Should You Cash Out While You Can?
As home prices soar, you'd be nuts not to ask the question. But do the math and you'll probably decide not to abandon ship.
(MONEY Magazine) – Way back in 2000, Debbie Daly and her husband had no inkling that paying $402,000 for a four-bedroom ranch house would turn out to be a jackpot move. But their timing proved flawless. Within four years, home prices in Calabasas, Calif., their Los Angeles suburb, more than doubled; heck, at the rate things were going, the Dalys would see their $100,000 down payment turn into a million bucks by 2006.
The windfall left Daly thrilled--and anxious. The 37-year-old mom had been a real estate agent in the early to mid-1990s, when home prices in Southern California fell 40%. "I remember what that was like," she recalls. "I sat around the kitchen table with people who couldn't pay off their mortgage with proceeds from their house sale."
When they could no longer stand the sense that history was about to repeat itself, the Dalys sold their home last year for $910,000 and rented nearby. In doing so, they joined a small cadre of homeowners choosing to cash out rather than risk losing their paper profits to a housing crash. And who could blame them? With prices soaring and condo-flipping all the rage among the get-rich-quick crowd, homes have become the new tech stocks. We all know how that boom turned out.
For every Debbie Daly, there are a thousand other nervous owners debating whether they should do exactly as she did. Federal Reserve chairman Alan Greenspan says there's "froth" along the coasts and in sunbelt states like Arizona and Nevada, where prices are soaring at impossible-to-sustain rates of 20% to 30% a year. Nationally, home prices posted year-over-year gains of 12.5% during the first three months of 2005. That is five times the growth rate of personal income, a pace that can't continue. In fact, the market could not have run this far if not for the proliferation of interest-only mortgages, which make it possible for people to purchase more home than they could otherwise afford. Question is, Can they still afford their homes once higher interest rates or the pesky demands of principal repayment drive up their monthly mortgage costs?
Of course, seeing a bubble and making money off it are two different things. Sell too soon and you'll play catch-up even if prices eventually fall. Then there are the transaction costs. Starting with the standard 6% broker commission, the price tag for trying to time the housing market is high--much higher than the cost of exiting stocks or funds.
It's also possible that today's bears are simply wrong. Stuart Gabriel, director of the University of Southern California's Lusk Center for Real Estate, was once concerned a crash was coming. Now he's less sure. Historically, price declines in real estate have been caused by a weak economy, not speculative fervor. Gabriel also notes that a marketwide shift toward adjustable-rate mortgages may be permanently altering the calculus for home prices. Since ARMs carry lower monthly payments than traditional 30-year fixed-rate mortgages, they give consumers considerably more buying power. That, concludes Gabriel, has led to a "structural upwards adjustment in home prices."
Remember too that where you live is first of all a question of lifestyle, not finance. If you're happy with your house, your neighborhood or your kids' schools, does it make sense to give all that up just to lock in profits that you might fritter away in transaction costs anyway? Only if you're not so attached to your home does cashing out now make any sense. Then the decision can get interesting...
Cash out and sit it out
Odds of success: VERY, VERY LOW Best for: ARMAGEDDON, PERHAPS
Most bubble-leery sellers have no intention of becoming lifelong renters. Their plan is to wait for the market to crater and then buy back in at a discount. But the many costs involved--from the broker's 6% commission to the round-trip moving charges to the loss of the mortgage-interest deduction while renting--can make this an iffy strategy. Indeed, the total cost associated with selling, renting and then buying a new house could easily total 10% of the sale price of your original home--and in some cases more than 15% (see the box at left). This is why veteran East Hampton, N.Y. real estate agent Dianne Saatchi discourages her clients from trying to time the market. "You'd have to be really, really bearish on the market to think you can sell your house, stay in the same community in a rental and then get back in later," says Saatchi, a vice president with Corcoran Group.
Should interest rates go up, moreover, that could gobble up what you'd gain by sitting out the downturn. Say the most you can afford is a $1,450 monthly payment. With a 30-year rate of 5.6%, $1,450 translates into a $250,000 mortgage. But were 30-year rates to climb to 7.6%, that same monthly payment would get you only a $205,000 loan. Assuming a 20% down payment, home prices would have to drop 15% just to offset the stiffer interest rates.
Property taxes are another consideration. States with tax caps, like California and Florida, have tied assessments to sale prices. A Californian who in 1995 paid $200,000 for a house that's now worth $500,000 is charged about half the property taxes owed by a recent buyer of a similar $500,000 house. That's an awfully hefty tax break to give up.
Finally, there's the extraordinary difficulty of timing any market. Consider the individual investor who sold his entire stock portfolio on Dec. 6, 1996, the day Greenspan first famously chided investors about "irrational exuberance." Our imaginary investor intended to buy back in once prices corrected. Unfortunately for him, the market staged one of its greatest rallies over the next four years, with Standard & Poor's 500-stock index climbing 150%. Yes, stocks did implode eventually, but even at its 2002 post-crash nadir, the S&P never fell to the levels Greenspan was so critical of in December 1996. (The Nasdaq index did--for all of five weeks.) Our investor is still looking for a re-entry point.
That's why it's best to enter any cash-out strategy with a clear game plan. Decide ahead of time exactly how long you're willing to wait for prices to fall. That's what Roel Amara has done. When he and his wife sold their Los Angeles home in 2004, they agreed they'd wait two years for prices to drop. What happens if come 2006 prices are still rising? "We'll move out of state," Amara answers. "We're both registered nurses. There's no shortage of places to work."
Cash out and invest
Odds of success: LOW Best for: MAYBE WARREN BUFFETT
Are there investments out there that could outperform real estate over the next few years? Absolutely. We just wouldn't recommend literally betting the house on any of them if your eventual goal is to buy another home. "You've got enough speculation in the decision to sell the home and wait for real estate prices to come down," says financial planner Raymond Ferrara, president of ProVise Management Group in Clearwater, Fla. "You don't need to double the speculation by putting the proceeds into stocks." Ferrara recommends parking real estate profits in short-term bonds and bond funds.
Here's something else to keep in mind before playing real estate arbitrage: The end of the bubble may not bring an end to high prices. "It's pretty rare for home prices to fall unless you lose a lot of jobs in the local area," says Christopher Thornberg, senior economist with the UCLA Anderson Forecast. "What you're really looking at is prices going flat for six or seven years while the fundamentals catch up." If prices don't actually decline, perfect timing becomes crucial. Your alternative investment will have an even loftier hurdle to clear if the real estate boom doesn't end for another two years.
Cash out and downsize
Odds of success: GOOD Best for: EMPTY-NESTERS AND INTEREST-ONLY LOAN HOLDERS
With high-priced homes pacing the housing boom, this can be an ideal time to downsize. For empty-nesters, it's almost a no-brainer. Same goes for near retirees already thinking about swapping their big colonial in the burbs for a city pad or a small condo on the beach.
But there's another group of owners who could benefit from some well-timed downsizing: the twenty- and thirtysomethings who've financed their first homes with interest-only mortgages, option ARMs and other hyperaggressive loans. These folks would be wise to pour their profits into a home they can afford with a more conventional mortgage. They may have to settle for a less luxurious kitchen or less desirable neighborhood or a longer commute. But if the real estate market does tank, that's better than being whacked three years from now with higher mortgage payments they can't afford on a house they can't sell.
Cash out and stay put
Odds of success: HIGH Best for: SENIORS
Once a financial novelty, reverse mortgages are entering the home-loan mainstream. That's good news for older homeowners--you have to be 62 or older to qualify--because this financial gambit is one of the few ways people can cash out part of their home equity without moving or incurring loan payments.
Reverse mortgages are essentially mirror images of regular mortgages. (See June's "Retire on the House" in the Money.com archive.) Rather than make payments to a lender, the lender makes payments to you--in a lump sum or via monthly installments. Best of all, you don't have to repay the loan so long as you live in your home; it's repaid from the sale of your house after you move or die.
One longtime downside to reverse mortgages has been their high up-front closing costs. Those charges have been falling, but even at 5% of a home's value (about what you'd expect today) they look much less vexing if the alternative is to sell and pay 6% to a real estate agent.
What if the home's value at the time of sale doesn't cover the balance of the reverse mortgage? The lender is on the hook for the loss, not the homeowner or his heirs. That's excellent downside protection. But the upside is even better: If the property's value rises over the years, the homeowner or his heirs can keep all of those profits after paying off the mortgage. In other words, you can cash in on cashing out--even if the market keeps going up.
Does Timing Pay Off?
Consider a single person who bought 15 years ago for $125,000 with 20% down. The cost of selling, sitting for two years and buying back in can add up fast.
Home prices had better decline an awful lot to cover that 17.6% bite out of the seller's gross profit.
NOTES: Assumes 15% tax on $377,000 capital gain after various deductions. (No taxes on first $250,000 in gains for single owner or first $500,000 for married couple.)  Two years' rent for three-bedroom house at $2,500 a month.  Assumes $610,000 invested in two-year CDs.