The Risk of Catching a Falling Knife

Lucas Lechuga, a Miami Realtor®, writes on market timing in his blog:

“Nowadays, it seems like everyone is looking for a deal and the right opportunity to buy in Miami. The million dollar question that I get from the people who contact me each day is ‘When will be the best time to buy a condo in Miami?’”.

“The answer to that question depends on your objectives and knowledge of the Miami condo market. If you’re an investor ‘looking to buy a condo in a good neighborhood of Miami at a significant discount’ then the answer to that question is as vague as your objective – ‘Nobody knows!’. That’s like saying that you want to buy the best stock at the bottom of a bear market. Good luck!”

“Keep in mind that the ‘market bottom’ for the Miami condo market might not necessarily be the best time to buy for people with such a pinpoint objective as the one above. These people might miss out on better opportunities that will have passed them by.”

While Mr. Lechuga is correct that nobody knows when the market will actually hit bottom, I will show that it is far riskier to buy “too early” than to “miss out on better opportunities that will have passed them by.”

It isn’t too difficult to see why buying into a rapidly falling market is a huge risk. If someone buys now and the market drops another 20%, it could take years of waiting for a market turnaround before their real estate purchase can be profitable. As we have seen in the daily F@cked Buyer posts, it is often impossible to sell a home after the market has dropped without paying cash at closing or ruining one’s credit through a short sale or foreclosure.

On the other hand, what happens when a buyer misses the bottom? Are they really missing a huge opportunity?

In order to illustrate what happens, I developed a simplified model to compare someone who buys “too early” versus someone who buys “too late.”

Model Assumptions

• I start by assuming the buyer is considering a median-priced home in South Florida, which is currently priced at $319,900 (see my previous post on median listing-prices in South Florida).
• I compare two buyers. The “Impatient Buyer” buys right now. The “Patient Buyer” buys three years from now.
• I assume the market can be in three possible phases: declining, stagnating, or experiencing modest growth. For the purposes of this model, I assume that we will not see hyperinflation in the housing market like we experience between 2001 and 2005, at least not in the near term. I think this is a safe assumption because new bubbles rarely appear soon after the collapse of an old bubble.
• For the declining price phases, I assume an 11.11% per year decline. I chose 11.11% because those are the estimated declines that we’ve experience between September 2006 and September 2007 (see my previous post on this estimate).
• For the modest growth phases, I use a 4% annual price increase. This is the normal and sustainable price growth that South Florida traditionally experience up until the anomaly that we experiences since 2001 (see my previous post on normal and sustainable price growth).
• I assume that the homebuyer will have to use a Realtor® if they want to sell their home. This will cost them 6% of the sales price. Of course, the seller does have the option of selling FSBO, which will reduce much of the risk once the market stabilizes. However, since most home sellers use Realtors®, including this assumption makes sense.
• I ignore opportunity costs, which mitigates some of the advantages of the “Patient Buyer.” In the three years that the “Patient Buyers” waits to purchase his home, this buyer can invest his down payment. He will also save money on property taxes, insurance, and interest. For the sake of simplicity, I ignore this impact.
• I ignore inflation. While this doesn’t impact the comparison between the two buyers, it does affect how we read the graphs below. Some of the graphs show what appear to be sizable profits. However, if we assume that inflation remains hovering around 3%, the actual (real) profits for both buyers are de minimis.

Using these assumptions, I tested the model to see how variations in the market affect the two buyers. I tried four possible scenarios based on the timing of the price phases. The graph shows the profit (loss) each buyer would experience if they sold their house over a 15-year planning horizon. The profit (loss) accounts for the 6% sales commission they would have to pay the Realtor® at the time of the sale.

Scenario 1 (My best guess – how I think the market will track)

• 2 years of a declining market
• 3 years of stagnation
• 10 years of modest growth
  
  
  
  
  Discussion: This graph shows the enormous risk a homebuyer commits by buying in a falling market. Because of the expected 6% Realtors® commission that will be charged at closing, the “Impatient Buyer” will not be able to get his original purchase price back until more than 13 years after his purchase. In other words, a homebuyer that uses 100% financing will have to come to the closing table with cash if he decides to see before the end of his thirteenth year in the house. For much of that period, the cash needed at closing is significant (as much as $81,711).
  
  On the other hand, the “Patient Buyer” who waits until the market stagnates will spend less than four years in the negative zone. More importantly, during those four years, the “Patient Buyer” can sell his home and never lose more than $15,204.

Scenario 2 (The rapid turnaround -- "Patient Buyer" misses the bottom)

• 1 year of declining markets
• 1 year of stagnation
• 13 years of modest growth
  
  
  
  Discussion: I like showing this graph because it shows what happens when the Patient Buyer misses the bottom. In this case, the Patient Buyer bought into the market one year after the turnaround (he could have bought at a median-priced home for $284,711, but instead spent $297,070. However, despite the missed opportunity, the Patient Buyer still does much better than the Impatient Buyer. Even in the fast turnaround, the Impatient Buyer must wait nearly 8 years before they can sell their home without bringing money to the closing table (assuming 100% financing).

Scenario 3: (Doomsday with longer declines)

• 3 years of declining markets
• 2 years of stagnation
• 10 years of modest growth
  
  
  
  Discussion: Many predict far greater and longer declines than the 22% declines predicted in Scenario 1. This shows what would happen if we had 33% declines over a three-year period. In this case, the “Patient Buyer” really comes out ahead because he buys at the bottom while the “Impatient Buyer” must endure three years of steadily dropping prices. In this case, the “Patient Buyer” will make $94,831 more than the “Impatient Buyer” over the long-term. It will take the “Impatient Buyer” 16 years before they recover their investment.

Scenario 4: (Pollyanna view – we’ve already hit bottom)

• 1 year stagnation
• 14 years of modest growth
  
  
  
  
  
  Discussion: This graph shows the potential upside to the “Impatient Buyer.” In this case, the “Patient Buyer” missed two years of growth and ended up paying 8% more for his house than had he bought at the bottom. For most the long-term planning horizon, the “Impatient Buyer” will make $27,240 more than the “Patient Buyer.” However, even in this case, the “Impatient Buyer” remains in the red for 29 months compared to the “Patient Buyer” who only there for 19 months.

Summary

The following chart shows the summary of the four scenarios:




This shows that in every case, the “Patient Buyer” has much less at risk than the “Impatient Buyer.” Even in Scenario 4, where the “Impatient Buyer” has a higher profit, he still puts himself at risk because he must remain in the red for a longer period of time.

Ultimately, each buyer must make their own decision on the appropriate time to buy. However, it is important to understand that there is typically more risk in buying into a falling market than there is risk in missing the bottom of the market.