April 06, 2004

Notes: Benjamin Wallace-Wells on the Housing Bubble

Given the restrictions on supply--the unwillingness of San Francisco or Cambridge neighborhoods to look more like the Upper West Side or Newbury Street, the unwillingness of Berkeley and Lexington neighborhoods to look more like San Francisco or Cambridge, et cetera--the only evidence that's convincing is the price/rental ratio. And even there the price/rental ratio ought to respond to interest rate changes by an amount proportional to the duration of housing as an asset--if Alan Greenspan is correct in his beliefs that the inflation risk premium has been permanently wrung out of interest rates, that cheap computers mean a higher capital-output ratio and may mean a lower marginal product of financial capital, et cetera.

Assessing whether our current housing price bubble is a little deal or a big deal depends on what the likely future path of real interest rates is, and that is a very hard problem to solve:

"There Goes the Neighborhood" by Benjamin Wallace-Wells: ...in most of the country there's no housing bubble. Perhaps the crucial ratio from which economists determine whether housing markets are out of whack is the ratio of home prices to annual income. In most of the country, it is modest, 2.4:1 in Wisconsin, 2.2:1 in Kentucky, 2.9:1 in Illinois. Only in about 20 metro areas, mostly located in eight states, does the relationship of home price to income defy logic. The bad news is that those areas contain roughly half the housing wealth of the country. In California, the price of a home stands at 8.3 times the annual family income of its occupants; in Massachusetts, the ratio is 5.9:1; in Hawaii, a stunning, 10.1:1. To some extent, there are sound and basic economic reasons for this anomaly: supply and demand. Salaries in these areas have been going up faster than in the nation as a whole. The other is supply: These metro areas are "built out," with zoning ordinances that limit the ability of developers to add new homes. But at some point, incomes simply can't sustain the prices. That point has now been reached. In California, a middle-class family with two earners each making $50,000 a year now owns, on average, an $830,000 home. In the late 80s, the last time these eight states saw price-to-income ratios this high, the real estate market collapsed.

By other measures, too, the market is badly bloated. One index of housing inflation is the difference between house prices and rents. In a healthy market, driven by demand, rents and sale prices ought to track roughly together. But while sale prices have soared, rents have stayed flat; and in some of the most overheated markets, like San Francisco and Seattle, they have actually been declining. Such a gap, the economist and New York Times columnist Paul Krugman has written, suggests "that people are now buying houses for speculation rather than merely for shelter," evidence that he called a "compelling case" for a housing bubble. "Within the next year or so," The Economist argued in a May 2003 editorial, these regional "bubbles are likely to burst, leading to falls in average real home prices of 15-20 percent" across America. And, of course, in the most heated markets the drop is likely to be steeper yet.

When housing bubbles burst, they can hurt more than their sector of the economy. Studies have shown that they exercise twice the effect on consumer spending as comparable declines in stock prices. So, a 20 percent drop in housing prices would have the same, shriveling effect on the economy as a 40 percent crash in the stock market. When investors lose value in their houses, many of them pull money out of other investments, like stocks. Then, too, jobs in construction, real estate, and other fields that depend on new home sales die off...

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Comments

When home prices reach such high multiples of income, purchasers are obviously using savings rather than earnings to pay for them. It seems to me that you need to somehow include equity ratios and carrying costs to more accurately determine if a bubble exists or not.

I know, for example, that here in Boston lots of wealthy immigrants are using family savings rather than large mortgages to purchase their homes.

Adrian

Posted by: Adrian Spidle on April 6, 2004 12:09 PM

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plus how many of them are rolling gains over from their last house? even still, what type of correction is likely? 20%? that still only accounts for a fraction of the run-up in some areas over the last 5 years.

Posted by: jjj on April 6, 2004 12:30 PM

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And could someone who is better informed on this subject than I am give me a rough figure for the expected (rational?) ratio between real estate values and housing rent? Or should that be between mortgage payments and housing rent?

Scott

Posted by: Scott Swank on April 6, 2004 12:57 PM

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see chart 3 here:
http://www.ntrs.com/library/econ_research/weekly/us/pc040204.pdf

yes, it's an index ratio, but it gives you some clue as to why people are concerned. plus, it's based on actual data, not just one or two samples.

Posted by: wcw on April 6, 2004 01:10 PM

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I know that I looked at the rental vs. buy ratio in the South San Francisco Bay area, and found that renting costs half the price of buying a home of the same size. Some reasons why rental prices are low: 1) Prop 13 reduces housing turnover, since you'll end up paying higher taxes (MUCH higher taxes) if you sell and buy another property. This drives up the price of resale houses. 2) Prop 13 also applies to commercial property. Much rental property was purchased at a low price many years ago. It can be rented out for cheaper than the mortgage payments on a new property while the owner still makes money. The owner has no incentive to turn it over, since he'd then have to purchase another property with much higher taxes at a muich higher cost. 3) Outflow vs. supply. Numerous new apartment complexes have opened in the South Bay in the past three years. The population of the South Bay has not increased anywhere near that.

In short, well-meaning government interference in the housing market (Prop 13) has caused a massive distortion in the rental vs. purchase equation. It is unclear what can be done to resolve this situation, however -- Prop 13 remains highly popular, especially amongst those who would be unable to pay taxes on current assessments. A solution such as in Arizona, where if property values in an area rise, tax assessments must be lowered to make things revenue-neutral (adjusted for inflation and population growth), would work much better than Prop 13 at keeping property taxes in check while avoiding the distortions caused by Prop 13. Prop 13 heaps the majority of property taxes upon a small number of recently-turned-over properties, leading to ever-increasing tax rates on that small number of properties, resulting in disincentive to sell and purchase properties, resulting in less mobility of assets, resulting in (ta da) higher prices for those assets that ARE turned over. It's nuts. It's the law. Hmm... you notice that "nuts" and "law" in the same sentence is like "peanut butter" and "jelly" in the same sandwich?!

Posted by: BadTux on April 6, 2004 01:17 PM

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prop 13 was not well-meaning. it was and remains a gift to commercial property owners. that it is popular among individuals baffles me, but its populist appeal is undeniable.

Posted by: wcw on April 6, 2004 01:27 PM

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"I know that I looked at the rental vs. buy ratio in the South San Francisco Bay area, and found that renting costs half the price of buying a home of the same size.
Posted by BadTux"

Do you mean price or cost? Price is a simpole number whereas cost is fairly complex.
Adrian

Posted by: Adrian Spidle on April 6, 2004 01:35 PM

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“Assessing whether our current housing price bubble is a little deal or a big deal depends on what the likely future path of real interest rates is, and that is a very hard problem to solve”

Hard, indeed. If we don’t know whether the bubble is little or big, isn’t there is a reasonable chance that there is no bubble? A really small bubble isn't a bubble. Thus beginning with the assumption there is a bubble probably bad start. Having heard no convincing argument that bubbles are identifiable except after the fact, I think we’ve gotten off to a bad start. So, we don’t have a “bubble”. We have higher than normal price-to-income ratios in 20 metropolitan areas that contain roughly half the housing wealth of the country. There, that wasn’t so hard, and it doesn’t reach a premature conclusion.

“In the late 80s, the last time these eight states saw price-to-income ratios this high, the real estate market collapsed.” The last time the real estate market collapsed, there was a tremendous regulatory failure that allowed financial institutions to get themselves in a terrible fix. I am aware of no similar circumstance now – unless Fannie and Freddie are a much bigger problem than just about anyone thinks they are. From all appearances, regulatory oversight is increasing without any serious problems coming to light.

Krugman, smart as he may be, is “speculating,” as surely as the homeowners he describes, when he predicts a 15%-20% drop in home prices nationwide. The “collapse” in the housing market in the 1980s saw nothing like a 15% drop in prices nationwide. Then, valuations were high and there were serious problems with housing finance. While valuation excesses (assuming that’s what they are) may be greater now, without the accompanying problem in the financial sector, it is far from certain that we are in for a worse reaction in prices than in the 1980s.

Posted by: K Harris on April 6, 2004 02:00 PM

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Prop 13 is a necessary evil, for both commercial AND residential real-estate. It is grossly unfair, but the limits on reassessment are necessary.

One of the greatest enemies to a long term business is unpredictibility. Having your property tax bill go up by 2x-4x in a 10 year period because of asett inflation, that is, tax on PAPER gains, is a real crippler.

Would anyone, in a non-prop-13 world, want to engage in ultra-long term leases, which are so common today?

Likewise, pre prop-13, the county assessor tended to become a den of corruption, because the roll was incredibly powerful.

Prop 13 is grossly unfair, but IMO, it is necessary unfairness.

Posted by: Nicholas Weaver on April 6, 2004 02:10 PM

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Bidding on houses and apartments in our neighborhood and others has been hot and heavy, but property tax increases are limited, insurance costs are limited because they are on the home and not the land and home, and the city is vibrant and a draw for families. Mortgage costs have been quite low, and have hopefully been locked in. Why should there be a substantial drop in real estate prices around us?

Posted by: anne on April 6, 2004 02:16 PM

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Nicholas, I already mentioned a better solution, the one used in many states other than California -- i.e., if property values go up, tax rates are reduced to maintain property taxes at a revenue-neutral state (when adjusted for inflation and population growth). This is far fairer than making the bulk of property taxes be assessed against a small minority of recently-turned-over properties.

Posted by: BadTux on April 6, 2004 02:24 PM

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Nicholas Weaver wrote, "Prop 13 is a necessary evil, for both commercial AND residential real-estate. It is grossly unfair, but the limits on reassessment are necessary."

Nonsense. Proposition 13 is both evil and destructive of the economy. California will remain an economic basket case as long as Proposition 13---namely, government handing Ricardian land rent to landowners with no strings attached---is repealed.

Land value taxation is one of the few win-wins available in public finance: both equitable and efficient.

For a good summary of LVT and Georgism, see:
http://members.aol.com/_ht_a/tma68/geo-faq.htm

Posted by: liberal on April 6, 2004 02:26 PM

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Adrian: I am addressing housing price. I do not view housing as an investment at this time, since I do not believe the current prices are sustainable. Thus the only thing that really matters is the amount of money I would pay per month to rent a home from the mortgage company, vs. the amount of money I would pay per month to rent a home from a private party.

And for the person who brought up Fannie and Freddie: At the moment, Fannie and Freddie are being subsidized by the Japanese and Chinese, who are using their trade surplusses with the United States to buy up mortgage-backed securities as well as U.S. government bonds (thus also subsidizing the U.S. deficit). The question is how long they will continue doing this. It may be next year, or, more likely, it may be 20-30 years from now when China believes they've finally caught up to the U.S. technologically and economically and no longer need to subsidize their own economy with exports to the United States, but sooner or later they will cut their losses.

Posted by: BadTux on April 6, 2004 02:31 PM

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Addendum: I meant "basketcase" from the point of view of public finance.

Posted by: liberal on April 6, 2004 02:34 PM

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http://www.cepr.net/

has good stuff on the housing bubble. In particular, they sponsored an essay contest to find the strongest argument against the claim there's a bubble. They posted the results today.

Posted by: liberal on April 6, 2004 02:38 PM

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Agreed, real estate in attractive areas is expensive just now. More than that, I will not admit to. Too risky to be selling your home thinking you will buy it back at a fine discount in due course.

Posted by: anne on April 6, 2004 02:50 PM

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By the by, Real Estate Investment Trusts have paced the S&P in gains in value since 1972. Actually they now have an edge.

Posted by: anne on April 6, 2004 02:52 PM

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Adrian Spidle: "When home prices reach such high multiples of income, purchasers are obviously using savings rather than earnings to pay for them."

If I were to buy a house where I live, I would use my savings plus a humonguous loan. As typically people put no more than 20% down (and often much less), the loan will then be serviced out of future income.

Posted by: cm on April 6, 2004 03:48 PM

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does it matter where the money comes from? what's indubitable is that homeowner equity is at record lows. just follow the link to Paul Kasriel's piece. he's unlikely to be 100% right, but I trust his ability not to get the data wrong.

in re: REITs, the last few days have seen some reassessment in the marketplace of the outlook for real estate:
http://ichart.yahoo.com/z?s=^NLR&t=5d&q=l&l=on&z=l&p=s

that's a chart of the iShares for the DJ US Real Estate Index. down 10% in two days -- not a bad little move. how'd you feel if your house value dropped 10% in two days?

Posted by: wcw on April 6, 2004 04:39 PM

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anne wrote, "By the by, Real Estate Investment Trusts have paced the S&P in gains in value since 1972. Actually they now have an edge."

*In the long run*, land is an excellent investment.

In the short run, who knows? And REITs have a lot of nonresidential holdings. And if a REIT holds apt bldgs, and owner-occupied homes are inflated relative to tenant bldgs, REITs won't be a part of the bubble.

wcw wrote, "in re: REITs, the last few days have seen some reassessment in the marketplace of the outlook for real estate:"

Yes...I just looked at some stocks, since I own some of the Vanguard REIT index. I cashed out quite a few shares when it was at about $14.50. It's recently been as high as $17.20. Crazy. My impression is that today's 4% decline was due to some Barron's interview.

In particular, one can view REITs as akin to closed-end funds. Here's a graph of some data for the premia/discounts:
http://www.greenstreetadvisors.com/premnav.html

Posted by: liberal on April 6, 2004 04:48 PM

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ann says "Agreed, real estate in attractive areas is expensive just now. More than that, I will not admit to. Too risky to be selling your home thinking you will buy it back at a fine discount in due course."

True. But that's not the risk people are taking. People aren't speculating that it is a bubble. People are speculating that it is _not_ a bubble.

The risk people are taking is in buying houses with huge mortgages, on the assumption that property values will rise. Especially for negatively-geared investment properties (where yearly costs will exceed yearly income) this is a large bet that this is _not_ a bubble.

As for who else is at risk: I wish I knew. If people really are flocking to fixed-interest mortgages (and your US laws encourage it) then someone must be at risk of losing money if interest rates revert to historic norms. But given how easy it is to sell and buy such risk on interest rate derivative markets, it's far from clear to me _who_ is carrying that risk.

Is it Fannie Mae and Freddie Mac?

Sean

Posted by: meno on April 6, 2004 06:30 PM

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Scott Swank
A while back PrudentBear had a piece that might interest you:
http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=26672
The author descibes his brief and profitable foray into the real estate market using just those calculations you are looking for.
wcw
I too read the cute guy at Northern Trust though the news about homeowner equity was not new. The PPI increases he noted April 5th (and argued that this heralded significant inflation) were more important and may have triggered the 10% shift in Real Estate index you cite. Or is that typical volatility?

meno asks who is at risk and who carries the risk ( lets pass on the distinction between speculating on a bubble vs speculating ) and it seems obvious to me it's the current taxpayers and the next generation. Or two.
OK, maybe that's what another dose of PrudentBear does to me.
http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=31605
This guy sees the crunch around late summer but what does he know? anne says there is no bubble.
Maybe I need to change my medication.

Posted by: calmo on April 6, 2004 06:57 PM

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I think that we waste too much time debating issues without first agreeing on the meaning of the terms we are using. So let me propose a definition of the term "bubble" that I picked up at a non-academic conference held at the University of Chicago during the height of the equity "bubble".

A bubble exists when the price of the asset involved is set by investors who are assessing the behavior of other investors rather than trying to evaluate underlying value. For example, at that conference I attended, Professor Thaler presented evidence that fund managers believed BOTH that stocks were substantially overvalued and that they would genrate large excess returns during the subseqent year as other investors pushed them to even more overvalued levels. Thaler suggested that such investors were, by his defintion, contributing to a bubble.

I know that the "true" meaning of a term is merely its conventional use. But I think Thaler's concept has the advantage of being tightly defined, easy to understand and testable.

It is interesting to question whether the real estate market fits this definition of a bubble. It is possible that real estate prices are too high and that they will fall when interest rates rise -- as Dr. Delong suggests. But that is not necessarily to say that real estate is in a bubble. Maybe people just have the wrong, sincerely-held interest rate forecast.

Or maybe people shorting mortgages to
buy a perpetual flow of housing services are pretty much hedging the interest rate question away.

Posted by: Gerard MacDonell on April 6, 2004 07:20 PM

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Some of the people buying these McMansions may be using savings, but I'll bet most of them are in debt over their heads, and one paycheck away from bankruptcy.

Real estate speculators are a key component of what C. Wright Mills, in The Power Elite, called "urban growth machines." Massive government subsidies to growth have, as one of their primary effects, an explosion in land values. The taxpayer who subsidizes growth through road taxes and utility rates, is at the same time driving up the rents accruing to land speculators and landlords. And of course, to increased property tax assessments on his own split-level ranch, which will in turn fund more roads and utilties, to subsidize more growth and real estate speculation.

I don't agree with the Georgist remedy, but they're pretty much on the mark about the nature of the evil. Homeowners need to stop paying tribute to the bank, tenants need to stop paying tribute to the landlord, and both need to stop paying tribute to the state. And infrastructure needs to be funded on a cost basis, so that ordinary taxpayers and ratepayers aren't subsidizing other people's profits from explosive urban growth.

Posted by: Kevin Carson on April 6, 2004 07:39 PM

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There was a bubble here in Santa Cruz when I bought my house five years ago, in the crazy times, bidding sight-unseen. Every year since, the coming death of the bubble has been announced, with great confidence. After all, we've been the worst place in the country for price-to-income measures. But prices never really stopped climbing, and now the crazy times have returned, with multiple over-offer bids. Yes, it feels like a bubble, just as it did five years ago. But if I'd taken BadTux's "safe" way then, renting from a landlord instead of renting from the bank, I'd have been priced right out of the market -- there now isn't a house in town for sale for less than I paid. For me, that was a much bigger risk than commiting to a fixed mortgage. Should I recommend that someone not follow my lead, just because I think prices seem high? Can I assure them that the coming crash won't be accompanied by increased interest rates that leave their costs just as high? Can I be confident that the free market has utterly failed to fairly price real estate in one of the most beautiful spots in the country? Isn't the market telling me that it is worth extra sacrifice (in terms of fraction of income) to live in a place (e.g., Berkeley or Cambridge) that many people desire to live?

Posted by: Steve on April 6, 2004 09:16 PM

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I'm reasonably sure there's a bubble in the most important metropolitan areas and when you combine it with Freddie and Fannie's overexposure to risk, it could well make the S&L bailout and cleanup look cheap. When interest rates increase and the spread between prime and fixed mortgage rates drops, or even turns negative, it's going to be a bloodbath.

Posted by: Ian Welsh on April 6, 2004 09:19 PM

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I still cannot wrap my mind around this statement:
"In California, a middle-class family with two earners each making $50,000 a year now owns, on average, an $830,000 home."

I just can't average that out. The homeowners I know with houses of more than $800,000 either have both earners making well over $50,000 or else so well off that there is only one wage earner or some other situations. I understand that this is about averages, but I don't know any household that fits this profile.

Posted by: J Edgar on April 6, 2004 09:23 PM

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the key is that tipoff phrase "on average". income and home prices are both highly skewed distributions. in neither case does the average value tell you anything about the typical case. that said, even a bad statistic is telling when prices are this high.

as for the DJ RE Index volatility, the last 900-odd trading days show an average return of 0.04%, standard deviation 0.87%. these last two days' moves were 4.8 and 4.3 sigma, respectively. if daily index returns are normally distributed, today's event is expected only once every 125,000 trading days, Friday's once every 162,000 trading days.

these happened two days in a row. yet another nail in the coffin of using normal distributions to model financial returns.

Posted by: wcw on April 6, 2004 10:13 PM

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wcw
Thanks for the details re volatility on your previous post and reminding us ( J Edgar) of the difference between typical (anecdotal?) and average. Today I see reports of a 15% drop in monthly refinancings in response to a 26 basis point hike in the mortgage rates.
http://biz.yahoo.com/rf/040407/economy_mortgages_3.html
Should that constitute a trend, it won't be long before what our friend Kasriel noted about M2 supply reverts back to it's Q3-4 slide. He sees businesses possibly taking up the slack in bank loans ( anticipating even higher prices shortly).
Given the miniscule spread between 30yr fixed and ARMs (~2%) and the preference for the latter, it is hard to believe that businesses would take up that slack. Will the tax rebates be enough to replenish the consumer to make these business decisions viable?

Gerald writes about specifying what we mean when we say 'bubble'. I want to defend the ordinary speaker's use of the term or atleast draw attention to the dispositional character of it. Like 'brittle' it means 'could shatter if knocked' or 'handle with care'. It doesn't mean 'shabby' or 'over-priced' or 'the probability of retaining it's present characteristics in an uncontrolled environment is exceedingly low'.
Specifying a technical or special ( Thaler) meaning to the term conceals this chunk of the ordinary meaning of 'bubble'. Is it "tightly defined, easy to understand and testable" as you say? Your claim "a bubble exists when the price of the asset involved is set by investors who are assessing the behavior of other investors rather than trying to evaluate underlying value", assumes we can separate the underlying value from the speculated value.
And this,well-meaning if not "tightly defined" and "easy to understand", is bunk, no?

Posted by: calmo on April 7, 2004 06:57 AM

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K Harris argued, "The last time the real estate market collapsed, there was a tremendous regulatory failure that allowed financial institutions to get themselves in a terrible fix. I am aware of no similar circumstance now – unless Fannie and Freddie are a much bigger problem than just about anyone thinks they are."

Interestingly, only a small part of Wallace's original article was quoted --and here's the good part-- most of what wasn't posted is all about the LAX REGULATORY OVERSIGHT of GSEs and Alan Greenspan's recent (and unusual) warnings to that effect!

Here is the complete article: http://www.washingtonmonthly.com/features/2004/0404.wallace-wells.html

Wallace makes a very powerful argument (with good reason) that Fannie and Freddie, indeed, ARE a much bigger problem than just about anyone thinks they are.

Posted by: FED-up on April 8, 2004 12:59 AM

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Ok, for any experts still reading this thread my situation: 2 years ago we bought a 2bd/1bth home for $81,500. on a quarter acre in a small town in California (about a thousand people) 40 miles from the nearest town. We refinanced to 5.25% 6 months ago. Our monthly payment is $292.00 P&I. It's too far to drive regularly so we'd been looking for something else with the intention to rent this one out and recently bought a 1 1/2 acre property in a beautiful area with two homes on it for $290,000. One is a manufactured home in very good shape, the other is an old farm house not in the greatest shape but livable (however the loan would not cover it). We have found a renter for the manufactured home and intend to live in the older one ourselves.

So basically we have 3 homes, with two set to rent out. Did we do the right thing or are we set to lose big? Should we immediately try to sell or hold onto these properties and ride out the burst (one worry - I have doubts about either home lasting for too long, the manufactired because it is manufactured and the old home because it is old; will they be able to hold their value long enough for a recovery?)?

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