Published March 02, 2012

House, Sweet House?

Dear Reader,

Vedran Vuk here, filling in for David Galland. Today, I'll be covering a number of topics from real estate to a useful personal finance trick for figuring out the value of a warranty. And lastly, I'll touch on a recent Bloomberg article about cigarette smokers in Greece and what they can tell us about the fiscal situation there. Let's start with some thoughts on real estate.

Houses Are Homes, Not Investments

By Vedran Vuk, Senior Research Analyst

Recently, my parents were considering purchasing some real estate. As the financial professional in the family, they asked me, "What do you think? Will it go up in value? You know… not now, but eventually?" I've heard the same thing over and over again. In response, I shared my opinion: "Would you pay the current market price to live there even if its value never increased?" If the answer is yes, buy the property." Essentially, is the house worth it as a home, not as an investment?

In the past few decades, the concept of home ownership has been completely turned on its head. Previously, homes were considered a very long-term consumption good. Do you think anyone in the 18th, 19th, and prior centuries ever considered tripling the value of their homes by retirement time and selling them to move beachside? In the vast majority of cases, such ideas never crossed their minds.

Yet, somehow along the way, this became a reasonable investment expectation. Even today, home buyers still make their purchases with the hopes of escalating prices. But are homes really wise investments?

Consider the difference between your house and an investment such as Apple (NASDAQ: AAPL) stock. At a major company, the opportunities can be truly limitless. Apple can produce cashflows from computers, iPods, iPads, and future innovations that are just dreams and concepts today. If the local market is oversaturated, Apple has the option of spreading out all across the world. As a result, Apple's stock price has gone from $17 in 2005 to $540 today. Can your house do the same? Unless there's a hyperinflation ahead or your house is located in the New York City or London of the 21st century, the answer is no. Why? Because your house is ultimately a product –and products have an upper bound to their prices.

To understand this difference, there's no need to drag out the Case-Shiller Index or analyze complex statistics. Suppose one bought a single-family house over a decade ago for $200K. At the peak of the housing bubble, the price reached $500K; to his joy, the owner sold it and moved thereafter to retire in Florida. Can the house's price go higher from here? With Apple, the stock price can just keep climbing with greater profits and innovations. But is that true with real estate?

For the sake of argument, let's say that prices do keep rising. Eventually, the second owner sells to another buyer for $1 million a decade later. Guy number two also peacefully retires in bounty. Well, where does that leave the third guy? Unless real salaries make an incredible jump in the same time period, no one will be able to afford the home next. The median US worker earning $51K won't be selling such a house for retirement; instead, it will take him until retirement to afford it. In many ways, this "investment" more closely resembles a Ponzi scheme. (Yes, Ponzi schemes work: for those who get in early and get out – as the recent real-estate bubble demonstrated.) Ultimately, there's an upper bound to housing prices – they can't continue rising perpetually with no end.

The same is true of any product. At $300 for the newest iPod Touch, Apple might be doing well, but at $10,000 per unit, there likely would be very few buyers. As a homeowner, you're not holding a company that can innovate, cut costs, and enter new markets. You're ultimately holding a product which must be either sold to the next user or leased to the next renter. Houses are a good created for a specific use – to put a roof over one's head. They are not magical money machines. Previous generations understood this very simple concept. One built a home as a place to live and escape the elements – and worse yet, the squalor of tenement housing. Homes were not retirement tools, but rather long-term goods.

Unfortunately, policy makers still view homes as investments and are always worried about low prices. But is it really healthy to play another round of the same Ponzi scheme? Suppose the Fed manages to inflate housing prices again. There will be another boom in which some folks will make a tremendous amount of money. Eventually, housing prices will hit an unrealistic upper bound. Again, home prices will violently drop, resulting in homeowners deeper underwater than now. Of course, the banks will again take a hit as the mortgage holders. As long as real incomes trail the rise in housing prices, there will ultimately be a correction of some sort.

So, do I think the current real estate market is just fine? No, of course not; but I don't think shocking houses prices back into a bubbly stratosphere is the solution. Ideally, I'd like to see increasing housing prices, but only at the pace of real growth in society's wealth. Over the last few decades, houses grew in value for good reasons and bad. On the good side, the economy had been expanding. On the bad side, the Fed's low-interest-rate bubble artificially inflated housing prices beyond what made sense for our economy to sustain.

If US companies such as Apple are creating greater abundance in society, it makes sense for housing prices to grow with greater wealth. But, bringing those prices higher on a wave of printed cash does not make us wise investors, but rather willing participants in a Ponzi scheme where someone else will be left holding the bag. Though that might be an attractive solution for those underwater on their mortgages, it's no solution for the economy as a whole – nor for the next buyer.

What Can Greek Smokers Tell Us About Fiscal Responsibility?

By Vedran Vuk

Recently, Bloomberg had an interesting article on Greek cigarette smokers titled Cigarette Taxes Can Help Cure Two of Greece's Ills. The piece focused on the extremely high rate of smoking in Greece and the ability of taxes to lower both the country's deficit as well as its bad habit. Here's an excerpt of the some startling statistics:

"In 2009, a shocking 40 percent of Greeks smoked. That is almost twice the OECD [Organization for Economic Cooperation and Development] average of 22 percent. In France and Spain, the smoking rate was 26 percent. In the U.S., the rate is half that in Greece. The Greek rate was six percentage points higher than even Russia, the only other developed economy whose rate was more than 30 percent. In Greece, smoking rates exceeded 30 percent even for medical students, a study by Constantine Vardavas and Anthony Kafatos of the University of Crete found.

"Perhaps even more troubling is that, in the past decade, the share of adult Greeks who smoke rose by almost 6 percent. Over that period, in the OECD as a whole, smoking prevalence declined by 18 percent. The only other developed country that experienced an increase in smoking was the Czech Republic – but Greece's rise was larger. ....

"One of the causes of high and rising smoking rates in Greece has been relatively low cigarette prices. In 2011, a pack of 20 premium cigarettes cost a little more than $5 in Greece, compared with more than $8 in France and more than $11 in the U.K. and Ireland, according to the Tobacco Manufacturers Association. In the U.S., prices vary significantly by state; in New York, a pack costs more than $10.

"The prices in Greece have reflected relatively low tax rates compared with other European countries. Before the recent policy changes, that pack of 20 cigarettes carried a tax of less than $4. In France, the tax exceeds $6. In the U.K., it amounts to almost $9."

In my opinion, this isn't as easy as drawing a demand curve based on cigarette prices. There are other factors to consider – for example, healthcare costs. With a universal healthcare system, the average Greek smoker has little concern for the financial impact of his habit. The same goes for smokers in the rest of Europe. In many ways, the US has the highest cost of tobacco use per smoker. At some point, many smokers will pay big out-of-pocket expenses for the habit.

The other issue is a cultural one involving tobacco. As a teenager on a trip back to the Balkans, I learned about this cultural phenomenon the hard way. I went to a downtown café with a group of locals about my age, ordered a beer, and drank it in twenty minutes or so. The other kids looked at me with shock – apparently, I didn't get it. The Balkans have a café culture of smoking cigarettes and very slowly drinking a beer or a coffee.  One orders a drink and sips it over an hour or longer while smoking countless cigarettes and talking with friends. By consuming my beverage so quickly, I committed an unstated faux pas.

This café culture of coffee, beer, and cigarettes is a daily social activity for practically everyone aged thirteen through death. If you're not a coffee or alcohol drinker and hate cigarettes, you would be very lonely living in the Balkans.

But, there's something more to the story. To sum up tobacco addiction, it's an unwillingness to face discomfort today in exchange for future health and years of life. I don't intend to demean any smokers among our readers, but that's just the honest truth – I've been there myself as a former smoker. So, what's that got to do with Greece?

If my point isn't already obvious by now, let me spell it out. Is it a coincidence that a country with a 40% smoking rate has dug itself into such a financial mess? What is fiscal irresponsibility, if not an unwillingness to deal with discomfort today in exchange for future financial health? With today on their minds rather than tomorrow, the Greeks spent like crazy on universal healthcare, pre-60 retirement benefits, and innumerable other government programs. This is really the same as the mentality behind smoking. You put off quitting because it isn't convenient. Then, you half-heartedly quit for a week only to find yourself smoking again. Similarly, with its finances, the Greek government kept smoking through piles of money and kept putting off its responsibilities for a later date.

There's just one problem with this approach: emphysema and cancer don't come when one plans for them – and neither do financial crises. The only way to avoid these misfortunes is by leading a healthy life or holding a clean balance sheet way ahead of time. When the news of disease or crisis strikes, it's too late to take action and make the wise decision. At that point, the damage has already been done from years of putting off the right choices.

How to Get a Good Deal on a Warranty

By Vedran Vuk

Often at Casey Research, we discuss the valuation of billion-dollar companies and enormous macroeconomic risks on the horizon. However, today, I want to take some financial insurance theory and apply it to a simple everyday concept – the warranty.

Here's the scenario: you just purchased a new gadget at the local Best Buy. At the last second, the checkout clerk asks if you want to purchase a warranty. Is it a good deal or a bad deal? Most of us in this situation just go with our gut feeling, but there's actually a simple mathematical way to figure it out in three easy steps.

Step 1: Divide the price of the warranty by the cost of the item. We'll call this percentage the "warranty ratio."

Step 2: Next, make an estimate of the item's probability of breaking during the warranty's duration. This can be difficult to assess, but your own activities and personal experiences can lend some guidance. Is that new tech gadget going to sit in your office relatively safe from the unplanned misfortunes of the world, or will you be taking it camping on a regular basis? Based on your use, previous experience, and even the brand name of the product, assign a percentage to the probability of malfunction. Choose a real number whatever it may be – 15%, 30%, or even a range such as 30%-50%. (Also make sure the warranty covers these possible malfunctions.)

Step 3: Compare these two percentages. If the probability of malfunction is greater than the warranty ratio, you're getting a good deal. In fact, the warranty company should lose money on customers with this strategy.

Let me go through the steps again with a personal example from last week. My earphones broke again, so I went to Radio Shack to purchase some new ones. Though the earphones were pretty cheap, the cashier offered a warranty on them.

Step 1: The price on the warranty was $4, and the earphones were $22. 4 divided by 22 equals about 18% for the warranty ratio.

Step 2: I've had some pretty bad luck with earphones. In the past two years, I've gone through three pairs. I take them to the gym and lots of different places almost on a daily basis. They certainly get a lot of wear. On top of that, these earphones were nice, but certainly not top of the line. Though I never tried the brand before, I could tell that the earphones weren't the sturdiest in the world. They were better than my previous pairs, but were unlikely to win any reliability awards. With these considerations in mind, I assumed the earphones had about a 30% chance of malfunction within a year.

Step 3: Since the warranty ratio of 18% is lower than my subjective chance of malfunction 30%, it made sense to purchase the warranty. Furthermore, there's a comfortable difference between the two. Even if I'm wrong about my malfunction estimate, the deal gives me some room for error. Another even easier method is to calculate the warranty ratio percentage and then ask, "Is the probability of malfunction higher or lower?" If it's higher, then it's a good deal. However, with this shortcut method, one doesn't know the margin of error.

So, how does this work? It's a numbers game over time. If you're any good at assessing your probabilities of malfunctions or have significant room for error in your deals, over the years you'll spend less money on the warranty than replacing the items – or vice versa. The bigger the difference between the probability of malfunction and the warranty ratio, the better the deal.

With that said, the ratio shouldn't always determine your decision. In most cases of insurance, we're not going to get ahead of the insurance company. In health care, for example, most of us would be better off self-insuring. There's just one problem: the majority of us don't have an expendable $500K or so for the worst-case scenarios. In the case of either health or life insurance, our probability of, well, malfunctioning is less than something equivalent to the warranty ratio in the insurance world. That's how insurance companies make money. They have a good idea of the odds and can calculate profitable insurance rates based on those probabilities.

However, in the case of smaller items such as electronics, it's fairly easy for consumers to self-insure by applying the same probability principles underlining bigger issues in finance and insurance theory. That's essentially what we've done above. And in fact, if you're good at predicting the probability of malfunctions, companies offering warranties will lose money on your purchases. You'll be buying a warranty only when the risk justifies the cost. Of course, the warranty companies will make their money back on more gullible consumers or those with bad estimates of malfunction, but nonetheless, you'll remain a statistical thorn in their sides.

[Casey Research Senior Analyst Vedran Vuk often probes issues of interest to investors, such as whether Facebook's IPO will hurt its users.]

Friday Funnies

For the Friday Funnies, we have a unique bit today. It's the reviews for one gallon of Tuscan whole milk. That's right, milk sold on Amazon. Surely this is a clever viral-marketing campaign by the company, but nonetheless, it left us chuckling. Enjoy.

Chateau du Lait Blanc, watch out!, August 9, 2006

By Philip Tone (San Diego, CA USA)

This review is from: Tuscan Whole Milk, 1 Gallon, 128 fl oz (Misc.)

One should not be intimidated by Tuscan Whole Milk. Nor should one prejudge, despite the fact that Tuscan is non-vintage and comes in such large containers. Do not be fooled: this is not a jug milk. I always find it important to taste milk using high-quality stemware – this is milk deserving of something better than a Flintstones plastic tumbler. One should pour just a small dollop and swirl it in the glass – note the coating and look for clots or discoloration. And the color – it should be opaque, and very, very white. Now, immerse your nose in the glass and take a whiff. Tuscan transports you instantly to scenic hill towns in central Italy (is that Montepulciano I detect?) – there is the loamy clay, the green grass of summer days, the towering cypress. And those gentle hints of Italian flowers – wild orchids, sunflowers, poppies. Then, one takes in the thick liquid and lets it roll across and under the tongue – what is that? perhaps a hint of a nutty Edam cheese? With Tuscan, you feel the love of every dairyperson involved – from the somewhat sad and deranged farmhand shovelling steaming cowpies to the bored union milk maiden dreaming of leaving this soul crushing life behind for a job waiting tables for obnoxious American tourists in Siena. But not too fast – sip gently, slowly, or one is in danger of not only missing the subtleties of the milk's texture and its terroir, but – if chilled too long – also of giving oneself a blinding ice cream headache. Nay, savor the goodness that only dairymen and dairywomen working at the apex of their craft can deliver. Tuscan is best drunk young – no, no, don't cellar this gem – I guarantee you'll be sorry if you do. I recommend pairing with freshly baked macadamia nut scones. Milk Expectorator gives this one a 92.


Planned Obsolescence!, June 24, 2009

By greg peterson (Midwest, USA)

This review is from: Tuscan Whole Milk, 1 Gallon, 128 fl oz (Misc.)

Initial set up of the Tuscan Whole Milk, 1 Gallon, 128 fl oz is easy, just unscrew the cap and remove the liner. It has a surprisingly rich set of standalone and integrated food possibilities and the addition of vitamin D was a bonus.

However, I find that this product quickly becomes unstable (even without overclocking) to the point that it is no longer usable. At first I tried passive cooling to prevent the degradation, but ultimately had to switch to an active cooling method to prolong the products usefulness.

Note that even with this extreme care the Tuscan Whole Milk, 1 Gallon, 128 fl oz will still break down. Even if you never use the product it will still fail! This is the worst kind of planned obsolescence, requiring you to replace this product every two weeks whether you use it or not!

Pros: Inexpensive, easy set up.
Cons: Short product lifecycle. No instruction manual. No optical/coax sound output.


Okay product but you have to buy a glass to use it., September 19, 2006

By troublemaker (San Francisco, CA United States)

This review is from: Tuscan Whole Milk, 1 Gallon, 128 fl oz (Misc.)

Don't get fooled by the easy-to-use look of this product.


How can you pass up such a bargain?, November 30, 2006

By Super Bargain!

This review is from: Tuscan Whole Milk, 1 Gallon, 128 fl oz (Misc.)

Online ordering of extremely perishable food is going to TAKE OFF when people realize how much fun and convenient the idea is. I got my milk just yesterday. Here are all the details!

Tuscan Whole Milk, 1 Gallon, 128 fl oz
$3.99 – Quantity: 1 – In Stock
Condition: new
Sold by: Gristedes Supermarkets of New York

I was considering buying used milk from a trusted Amazon reseller but decided against it. So you'll notice the condition of MY milk was "New." I deserve this luxury.

I toyed with the idea of second business day delivery but Amazon in its infinite wisdom limited me to "Expedited."

Shipping Method: Expedited

Here's the best part.

Order Summary
Items: $3.99
Shipping & Handling: $26.25

Total Before Tax: $30.24
Estimated Tax:* $0.00

Order Total: $30.24

Why go to my local store and pay $2.99 for a galon of milk when I can have it overnight delivered for 10 times that price? I think I'll get three gallons next time. As a current Pentagon employee, this makes perfect sense to me. You won't Be-Lieve the taste of 30 dollar milk. It just coats the tongue with layer upon layer of bovine extract luxury. Internet milk is soooo much more milkyliscious than crappy store bought. Next, I'll be checking out the $50 12 ounce hot coffee order. Catch the wave!


A quick yet satisfying read, March 1, 2007

By Randall Black (Irvine, CA USA)

This review is from: Tuscan Whole Milk, 1 Gallon, 128 fl oz (Misc.)

The author of Tuscan Milk gets right to the point and saves the busy reader time with a crisp, focused narrative. I read it in one night and part of the next day. Not elaborate, the illustrations make the point: cows can fly in New York, although lunar gravity and near-light velocities "curve" space to create strange relativistic bovine warping. Lay readers will appreciate the constrained use of math, but may miss beloved traditional elements: Cat? Fiddle? Dish? Spoon? Stop looking! This is a modern work of milk that doesn't look back. Customers who liked Tuscan might like the edgy, high-tech read on Eagle Brand Condensed or even Carnation Powdered. Buying used is not a recommended option.

That's it for today. Thank you for reading and subscribing to Casey Daily Dispatch.

Vedran Vuk
Senior Research Analyst