Sunday, May 8, 2022

My House Price is Inflated – Should I Sell?

Average U.S. national house prices have increased to record levels.  Homeowners may view the current market as an excellent opportunity to sell.  While the market is high, there are also indications that a correction may occur within the next few years.  Selling near peak and waiting out a correction to buy at a lower price is a potentially profitable option.  In pursuing such action, it is important to distinguish assumptions from facts in decision-making.

In my last blog post, Real Estate and the First Time Buyer,” I provided an assessment of how the housing market arrived at its present state and explored possible outcomes in the market in the coming two years.  It was written for the benefit of the first-time buyer.   This post builds upon that analysis and explores options for the high equity owner thinking of selling.

There are many reasons to consider selling in the current market.   For example, one’s financial portfolio may be disproportionately allocated to real estate due to the rise in prices.   Or one might be at the limit of the real estate capital gain tax exclusion ($250,000 single or $500,00 couple).   Selling now would restart the two-year exemption timeline on the next house and save significant taxation.  Maybe there were already plans to downsize or retire or move to another job or make a vacation home or rental property into a permanent residence.

There are too many scenarios to assess in this limited space.   The context of people’s lives and regional housing market conditions vary considerably.  So, the remainder of this post will explore a single case study that can provide broad insight in many scenarios. 

For this analysis, assume the strategy is to sell in anticipation of a significant market decline, and to then reenter the market when a price correction occurs.   This is a market timing scenario.  To successfully accomplish this market timing strategy requires occupying temporary housing for up to two years awaiting the market correction.  In an ideal situation the seller may own a vacation home or a vacant rental property they can occupy full time for the necessary period while they extract themselves from the market.  Those without must rent and account for temporary housing costs while sitting out the market.

This strategy anticipates a significant housing market price correction will occur in the coming two years.  There is debate among experts over whether a correction will occur, when, and to what extent; however, there are increasing numbers of reports pointing in that direction.  Most do not anticipate a severe collapse such as occurred in 2008; however, there is a growing body of opinion that a significant correction may occur.  Any national correction is expected to have broad regional variation.

There is reason for concern that the U.S. economy is facing serious headwinds.  Inflation and interest rates are on the rise and many experts think the Federal Reserve is not handling these issues well.  Concerns a recession is within two years are increasing.  The Ukraine War and the Chinese Covid lockdown are exacerbating supply chain issues.  The stock market is in correction territory (down over 10%) and may potentially extend declines to Bear Market territory (down over 20%).  These conditions may influence the housing market negatively but realize that predicting the future is very risky.  Proceed with caution.   Mitigate risk by knowing your circumstance and regional market well.

Selling one’s home is a major undertaking.  It has many implications for a family.  The analysis here is financially focused, but the intangible things – disruption of lifestyle and stress – may be more important and deserve full consideration.   Ultimately, the decision will come to, “Is the potential gain of selling worth the risk and personal disruption and stress of the process.”

Moving is considered one of the most stressful events in life.  Some folks have a lot of experience with multiple home sales in their lifetime.  They have developed a knack for organizing an efficient moving cycle process.  They have reduced their inventory of “stuff” to be carted from place to place. They know how to efficiently perform renovations and improvements, and their experience in this activity has proven profitable in the past.   They view the process as a creative adventure. They enjoy new places and transforming houses.

At the other end of the spectrum are folks who have had one or two homes in the past 30 years.  They may be recent empty nesters looking toward retirement or already have retired.  Maybe their home needs updating, and they have accumulated “stuff” throughout their house, garage, and maybe even a rented storage unit.  To them, selling may seem a daunting task.  But the record market prices may represent the best opportunity in a lifetime to transition.

First, know that simply selling a home at a peak and buying another equivalent home in the same market may be a losing proposition.   That house down the street or across town is also inflated.  The transaction costs (e.g. agent fees, taxes and other closing costs) for the house you are selling may be seven percent or more of the sale price.  There will be moving, storage, and temporary housing costs.  The house you buy will have closing costs, updating, and furnishing requirements.   If financing, there will be mortgage fees and points.  These new house transaction costs may represent an additional five percent or more of the purchase price – ensuring a loss.

The remainder of this post will use a case study of a hypothetical house in Florida to analyze the financial implications.  In this case, the hypothetical house is in the Naples market.  The region has a high concentration of retirees.  Over 50% of houses are bought with cash.  Much of the housing stock is seasonal second and third home accommodation.   Despite a robust new home builder presence, inventory is not keeping pace with demand. 

A national moderation of the market can result in much broader and more severe regional impact based on circumstance and market type.  CNBC reported on CoreLogic data in 2011 that the Naples market suffered a 55% decline in prices following the 2008 housing collapse.  Is this likely again?  Probably not, but whatever national average price correction occurs - it will likely be significantly amplified in Florida – particularly if there is a recession and stock market decline.  

A conservative approach will be taken here and use three scenarios for analysis: 1) A minor moderation of prices; 2) a 10% regional average price decline; and 3) a 20% regional average price decline.

The first step is to determine accurately the Cost Basis of the house to be sold.  Knowing this number is essential to calculating capital gain tax implications.   Start with the sale price.  In this hypothetical case it is $400,000.   Then add expenses for fees and closing costs and improvements allowed by the Internal Revenue Service.  Any costs of repairs or maintenance that are necessary to keep your home in good condition but don’t add to its value or prolong its life are not allowed.  As shown in the adjacent table “House Selling Cost Basis,” the Cost Basis of the house rises to $437,000.

The second step is to estimate the return on the sale of the current home.   An agent commission of 5-6% is typical if a real estate agent is used.  According to the National Association of Realtors 89% of sales are through a realtor.  There are also closing cost fees and charges.   As indicated in the adjacent table, “House Selling Peak Sale Price Return,” in the current market the owner is expecting a $750,000 sale price.  This results in net proceeds of $707,150, a net profit of $270,150, and a return on investment of 62%.   Not bad!

The third step is to estimate the transaction costs associated with purchasing the new home.  Estimated closing costs are $7,000 and repairs and improvements are estimated at $35,000.  Rarely is a house purchased that is in perfect condition.   It will have some typical costs such as new flooring, painting, minor repairs, appliances, and decoration.   This is a basic cosmetic uplift budget.  A thorough examination of a home for additional work such as roof or replacement windows may increase those costs.

The fourth step is to estimate the moving, storage, and temporary housing costs shown in the tables below.  Again, if one owns a vacation home or vacant rental property that can be used for temporary lodging while waiting for a market correction all the better both for convenience and financial outcomes.  But many folks will need to rent an apartment or house for the waiting period.  The table reflects a two-year temporary housing period.  Shorter periods may have lower costs.


The fifth step is to estimate the savings that arise from selling the original home.   Operating a home can be costly - particularly if there are high property taxes in the area and if the home is part of a Homeowners Association.   The adjacent table, “House Operating Costs Saved,” provides the estimated savings for a full two years.

The sixth step is to estimate the earnings from investing the proceeds of the sale of the house during the two-year waiting period.   Given that the funds will be needed to purchase the new home within two years they will have to be invested in very conservative and liquid vehicles.  The stock market is not a good place for these funds.  It is best to deposit them in money market funds and short-term certificates of deposit.  Rates in these accounts are on the rise, but for now can only be estimated at one percent return.  Such a low return is disappointing, but the funds cannot be risked in the stock market and need to be available immediately when the market correction occurs, and a new house becomes available.

Having the detailed estimates of all costs of executing this market correction strategy it is possible to project outcomes.   To fully understand the implications of this activity it is better to look at a ten-year time horizon.  The table below shows three sale scenarios on the left-hand column and three potential market outcomes across the top row over a ten-year period.

To understand what the table, please look at the Market Slow Down column.  Under the No Sale scenario in which we take no action and keep the original house for ten years that house is projected to be worth $1,031,004.70 with low annual price increases going forward over the next ten years.  In the next scenario where the original house is sold and the seller sits out the market for six months, the projected value of the new house and any savings/earnings from invested funds over ten years is $1,060.895.90 for a gain of $29,891.20 over the period.   In the next scenario, where the original house is sold and the seller sits out the market for two years, the projected value of the new house and savings/earnings from invested funds over ten years is $1,076,207.40 for a gain of $45,202.70.

Notice the gain rises with the 10% Market Drop and 20% Market Drop.   In these scenarios the market timing has worked.  The original house was sold near peak market, a correction occurred of 10% or 20%, and a new home was purchased in that new pricing market.   The net remaining funds were invested in the stock market for the remainder of the ten-year window with a conservative return of 5%.   As can be seen, under this scenario the gain could be more than $200,000 over ten years.

What is driving these returns?

First, the model assumes that the market correction is timed right.  The seller gets the maximum price for sale of their existing home, sits out of the market to catch the correction, and reenters to buy a house up to 20% less than it was previously valued.   But even if there is just a market slow down there is still a modest gain of $29,891.20 sitting out the market for six months and $45,202.70 sitting out for two years.

Some of the gain is largely driven by capital gains tax savings.   It is very important to understand capital gains taxes on both real estate and investments.   When a house is sold, the seller is liable for capital gains taxes on the proceeds.   There is an exemption of up to $250,000 if single and $500,000 if a couple when selling real estate.   The home must be your permanent residence and you must have lived in it for two years.   In the case study, one can see that if the owner decides to stay in the house for another ten years and then sell, the gain on the house exceeds the $500,000 exemption.  Capital gains taxes will be due on that excess.  Capital gains taxes are typically 15% or 20% of the gain (see table adjacent).  By selling the house now, the gain is less than $500,000 and is fully exempt from tax.  Again, have a complete understanding of capital gains taxes if engaged in this activity.

There is also gain from the investment of the funds that remain after the discounted house is purchased.  In this case study the original house was sold for $750,000.   In the 20% correction scenario the new house is purchased for much less, leaving a balance of about $150,000 to be invested.  In this case study we estimate a 5% return on the investment annually and a 15% tax on any capital gains generated by the investment.  These returns have a positive impact over the ten years and beyond.

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