Common factors drive price of real estate

By Michael Haubrich, CFP

Racine Journal Times/Sept 1, 2005

Lotteries for lots in new developments, prices rising by 5% per month, buyers purchasing homes they never plan on living in – these are just a few symptoms of the real estate bubble we’ve seen in the US real estate market in recent years.

These symptoms are mostly found in hot markets such as Florida, California, Arizona and the East Coast. Fortunately, what happens in those hot markets does not have a direct impact on real estate values in Racine. This is because real estate is not a national market, but a local, even a neighborhood market with prices determined by factors such as amenities, public services, transportation, and proximity to other markets.

There are two factors that impact real estate prices regardless of the market -- building costs (materials and labor) and cost of financing. The cost of home building has and always will increase over time. Events such as a devastating hurricane or other natural disaster can drive up building costs quickly but, over time, price increases tend to follow inflation.

What is also common in all real estate markets is the cost of financing or mortgage rates. Over the past three years record low rates have lowered the monthly costs of borrowing. It is the affordability of monthly mortgage payments more than anything else that determines how much a buyer is willing to spend on purchasing a home. A lower interest rate means a buyer can have a larger mortgage to buy more house. Add this to a limited supply of available housing, and price increases follow.

Let’s assume a buyer can afford $1,000 per month in mortgage payments. With a 30 year term and an 8% rate, a buyer gets a $136,000 mortgage. A 2% decline in the interest rates and that same $1,000 payment buys a $167,000 mortgage representing nearly 20% more house they can buy.

Our local market has also experienced appreciation, although not as rapidly as hot markets like Las Vegas or Naples which experienced gains of more than 50% over the past couple of years. Western Racine experienced average selling price gains of 11.6% while east of I-94 average selling price was up 10.7%, according to John Crimmings, president of N. Christiansen Realty, who provided data from the Multiple Listing Service on Racine County sales over the past 12 months.

Rules to follow, dangers to avoid

Do not buy a home unless you plan on keeping it for at least five years. If you end up paying what turns out to be the top of the market price, odds are that the market will eventually recover as building costs continue to rise. If you use a 30 year amortized mortgage (which we recommend) in five years, you will have gained about seven percent in principal pay down on the mortgage. This should cover the transaction costs to sell the property.

Buy what you can afford. Do not over extend yourself so you are a slave to your home. A rule of thumb is to not spend more than two and one half times your annual income for the purchase price of your home. This means if your household income is $100,000, you should not spend more than $250,000 for your primary residence.

Avoid any mortgage where the interest rate is not fixed over the time you plan on living in that home such as interest only mortgages or reverse amortization mortgages. For more information on how these mortgages work and the dangers associated with them, check out www.toyourwealth.com for a consumers guide on mortgages.

Do not buy in markets you do not know. The best source of information on local markets is from the Multiple Listing Service available through real estate agents who are members. I always recommend that buyers be represented by a buyer’s agent throughout the purchasing process.

Michael P. Haubrich, CFP is President of Financial Service Group, Inc., a Registered Investment Advisory Firm in Racine. Website address www.toyourwealth.com.