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Riding Out the Dips: A California Story

Once again, no investment is 100 percent guaranteed. Sometimes pockets of the housing market are infected by price declines—such as Texas during the oil-price drop of the 1980s, California in the early 1990s, and Northern California after the Internet bubble popped in 2000. But these are fluctuations around the long-term trend. Although home-owning is not always a sure thing on a shorter-term basis, the longer you own a property, the greater your chances are of navigating through any disturbances in the market.

In my home state of California, real-estate prices declined by a third in the early 1990s. Worse, in many cases, home prices fell below the value of mortgages. In California, home loans are "nonrecourse," meaning that when homeowners walk away from mortgages, creditors must either chase them down or take possession of their vacated properties. In general, creditors have chosen the latter. So back in the early 1990s, the temptation to abandon a home in California and let the creditor worry about it was great. But did those who took this option act prudently (at least, in a cold, economic sense)?

This is a simple calculation. Using the average annual gain of the median home price, 5.6 percent, we can figure out how many years a sample California couple in the early 1990s needed to wait to recapture the full value of their property. (Central to this calculation is the belief that home prices can recover from situations such as the one that occurred in California. But the long-term trends for home prices in the U.S. are simply too positive and reliable not to be banked on.) Let's assume that our California couple held a home loan with an 80 percent loan-to-value ratio (meaning that the value of the loan was 80 percent of the home price) when the price shock occurred. So a 30 percent decline in the value of their home meant their loan was worth 10 percent more than the value of their home. That is, the California couple was suddenly 10 percent underwater. Time to flee? Well, we now know this 10 percent deficit to be in the neighborhood of two years' worth of home appreciation, on average, or 5.6 percent plus 5.6 percent. So if the California couple held on to their house for just two years more, they may very well have been made "whole" again.

On the other hand, had they jumped, they would have lost even more than their original investment. The loss the bank or lender would have realized if the house were taken back would have been considered a "gift-in-kind" to the couple that abandoned their mortgage. The couple would have been expected to pay taxes on that gift, and the mortgage bank would have sent them a 1099 tax form to facilitate the process. So what we now have are two types of incentives: On the positive side, we have the historical appreciation of home prices; on the negative, we have the complete loss of an original investment, coupled with a sudden gift-in-kind tax owed to the IRS.

That, in a nutshell, is why people tend to buy and hold through thick and thin—homeowners and stock investors alike.

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