Monday, October 27, 2008

Question -- When is a house a bargain?

Answer -- The formula I've always used is that when you buy a house it costs you 10% a year of the price to carry that house -- which includes mortgage payment and loss of income, insurance, taxes,, repairs, etc. A house is a bargain when you can buy a house and rent it out and cover all expenses with your rent. In other words, your rent income per year should be 10% of the cost of your house.

That's the way it worked during the Great Depression. My dad, who was a top real estate man and I would go over hundreds of "breakdowns" and in those days there were any number of deals where you could buy a house in NYC that was only half rented out, and you could make money on that house. The problem was that everyone was scared to part with their money, and nobody wanted to "do deals."

There was one large hotel in Manhattan that my father wanted to buy. The hotel bar alone was covering the cost of buying the hotel. My father went to many financiers trying to borrow the money to buy that hotel. Nobody was willing to put up the money on that fabulous deal. Confidence in the future was zero. If you had any money, you hung on to it like grim death.

Are houses today anywhere near the bargain prices that existed during the Great Depression. I'm afraid the answer is "no, not by a long shot." Can housing decline that far? The answer is in human emotions and confidence, how low will it go? In this market nothing will surprise me.

What is the VIX.

The VIX (often called the "fear index") closed Friday over 70. What is the VIX? It is a measure of volatility and a sentiment indicator.

What is volatility? Some define it as the possible rate and magnitude of change in price. When prices are calm and tend to have an upward bias, volatility is low and traders feel bullish.

Conversely, when the market sells off strongly, anxiety among investors tends to rise. Traders rush to buy puts, which in turn pushes the price of these options higher. The increased amount investors are willing to pay for put options shows up in higher readings on the VIX. High readings typically represent a fearful marketplace. Paradoxically, an oversold market that is filled with fear is apt to turn and head higher.

From: DowTheory


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