Posted on 12/19/2005 11:47:44 AM PST by SirLinksalot
The Future for Investors
by Jeremy Siegel, Ph.D.
Is Real Estate a House of Cards?
Monday, December 19, 2005
Real estate has been the hottest asset class over the past five years. Some locales have seen prices double in two or three years and news of investors flipping condos reminds me of the frenzied days of Internet IPOs in the late 1990s.
But with the latest rise in mortgage rates there's been an unmistakable shift in sentiment. Recent data from the research firm ISI shows that the dollar value of unsold homes in the U.S. has now surpassed $500 billion, up an unprecedented 33 percent from a year ago.
It seems like everyone wants to sell, which could spell big trouble for the housing market. So now is an especially good time to ask: How does real estate fit into my long-term portfolio?
The Rates That Really Matter
It's no secret that housing prices have soared in recent years. The main reason: The remarkable drop in interest rates.
Particularly important for the housing market is the real rate. This is the interest rate minus the rate of inflation. The real rate is important for the housing market because the two move in opposite directions.
The yield on Treasury Inflation-Protected Securities (TIPS) provides a measure of real rates. It's currently just 2 percent -- about half its 2000 level. This drop in real rates over the past five years means that the after-inflation cost of long-term borrowing has plunged by about 50 percent.
These declining rates can justify big increases in home prices. In fact, the average price of U.S. single-family homes has jumped from $160,000 in 1999 to $265,000 today, a whopping 66 percent increase.
Housing Still Has Sturdy Foundation
Does all this mean that the roof will come crashing down on the housing market?
No!
While many fear rising rates will trigger a disaster for the real estate market, I see a housing market with a firm, concrete foundation. I believe interest rates are near their peak and that any further rise in long-term rates will be modest.
And although historically low interest rates largely explain the jump in housing prices, other favorable developments also played a role. Changes in the tax code in 1998, in a best-case scenario, allow up to $500,000 of capital gains to be exempt from federal tax if realized from owner-occupied homes. This exemption gives real estate a tax advantage over other asset classes. Rising household incomes and a competitive mortgage market have also boosted housing prices.
But this doesn't mean that recent gains will continue apace. In fact, prices very well may fall in markets where price speculation has been the most intense, such as parts of California and the Northeast. Such softening has already occurred in countries where the housing market was particularly strong and the central bank raised rates to prevent overheating.
For example, over the past couple of years the Bank of England has raised short-term rates from 3.5 percent to 4.75 percent, and the Reserve Bank of Australia raised rates to 5.5 percent. Both countries succeeded in cooling down their super-hot housing markets, and prices have leveled off. It's logical to expect the same to happen now that the Fed has raised rates from an extraordinarily low 1 percent in early 2003 to over 4 percent today.
What to Do Now?
Given this, investors may wonder if they should buy rental property. In many cases, the answer is "no." The cost of financing, taxes, and upkeep is often greater than the incoming rent, creating what real estate investors call "negative carrying costs." These costs can only be justified if there is enough appreciation to offset these costs.
And that's a problem.
Historically the majority of real estate's return does not come from capital appreciation, but from "implied rent," which is the amount one would otherwise spend on rent for the same home. This surprises most investors, because capital gains have overwhelmed rental income in the past decade. But investors must realize this was a highly unusual period that will not continue in the future.
The Bottom Line
If you're comfortable in the home you're living in, keep it. And, if you have a second one, keep that too -- as long as you're not holding it solely for future capital gains.
Furthermore, much of the real estate held in real estate investment trusts (REITs) that trade on the major stock exchanges still offer good yields. Their average dividend yields are between 4 percent and 5 percent, a rate that matches or exceeds what you can get on government bonds. So even if REITs don't rise in price, you're getting a decent yield on your money.
However, if you're thinking of downsizing or selling your home, now might be a good time to do so, especially if it will generate tax-free capital gains. And if you're waiting to purchase real estate as an investment, I'd wait a little longer. The increase in the number of units for sale means that a buyer's market is close at hand.
Jeremy Siegel is a Wharton Business School finance professor in Philadelphia, Pennsylvania. He has been a frequent guest on the business TV program Kudlow & Company on CNBC, where supply-side economics fan Lawrence Kudlow hosts.
Siegel has his own financial advice Web site. He is also a supply-side fan like Kudlow.
Prof. Siegel has written and lectured extensively about the economy and financial markets, has appeared frequently on CNN, CNBC, NPR and others networks. He is a regular columnist for Kiplinger's and has contributed articles to The Wall Street Journal, Barron's, The Financial Times and other national and international news media. Prof. Siegel served for 15 years as head of economics training at JP Morgan and is currently the academic director of the U.S. Securities Industry Institute.
Prof. Siegel is the author of numerous professional articles and two books. His latest, Stocks for the Long Run was named by Business Week magazine as one of the top ten business books published in 1994 and by James Glassman of the Washington Post as one of the ten-best investment books of all time. A third expanded edition of Stocks for the Long Run was published in June 2002.
Prof. Siegel has received many awards and citations for his research and excellence in teaching. In 1992 he won the Graham and Dodd Award for the best article published in The Financial Analysts Journal and in 2000 was awarded the Peter Bernstein and Frank Fabozzi Award for the best article published in The Journal of Portfolio Management. In 1994 Professor Siegel received the highest teaching rating in a worldwide ranking of business school professors conducted by Business Week magazine. In December 2001, Forbes named JeremySiegel.com as one of the "Best Business School Guru" websites.
bump for later reading
I've notice that mortgage interest rates quoted on bankrate.com have been falling since the Fed increase, and have trended slightly downward on average since mid-November. Today's average for a 30 year conventional is 5.74%, but good luck in actually getting anything like that ... reality is closer to 6% with no points, still better than what you're likely to find at your friendly neighborhood bank or mortgage broker.
ARMs and I/O ARMs are not nearly as attractive as they were as little as six months ago, though, which is playing some part in shaking the speculators out of the market. This will probably cause something of a shakeout in the high-appreciation markets where speculation has been rampant, but should be a good thing overall, long term. Near term, recent buyers in these markets are going to be singing the blues.
20% price collapse in the high end in Boston... Sacramento Housing falling... Foreclosures at record highs across the country.. Yea, its not a house of cards... RIGHT!!...
THere will always be places that boom amid busts, but it is evidently clear that the cycle after a very extended boom, is popping, in the general nationwide case.
"in the general nationwide case."
Sacramento and Boston do not the nation make. That's "flyover" thinking.
The beginning of the buyer's market is close at hand. The real buyers market is 3 to 5 years from now.
"The beginning of the buyer's market is close at hand."
It's been a buyer's market where I am (northwestern NC) since 2000, and is just now climbing out of the doldrums. Job loss drove it then, with better prospects and new employers coming to the area driving it now. As a result, I just don't see the disaster that you guys apparently foresee, even if rates return to pre-2000 levels, around 8%.
There was a front page article in our local paper on Sunday, that explained that although the market had slowed slightly, it is definitely not a bubble.
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but it is evidently clear that the cycle after a very extended boom, is popping, in the general nationwide case.
>>>>>
I live in New York and I don't see any popping. What I do see is a FLATTENING of prices. In other words, you won't be getting several offers within a week like you used to. Don't expect the outrageous property appreciations you used to see before either. However, I don't expect a DOT COM like bust where Housing prices suddenly fall to half its current value. Too many immigrants and too many people come here to cause that to happen.
"I live in New York and I don't see any popping."
We've actually broken 5% year over year, for the first time since 1999, but had slow, steady appreciation all through the 2000 - 2004 period, 2 to 3% each year with no period being negative. Average days on market has declined from 120 last year to 70 this year. I don't know of a single instance of a bidding war here; the highly desireable properties at a good price just tend to get snapped up by RE insiders before the listing ever get on the MLS.
By law to buy a dot com stock on credit you must put 50% down. There is no similar law for real estate. Some people who are highly leveraged will lose everything. House values won't crash, but a 20% drop will totally wipe them out.
bttt
In real estate, that's where it starts... Higher end generally, flattens... then starts its wayward dip. If you think NYC is immune, talk to some folks who have been investing in that area for 20 years or more.
First it flattens.. then decreases, and then once the decrease begins, particularly in areas that had skyrocking appreciation, it falls incredibly fast.. because the mentality of I must buy today, because it will cost more tommorrow, rapidly becomes, I won't buy today because it will be cheaper tommorrow.
Areas of Modest appreciation, will see flatlinging and modest depreciations.. places that were going through the roof for no real reasons, other than speculation on the market... will fall.
Generally we are in the downturn now nationally. Always are exceptions due to local economics.. but nationally its clearly trending down.
Regulator, I can quote you states from cities all over the map.. LV has popped, Boston has popped, Sacramento is popping, Pittsburgh is flatlining/falling in the high end, NYC is flattening, Cleveland, Atlanta, Minnesota, Colorado.. etc etc etc...
Reality is the run up is over.. and the down cycle has begun... Some will crash harder than others, as is always the case... and some places will grow (just like some places last during the boom) because of local economic trends.
Reality though is.. the general national run up is over, and the bust is now underway.
With the no money down programs, and refi crazes of last few years.. lots of folks will get whiped out on any sort of depreciation, let alone 20% drop.
Yes, the asset will still have value.. but if you owe more than its worth, it doesn't really help you much.
This is amusing. The guy tells you its ok to hold on to properties as long as you are not planning on ever needing capital gains from them, and then he tells you that it is a good time to sell if the time is right for you.
That is not exactly a bullish sentiment, although he tries to pass if off as one.
"The guy tells you its ok to hold on to properties as long as you are not planning on ever needing capital gains from them, and then he tells you that it is a good time to sell if the time is right for you."
It's perfectly rational advice for anyone who is not holding residential real estate strictly for appreciation, i.e. speculating. It's tax favored, and everyone needs a place to live. But, if you're considering selling, he's advising to go ahead and do it, because the upside, further high appreciation, is looking uncertain in many areas, with depreciation a possibility in the peakiest markets.
I think the guy's striking a good balance, between the excessive bullishness of the recent past, and the abject doom-and-gloom of the kitco.com crowd. They both have an agenda and are speaking to their own self-interest. So am I. I own a home, and don't want to see the value decrease due to the pendulum swinging too far in the other direction, resulting in an irrational talking down of residential real estate.
The run up is probably over, but I don't think there will be a 'bust'. If you just bought in the last few months and need to resale in the next year or so you may be in trouble, but 99% of homeowners they will be just fine.
Well, real estate always favors those who can "sit".. unfortunately with ARMS/ I/O loans... most of those folks who are going to be burned are not going to have the option to sit.. they won't qualify for refinancing when teh ARMs go up... (already happening in big numbers).. so they are going to lose it.
And as for a year.. last time S. Cal burst, it took over 8 years for folks to just break even on their mortgage values vs sales price of their homes. I've seen homes drop over 20% of their value in less than a year.... and after a decade not be back where they were before the pop.
Most folks are not going to be fine.. especially those who bought as much house as they could, on unstable financing underneath it with the anticipation that values will just keep going up.
Bigger fool has been driving the real estate market now for a while... in most areas... and now the payday comes.
"Bigger fool has been driving the real estate market now for a while... in most areas... and now the payday comes."
What do you see as a decent place to "park" investment money in the interim, assuming that a nationwide real estate slump or "bust" actually does become reality?
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