The Case for Selling in a Falling Housing Market by Stan Humphries – The Housing Theorem
The problem with the American housing market isn’t that too few of us want to move. We estimate that at least 4 million homeowners would love to sell their home and buy another one that’s bigger, smaller, better located or more affordable.
What’s holding back these “sidelined sellers?” Some can’t sell because they owe more than their homes are worth, of course. But many more are simply paralyzed by the fear of selling and buying again in a falling market. Often at root here is what psychologists and behavioral economists call “loss aversion.” We avoid accepting a grim loss on a current investment, and recent research suggests that we over-estimate the pain associated with a future loss (say, with buying a home that then loses value).
So it’s understandable to want to wait for better days to sell, but—at least when it comes to your house—you’re probably making a mistake.
First, let’s dispense with the idea that better days are coming soon. The consensus among the 100 economists surveyed by Cambridge-based data firm MacroMarkets is that housing prices will slip 1.3% in 2011. That’s far, far too optimistic. At Zillow, we believe prices will tumble as much as 7% in 2011. After reaching the bottom, we expect real estate appreciation will remain in the doldrums for three to five years—something we’ve been forecasting for more than three years.
So we’re all going to have to make a little peace with falling prices. But here’s the good news: If you run some numbers, you find that selling in a falling market is not always a bad idea. Especially if you’re thinking of trading in your current home for a smaller home or one in a less expensive neighborhood.
Check the math. Say you and your spouse own a nice two-bedroom condo like this on the north side of Chicago. You bought it in 2007 for $390,000, but it may only sell for $310,000 now.
Now say you’re feeling crowded in this condo because your two increasingly energetic kids have hit school age. You’ve got some savings and a good commuter car, and you think you can buy a 2,500-square-foot house like this one in a kid-friendly section of suburban Elgin for $370,000.
This is the oldest trade in the book—but here comes the loss aversion. First, you recognize that selling the condo means you’ll finally realize the painful $80,000 loss on your condo purchase. Then—and this is almost worse—there’s an anticipated loss on the new house. In February home prices in Chicago were down 10.3% from a year earlier, and you’re convinced they are likely to continue that decline and fall another 5%. Buy the new house and in a year you could be sitting on another $18,500 capital loss. It churns your guts, and maybe you decide it’s better to stay put and take the 5% hit in a smaller home.
Trouble is, most of us wildly overestimate the benefits of waiting. We convince ourselves that avoiding a potential future loss is the same as saving money. We underestimate the risks that we’ll face by waiting another year. And we totally ignore the real, measurable costs of staying in a home that’s too big or too small or poorly located.
Start with the $18,500 in savings that you thought you would garner by waiting another year to relocate to the suburb. Those savings will probably be offset by a similar decline in value on your downtown condo, which could sell for $15,500 less a year from now. Yes, by waiting you’ll also save $1,200 or so in reduced realty brokerage fees and closing costs to sell the depreciated condo. But add it all up and your total actual savings will be just $4,300.
That’s a couple of house payments, you may be thinking. That’s a solid down payment on second car—pretty handy when you move to a suburb. Wrong.
See, $3,500 of it that $4,300 would just be a net savings of home equity. It’s a paper loss you would avoid. The value would be on your family’s balance sheet, so perhaps it could serve as collateral for a loan. But it wouldn’t be real money in your pockets.
Now consider the risks you would have to take to get a shot at that $4,300 gain. Because while the potential savings are mostly on paper, the potential costs are quite real.
For one, you took an entire year’s worth of interest-rate risk. There are wars in the Middle East, escalating energy costs and lots of talk of inflation these days. If 30-year fixed mortgage rates move from 5% to 6.5%, the payment on a $200,000 loan goes from $1,070 to $1,260. That’s an extra $2,300 a year in mortgage costs.
Then there’s market-timing risk. Different neighborhoods don’t always snap out of a market correction at the same moment. Maybe demand for bigger suburban homes will snap back faster than demand for condos in the city. That house in Elgin could get more expensive while the condo’s value continues to slide.
Then other, practical costs of holding the condo also creep in. Will you rent a storage space to hold the clutter that you would have shoved into the backyard shed in the suburbs? That’s at least $700 for the year. And what about the cost of sending two kids to private schools in the city for an additional year instead of sending them to Elgin’s public schools? That’s at least $10,000 per child. These costs won’t show up in the your house payment, but they’re real, measurable hits to the family cash flow.
That’s just the math for a trade-up. Now suppose instead you want to downsize. The numbers become even more compelling.
Suppose you’re retiring. Say you dream of selling this home in Santa Monica for $900,000 and purchasing a significantly larger house like this 20 minutes away in Encino for $750,000.
Here, the costs of waiting to sell really pile up. If prices in Los Angeles fall 5% over the next year, the $150,000 difference in prices of the two homes will shrink by $8,000. And that $8,000 cost of waiting a year would not merely be a paper loss. You will actually have that much less money in your pocket after the sale of your home in Santa Monica.
The $8,000 potential loss would be offset only somewhat by the lower commissions and closing costs you would face by waiting a year to sell your home in Santa Monica. But there would also be other costs involved in waiting for the trade-down. Like property taxes. Say you purchased your Santa Monica bungalow during the property bubble, when it was worth more than $1 million, and that your annual property-tax bill is roughly $13,000. That’s $3,000 to $5,000 more than you would have paid if you had moved to the Encino home.
Overall, it’s helpful to think of house prices as a river that flows forward and, on very rare occasions, backward. It’s natural for us to prefer to jump from one raft to the next when the river is moving forward—that is, when prices are rising, not falling. But even when the river is flowing backward, jumping rafts midstream can make sense. When the river is flowing backward, we tend to fixate on the speed of the next raft relative to the stationary riverbank (e.g., “My next home is going to fall 5% in value after I buy it”). We should focus instead on the speed of the two rafts relative to each other (e.g., “Both homes are going to fall 5% in value”).
Here’s the bottom line. Of the three general classes of homeowner—first-time buyers, existing homeowners buying another home and existing homeowners exiting real estate altogether—only first-time buyers face a substantial risk when buying in a declining market. For homeowners seeking a trade, there are only real costs of selling now for people trading up, and even those are less than most of us perceive.
We devised this chart to show the potential loss (shown in amber or red) or gain (shown in green) you’d face in a year if you trade up or down in a falling market now. For example, trading up now to a house priced 20% greater than your current one in a market that you expect to decline by 5% over the coming year results in a 1.4% loss relative to waiting one year to buy that house. Most people likely anchor their loss expectations around the expected 5% decline in home values when, in reality, the actual loss is much less.
The third group—people leaving home ownership altogether in favor of renting—should, of course, always sell as early as possible in a falling market. That way they’re most likely to preserve as much equity as they can. In reality, I think many of these sellers are holding out in the current market hoping for some recovery in home values in the near-term. These people are waiting for Godot.
My advice here doesn’t require you to be either a bear or a bull on home value appreciation. My chief point is that, when trading homes, future home value declines will matter a lot less than most people believe.
“I feel like this morning I’ve had nine different people tell me they don’t want to sell when the market is still falling,” Detroit-area real estate agent Jeff Glover says with a sigh. Glover wishes he could get more people into the leafy, prosperous suburbs west of the city, where prices have been falling now for nearly six years. He’s even got a catchy line he uses: “Do you want to wait this market out in your current house or do you want to wait it out in your next house?”
Most people ignore him. Maybe they shouldn’t.