistake. This all supports the author's premise perfectly: that on the high-end houses will return to their fundamental floors (rent price = capital cost + upkeep + profit).

In my little high-end suburb, that's about 50% away for the most part...


OP

Jun 05 03:43 AM

[Jason Tillberg:]

Thanks Rhino.

The fact that some on here are in disagreement goes to show there are still people willing to over pay for real estate.

On Jun 04 09:10 PM Rhino Realty wrote:

> Jason - good article...I agree with your valuation methodology. I
> purchased a house in SC in 2004 for 1.85 M. I lived in the house
> for 3 years and sold the house back to the builder in 2007 for 1.3
> M. After walking away from a few hundred thousand dollars, I am now
> thrilled that I got off the ship. That same house is now worth 1
> M or less....also, I agree with the 12% figure...you can purchase
> an investment grade leased building with minimum 15 year lease term
> at 7.75% (Walgreen A+) to Dollar General 9% (B+).....I would say
> that 12% would be a minimum risk adjusted return for a non credit
> renter considering the alternative single tenant investment properties
> just referenced. In summary, your article is right on target and
> all readers should consider that the safest real estate investment
> today are in necessity branded single tenant buildings, not residential
> real estate properties. :)

Jun 05 10:05 AM

[nexttimedown:]

I live in the suburban New York town where Geithner's unsold home is located. The market is not great, but it is not horrible either. Homes priced right sell relatively quickly, but homes where the asking price is too high sit on the market indefinitely.

Thus, I suspect Geithner's asking price is too high.

Also, the town has a relatively active rental market due to its proximity to New York City and the existence of a French American school. This attracts a lot of French ex-pats who may be working in the states for only a year or two.

Jun 05 03:23 PM