One of the things that a buyer has to watch out for, especially with new build houses, is whether or not they are buying in at too great of a negative equity position. Builders always seem to price a little higher than the sold price averages of existing homes in the current market would dictate. Some of that is attributable to the “new factor”. Everything is new, so there should be little in the way of maintenance or update costs for several years. That certainly justifies a premium of some sort; but, it is that premium that is contributing to the negative equity of the property.
Equity may be defined as the net value of the house as an asset – it’s sales value less the cost to payoff whatever the remaining mortgage balance is at the time, i.e. what you put in your pocket after the sale is closed. Prior to the recession there had been a commonly accepted notion that equity in homes always went up; sometimes slowly and sometimes rapidly, but always in the same positive direction. If the quick run-up during the housing balloon period that led to the Great Recession is taken out, the historic appreciation curve showed a steady increase in home values of about 3.0 - 3.5% per year for decades, going back to the end of WWII. So, if you bought a house and maintained it well, you could count on its market value increasing that much each year.
Then the Great Recession hit and our notions about home values and the equity that we have in them got turned upside down. We all got somewhat used to the concept of negative equity during the recent “Great Recession.” Some homes in the area around Southeastern Michigan lost 30-40% of their pre-recession values; with many in cities like Detroit, Pontiac, Ypsilanti and other losing more than 50% of their pre-recession values. That is where the house is worth less that what you paid for it. New terms were coined like “being underwater” or being “upside down”. Those were terms in the vernacular to describe being in a negative equity position.
In reality, all homeowners are in negative equity positions on the day that they close on the purchase of their new home. That is caused by the fact that the price paid for the home includes costs that were independent of the home’s underlying value and which were paid for by the seller (so the buyer never saw them), but which are part of the “value” that is reflected in the mortgage. Those costs include the commissions that were paid to the real estate brokerages involved as well as the various fees and taxes that the seller had to pay and which were “rolled into” the purchase price and thus into the mortgage. In Michigan those costs average about 7.5 to 8% of the purchase price. So the day that you walk out of the closing room with your new house keys in your hand you are underwater by at least that much – 7-8%. Why is that on you? Because, if you had a misfortune in the next week or month or year and had to sell that same house for exactly what you paid for it that 7.5 – 8% would come out of your pocket now, because you are the seller.
In the “good old days” of positive equity grow it might take you 2-3 years to get back to the breakeven point on that house. Breakeven is where you walk out of the closing with no debt, but also with no money in your pocket. For many who bought just at the peak of the housing bubble in 2007/8, that is still an elusive goal. They still have negative equity in their homes. The good news is that somewhere between 80-85% of all homes across America have regained enough value to put their owners into positive equity positions.
So what does all of this have to do with were we started? We are well out of the recession and home values have come roaring back much quicker than most experts expected they would. That rapid run-up of values is being driven mostly by a scarcity of homes on the market and the pent up demand for housing that was stifled during the recession. The good news is that the most home owners have recovered the value that was lost in the recession. The bad news is that many home sellers have gotten greedy and inflated the asking prices for their homes. That has been especially true for some builders who have recently been pricing their new build homes well above what can be justified in the current local markets.
How do you know what the current local markets justify for home prices? The best way to know is to work with a good Realtor® who can do a Comparative Market Analysis for you of the local market. Tell him what the characteristics ae f the house that you are interested in – size in Sq. Ft., number of bedrooms and baths and ½ baths, and features like a garage and basement and the size of the lot or land with the home. The agent will be able to look at the similar homes that have sold in the area that you desire and tell you what the average cost per Sq. Ft. is for homes that meet your criteria. Usually the agent will give you a range that helps cover the differences between homes in great shape and with really good finished on the high end and those that might need some work or redecorating on the low end. For instance, in the Village of Milford where I live and do business, the range for a mid-market, 3 or 4 bedroom. 2.5 bath house of 2200 t0 2500 Sq. Ft. would be $125 – $145/Sq. Ft.
So, let’s say that you were out looking and you come across a new build subdivision that featured similar sized homes and they want $180/Sq. Ft. for their homes. A red flag should go up! Right away you would be paying well above the prevailing local market averages and are probably will end up in a larger negative equity position. Remember that you are already going to be 7-8% to the negative the day that you close, just due to the cost of the real estate transaction. Now add to that having paid a price that is 25% above the prevailing average and you are now in the hole more than 30% against the market. At the historic rate of appreciation it would take you more than 8 years to reach breakeven.
Buying in at the prevailing local value averages is about the best that you can do, unless you happen to get a great deal on a house that is priced below market. At a minimum you should think long and hard before you buy in to negative equity that will take you longer than 5 years to recover, especially if you are at the beginning of your home owning years. The U.S. Census Bureau reports that the average American moves 12 times during his lifetime; so you probably aren’t going to be there all that long. If that is the case, don’t buy into too much negative equity. Your local Realtor is the best source for the kind of information that you need to make good decisions. If it’s the Milford, Michigan area, give me a call and I’ll help you.