AIPIS 239 - Why People Aren't Taking the Mortgage Tax Deduction

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Welcome to the Commercial Investing show where we analyze, explain and exploit the opportunities presented in today's commercial property marketplace. If you're interested in apartments, mobile home parks, self storage facilities and other income property, you've come to the right place. We'll explore what's hot and what's not in markets nationwide in the relentless pursuit of return on investment. Here's your host, Jason Hartman. It's my pleasure to welcome a gentleman that I have been following his career for many, many years, probably 20 or more. And that is Barry Habib. He is CEO of MBS Highway. He was named top real estate forecasters Zillow and Pulseonomics. He's winner of the Crystal Ball Award. I love that name, by the way, for the most accurate real estate forecasters out of 150 of the top U.S. economists. Barry, welcome. How are you?

Thank you, Jason. I'm well. Great to be here.

It's good to have you. So you are coming to us from a very stormy, snowy New Jersey area. Of course, it's snowing and storming and freezing because it's warming. But we won't get into that topic. I just thought I'd start off with a little funny snipe. But what's going on in the real estate market? Where do you think we're going? Are we, are you still really bullish?

Very bullish. We've been so for a long time. Although the media seems to have a very negative bias, they've been wrong for many years. It seems to be married to the fact that real estate is not the place to be. However, it's continuously outperformed. But when you take a look at the factors that are very important and you just make it simple and you just look at supply and demand, the supply side, as we all know, is very tight. There's a dearth of inventory. There's builders are not keeping up with household formations and household formations, very interestingly, are going to continue to rise. Household formations are based on two things. One is people who are living together who then split up and now need two residences instead of one. So unless you think people are going to stop getting divorced or stop splitting up, that part should keep up. And the other aspect is people that are living at home that go out and either buy their own place or rent their own place. Now, Zillow tells us the median age for that is 33 years old today.

That is shocking, isn't that shocking, by the way.

It is, it is. If you go back 33 years ago to 1985 and you look at the birth rates, what you see is that for the next subsequent eight years, it looks like a staircase. With each year that beyond 1985 having higher rates of birth than the previous year, which tells us that demand is going to continue to be really strong. I don't see supply loosening up. It's an amazing dynamic that I think will continue. So people often say, hey look, can prices continue to escalate? And if incomes aren't escalating, that's because they don't understand the math behind it. Incomes don't need to line up with price appreciation in lockstep. Here's a very simple example and perhaps oversimplifying it, but if someone were looking at a property and that property would cost them, simple again, 1,000 bucks a month, chances are for principal and interest now, not taxes and insurance. Chances are the math bears this out that their income would likely be about $5,000 a month. So now if they missed the boat on that property a year ago, and if it went up 5% this year, if they were to purchase that same home, and if interest rates were to be about the same, which they are, then they would cost them 5% per month more, or 5% on that thousand dollar payment would be 50 bucks a month. In order for their income to keep up with that, their income would need to rise by $50 a month, which is just 1% of their monthly income. So when the media talks about this, they say, well, properties are going up at 6%, incomes are going up at 2%. They don't recognize the fact that that's just fine to keep up with affordability.

Barry, you know, it is mind boggling how stupid the media is. I mean, I sometimes I want to throw bricks at the television when I'm watching CNBC or something. And even reading ostensibly brilliant guy's book like Robert Shiller in his, I believe it was irrational exuberance number two, when he talks about real estate or you hear Jim Cramer talking about real estate, they don't account for the leverage component. It's fricking mind boggling I mean, it really is so frustrating to me because if you just look at it in a vacuum, you know, housing prices versus income, you're an idiot. It's people buy a house on a payment, not a price. So of course the interest rates play a huge part in that, as we both know. Yeah, it's truly mind boggling. But here's the other thing that nobody ever. Can I just.

Can I say.

Go ahead, go ahead.

Can I say one thing on your left? Can I say one thing on your leverage point? Because you make such a great point, Jason, and the LE component of this is one where in fact, Dan Olich from CNBC just put a whole piece out on this. It's on their site saying you shouldn't buy a home because if you rented and took the difference and invested in the stock market, you would have done better. I mean, first of all, that's nuts because the stock market isn't necessarily for everyone. But also the stock market had a banner year. It's not like that every year. So she goes on to say, well, real estate went up 6%, 6.2% to be exact, and the stock market was up over 20%. So I like to do the math. Take $100,000 home, right? If you were to say most people don't pay that whole thing cash. According to the National association of Realtors, 60% of purchase transactions are done with 10% down. So let's assume that for a minute that means you invested ten thousand dollars. Well, that hundred thousand dollar home went up 6%. For round numbers, it went up six thousand dollars. A six thousand dollars gain on your ten thousand dollars investment is a 60% rate of return really dwarfs the 20 some odd percent the stock market got in about a year. I mean, this just underscores your point because I think you really nailed it. Right?

But you know, what's. Barry, thank you for illustrating that, by the way. And in one of Robert Kiyosaki's books, who Took My Money, that was the one, he shows this great chart of like the s and P versus just $100,000 house, right? And basically over the course of the 10 years that he picked in his sample. Now arguably, you know, people can choose favorable and least favorable time periods. And that's why, you know, that's why there's a book called how to Lie with Statistics.

Okay, but, but I love that book by the way. It's like 60 years old. I love that.

Yeah, that's a great book. You know, that's a famous book. So it's good. But it shows that the. Just the traditional single family home with 10% down. Now this was someone living in the house outperformed the S P just from the appreciation only metric. And we know it's a multi dimensional asset class. Unlike the S and P, it outperformed it by almost 800% because of the leverage. So you know, it's not even a contest. It's crazy. But to go back to your earlier point, and I love what you were saying there about, you know, how they're not really just doing the math. Right. The other thing that's interesting that is never considered is that, you know, when they say things like, well, you know, housing prices are going up this and incomes are only going up that amount and, you know, let's just give them that and not even argue the leverage point for just a quick moment for a thought experiment. But you know what they never talk about, Barry, is they never talk about this assumption that is completely flawed that assumes the expectation of the standard of living of the. In other words, the type of house someone lives in is some static, stagnant thing that changes. People will have to say things get bad. People, people will have to accept less. You know, they'll move down the ladder and instead of having a 2000 square foot house, they'll have a 1400 square foot house. You know, it's, that's, that ladder moves of what people get. It's, you know, maybe they can't buy the exact same house. You know, we're assuming bad times, right? That's a moving target is all I'm saying.

You know, and you're right, it is a moving target. And just again, underscore your point. Take 10 years ago when you had McMansions all over, and that's changed a bit now, right? With a new paradigm. However, I'd like to also say that when the media discusses the benefits of renting and the negatives of making a purchase, again, they don't do the math because they always assume that the rent stays the same. We know that according to the Consumer Price Index, rents are going up at 3.9% a year nationally. But let's just say for a minute that's 4%. As Albert Einstein said, the eighth wonder of the world is compound interest. And it's amazing what 4% will do to that rent. Just over a short period of time, it will begin to eclipse the monthly payment on a mortgage. The other thing that no one considers, and this is mind boggling, is that when people make a mortgage payment, they know that the payment's made of principal and interest. And everybody says, okay, well, the interest goes to the lender, but where does the principal go? The principal is your own money. All you're doing is moving from your checking account to another area where it's still your money. And no one talks about that. And in fact, what happens is over Time. If you look at the average residency that someone lives in a home, let's just take it for nine or 10 years, they would accumulate guaranteed tax free just by making their mortgage 70 or 80 or $90,000. If it was a $300,000 or $350,000 mortgage, that would be their money. And people don't discuss this. It's an incredible benefit of homeownership that people don't discuss.

The mortgage pay down should be considered positive cash flow. That's really what it is. Yeah, go ahead.

It's exactly what it is. And then the other thing that I hear a lot today is that, well, we have taken the incentive out of purchasing a home because of this new tax plan. And listen, I live in New Jersey.

Didn'T for you, that's significant. Yeah, yeah, correct.

And there's, there's six states that it didn't work out well for. But here's what we have to remember is currently only 21%. 21% tax returns utilize the mortgage tax deduction. Now, we know the homeownership rate is closer to 64%. So a lot of people aren't using it to begin with because of the current standard deduction. Now they've gone ahead and doubled the standard deduction. So we've done the math. We estimate only approximately 4% of tax returns will utilize the mortgage deduction. So that means you'll be getting less of a mortgage deduction. And in doing the math, it is definitely a headwind. No question about it. However, we do not feel in any way, shape or form it derails the housing market. We also see a headwind being a little bit higher interest rates this year. Not because the Fed's going to hike, but mortgage rates do well, because even when the Fed hikes, the secret here is that there's liquidity being drained around the globe. The European Central bank's going from 60 billion a month to 30 billion. And our Fed has already started to slow the pace of reinvestments of principal that they have from their current holdings and treasuries and mortgage bonds they did in the fourth quarter of last year by 4 billion a month. They've now begun to up it to 8 billion a month. That's the curtailment amount. And then in April that goes up another 4 billion. In July, another 4 billion. October, another 4 billion will rest at $20 billion a month less. They were the largest and they will be the largest still for a while. Purchase or mortgage backed securities. We've already seen rates start to Tick a little higher because less fed buying and all else equal, I anticipate mortgage rates to be up about a half a percent on average through 2018. Not enough to derail the housing market. However, between that and the tax benefit, it does create a tail, a headwind. And I think that Instead of seeing 6% appreciation, you probably see closer to 4.5% appreciation, still can create enormous wealth.

By the way, that stat you cited about the 21% mortgage, you know, using the mortgage interest deduction on tax returns, that is shocking to me. I had no idea. Just out of curiosity, why wouldn't someone be taking that deduction? I mean, it's a great tax perk, you know, that encourages homeownership. Now we're talking, by the way, all this talk is about homeowners who owner occupy. This talk is, you know, that aspect of it is not about investment properties, but it does play into the overall market because of less people are buying homes and there's less demand, but there's more demand for rentals. So there's a, you know, offsetting effect always. I call that the three dimensions of real estate, which I've talked about extensively. But the mortgage interest deduction, just elaborate on that, if you would. Why? Why aren't people taking it?

So if we just do the math, so we know that 64%, let's call it 63, and a fraction of homeownership. Right. But of that, approximately a third do not have a mortgage. Okay. So now you're left with somewhere in the neighborhood of, let's call it, you know, 42% of people could take the mortgage tax deduction, but only 21%, half of them are half of aren't. Why? It's because the standard deduction, which if you were married in 2017, was $12,700. So in order to take advantage of the mortgage tax deduction, your tax benefit of what you paid in either interest and what you pay in real estate taxes would have had to exceed that. And it only did for about half the people. That's why.

Interesting, interesting. And then you really have to divide that talk up into high end properties versus lower end properties because, you know, this is only the upper parts of the market that are even in question here. Right. You know, when you've got a mortgage balance over $750,000.

Yes, yeah. Yes, exactly. Right.

Okay. All right. What else is going on out there? You know, I mean, we kind of went into the media, doesn't get it. We both agree on that. You know, understanding leverage and People buy a house on a payment, not. Not the price. What other elements or aspects do you want to share with our audience?

We could pretty much talk about anything. If you think about even the stock market. The stock market always has a bearing on real estate and really just the wealth effect in general. And it's been flying. But I do think because predominantly because of the drain of central bank liquidity and because optimism in the stock market is at extremely bullish levels, we have, according to some of the surveys, the bullish sentiment is the highest it's been since 1987. The bearish sentiment, the highest. The lowest it's been since 1987. The spread between bullish and bearish sentiment reaching levels that we haven't seen in a very long time. Just history tells us when we reach these levels of optimism and such low levels of pessimism. Why is that? Well, because if you're bullish, it means you're probably in the market. If you're bearish, you're probably out of the market. So with so few people out of the market and so many people in the market, the question is, where is the new money going to come from to continue to fuel the stock market's rise? And that was the question Joe Kennedy asked back in 1929, before the stock market crashed when a shoeshine boy started talking stocks with them. The famous story I love does not mean that there's a stock market crash coming. I'm not saying there's a stock market crash coming, but it sure feels to me that when you look at the stock market currently, it is now the most expensive stock market in history on a price to sales ratio, the third most expensive on a price to earnings ratio. And we have had a very long run to the upside here. It seems like some point in 2018, there should be a breather that's taken. Now, if it's just a correction, that'll be good news. Rates will drop as money comes out of stocks into bonds, probably fuels real estate. But if it's a prolonged drop, then people lose a bit of confidence, and that could negatively impact real estate. But I do think a correction is coming this year.

Yeah. Yeah. In the stock market, right?

Correct. Yes.

Yeah. Okay, good. You know, what I meant to ask you about earlier in our talk, Barry, was you talked about how people are. I mean, you didn't say it exactly, but your point was the same about how this household formation is happening so much later with the millennial generation. I mean, people living at. When you say at home, that meaning with their parents till they're 32, 33 years old. I mean, that's that. This is absolutely like never happened before. It's crazy. And this represents a giant shadow demand on the marketplace. Shadow demand. You know, we used to talk during the Great Recession about shadow inventory. Now it's the opposite. There's a shadow housing demand that's kind of unaccounted for. A lot of that is going to be coming into the market to rent or buy. And either way, investors do well, because upward pressure on rents or upward pressure on prices, hey, either way you play the game, it's fine. Did you have anything more you wanted to say about that?

I do, because there's also something that people don't talk about and there's double up households. So in other words, roommates. I'm not living with my parents. I've taken on a roommate or I've gone ahead to defray some of those costs. So listen, if any of us have had the situation where you've taken on a roommate or you've been somebody's roommate or whatever it is, got to tell you, after a little while, that gets old.

Yep, sure does.

So as you say, that creates a shadow demand that is kind of a half step towards what would be a household formation. So I do believe that will happen. And let me just tell you something else about household formations. When you look at the birth rate charts and you can pull them up anywhere, you can see what I'm talking about, how we've got this move that looks a lot like the baby boomer move, which changed everything financially, right? So you've got this echo boom of late Gen Xers into millennials where you see this rise, rise, rise, rise, rise. And it's going to kind of level at about 4 million births a year. It doesn't drop off a clip after this eight year move higher. When you take a look back and you say, okay, we had the housing bubble. The housing bubble was back in 2006, 2007, let's just say 2008, 9, 10, around that period of time. And if you were to say, okay, well, let's use the same logic for a minute and go back on this chart 33 years before that. What you see is an enormous drop in the birth rates in 1973, 33 years before 2006, 73, 74, 75. And Jason, maybe you know this, maybe some people that are listening know this. What major law was passed in 1973 that was a sea change law? Well, I mean, I'll just tell you.

There was the gold standard or Roe v. Wade. Was that. I thought it was earlier.

Bingo, bingo. In 1973, Roe v. Wade is passed, abortions become legal, the birth rates drop precipitously.

Right.

And 33 years later, you have yourself a housing bubble.

Yep.

Builders kept building homes.

Barry, now you sound like Harry Dent and the Freakonomics guys.

I know, I know, Malcolm, gladly.

I got Harry Den coming back on the show today and he's interesting for sure. But yeah, that's fascinating. Okay, so what does that mean, though, to us? Tell us more about that.

What it means to us is essentially we're going to continue. If you believe in the laws of economics, you believe, believe in supply and demand. Demand is going to continue to be really strong. Supply is going to continue to be really tight. And that's just a recipe for well supported prices in real estate. So that's the point there. And income levels in this tight labor market are eventually going to start to see some additional increases. Maybe we get a little wage pressure, inflation. But I do think that this real estate market has a lot of legs for a long time. It's got a much better shelf life and outlook than the stock market does, in my humble opinion. Certainly a lot better than the bond market. The bond market to me seems like that's due for a little bit of troubled waters. I don't think it's terrible, but I do see yields rising, which means your investment in bonds might see a little price erosion there. Again, not crazy, but I think of the asset classes that are there, real estate, to me seems like it is a great place to be.

Yeah. And not only that, the bond market, you know, if we get some significant inflation, it's going to be shredded and real estate will do great. So that's another thing. And Barry, you know, we've run out of time and I know you've got to run to your next call, but some of the things we didn't talk about that are very bullish, I think you'll agree with these, is the softening or possible repeal of Dodd Frank, you know, means more money flowing into real estate. The general overall economic boom that we're experiencing. Love or hate Trump, but hey, I think he's good for the economy, I'll say that much about him. Maybe not good on Twitter, but you know, that's horrible on Twitter, but for the economy. Also this shadow inventory, I mean, the demographics coming at the rental housing market for 10 more years are phenomenal. A lot of very positive things there. And then the real question everybody always has to ask is compared to what? You know, it doesn't have to do great, it just has to do better than other things. Right. So compared to what? But, you know, one thing we didn't get a chance to talk on, and I think you'll have some really interesting insights. Maybe you can mention them quickly. But way back to 2004, I was talking about an article that really influenced me quite a bit by Michael Milken and Jeremy Siegel where they were predicting something called the looming asset shortage. And you alluded to it a few minutes ago when you're talking about all of this money flowing and you know it needs to go somewhere, it just feels like we've got this tidal wave of money in the world that is just looking for a place to deploy. I think that's a significant thing. You know, when it comes to housing, there's not enough inventory, the population growth, the shadow inventory, et cetera. But, you know, just thought I'd see if you have any quick opinion on that. And please give out your website before you go to.

It's mbshighway.com I agree with so much of what you said, but just an interesting point. One of the things you had mentioned was Dodd Frank, you know, Barney Frank and The beauty of YouTube is that you could watch this now right before the housing, but a year before the housing bubble, he's out there saying, no housing bubble. It's a great place to be. We need to get more people in homeownership. Lenders need to be loosening their guideline. Okay. And then the same man after the housing bubble comes out with Dodd Frank to punish banks. So yes, it would be a great thing to ease up on that. Just an amazing, amazing, amazing. How people get away with this, of course, amazes me. But anyway, listen, this was a lot of fun and I thank you. You're awesome. Thanks for everything you do.

All right. Likewise, Barry. Keep up the great work and we'd love to have you back on the show in the comments future. Thanks for joining us.

Be my pleasure.

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