"Median Price Dips Slightly" - Is the sky falling?

By your real estate dude

According to an article from rereport.com, "The median price for a single family home in San Diego County dipped 0.7% to $586,000 in August from the month before, a year-over-year gain of 6.5%. This is the fifth month in a row year-over-year appreciation has been in the single- digits. The average home price gained 8.2% to $732,378. Condo prices continued setting new highs in August with the median price up 5.1% to $389,000. Annual price gains have been in the single-digits five of the Last six months. Sales of single-family homes continue below last year's record-setting pace. Home sales fell 5%. Condo sales were off 8.3%. The sales price to list price ratio for single-family homes gained 0.1 of a point to 96.1%. The ratio for condos is at 97.2%."

Wow! That’s a bunch of numbers that look pretty frightening to me. But, what does all this mean? Well truthfully, it’s not as terrifying as it looks. The bottom line is that while fewer homes are selling than before and taking longer to do it, the prices are still going up. They're just not going up in double digit percentages because the market has softened. This may be concerning to some folks, but not to those of us who know how to do the numbers. That’s because when homes increase in value by single digits most people have had a double digit return. What?

Unlike stocks, most people do not purchase homes with cash. In fact, the vast majority of homes are purchased with a lender's money. When you take out a loan to buy something, it's called leverage. In grade school I learned about the use of the fulcrum and the lever. By using a lever and fulcrum I could move a big object easily that I could never move otherwise. We've probably all seen the picture of the strong man with the lever and fulcrum about ready to move the earth. That's how leverage works with money. With leverage you can buy more than you could buy without it. When leverage is applied to investments you have the chance to make more money than you would otherwise. With stocks, using leverage can be very risky and only some folks with lots of “green” are aloud to do it. On the other hand, using leverage with real estate works out well most of the time.

Let's look at the 6.5% year-over-year gain for the median priced single family home that’s listed in the article above and apply some leverage. If I had purchased a $500,000 home last year with cash and the home increased in value by 6.5% over the year, my home would now be worth $532,500. Since my original investment in the property was $500,000 I would have made 6.5% on my investment. But what if I had purchased the same home with a 20% down payment and took out a loan for the rest? My original investment would have been $100,000 not $500,000. The increase in the value of the property would still have been $32,500 in one year but the percentage of return on my investment of $100,000 would be 32.5%. Boy… that beats 6.5% any day! "But" you ask, "what about the house payment?" Well... if I purchased the house with $100,000 down and a loan of $400,000 at 5% or even 6% interest, I would still have made more money in appreciation over the last year than the total of that year's loan payments would have been. For example: At 5% interest, my total loan payments for the year would have been $25,764. At 6% interest my total loan payments for the year would have been $28,776. In both cases, my value increase of $32,500 would have been greater than the total of 12 months of loan payments. And let's not forget about taxes. With amortized loans (like home loans), the first five years of payments are mostly interest. You don't really start paying down the principle until after 5 years. That means that the majority of my payments for this past year would have consisted of mortgage interest with very little being applied to principle. As I’m sure you already know, mortgage interest is deductible! That means that in addition to making more money on the value of my house than I would have spent in payments to buy it, I would have had a $20,000 tax deduction for mortgage interest. I would not have had that deduction had I paid cash. So, as you can see, since most people buy homes using leverage the 6.5% growth figure is misleading. That figure only relates to the value of the home, it does not related to the amount of the original investment.