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.
Well if you like Real Estate, park it someplace easily liquid and safe, protect your egg... And then slurp up the deals that will be coming.
Skyrocketting gains come from panic buying. What you are describing is nonbuying. What is required for big drops is panic selling. Where will the panic selling come from? If your answer is higher interest rates, think again, the Fed will lower them in a heartbeat if they think that's happening especially helicopter Beernanke.
"Well if you like Real Estate, park it someplace easily liquid and safe"
How about other than RE?
Panic selling will come from the people who have been speculating on new homes or condos.
I see a lot of speculators around here (No. VA) and know some, but no panic yet. When I point out that the market will probably stagnate for 10-12 years (for prices to catch up to long term average increase) they seem to accept that. A few won't but I don't think mass panic is in the cards.
"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."
Don't expect an investment guy to admit that.
It's true. Houses are on the market LONGER and prices are coming DOWN
"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."
In Calif. prices have risen each year but NOT at the high percentages of some other places (Vegas, etc.).
So if somebody bought three years ago, put 20 percent down, they have a long way to go, before price stabilization, or reasonable declines impact them.
You are pointing out the situation for somebody with a small down payment, that bought the year before prices decline.
The decline in Calif. from 1990 thru about 1995 was gradual--about 5 percent per year. It was significant. I make no argument about that.
If prices in California simply stabilize at "no increase" for year, that wouldn't be horrible. It has NOT happened, yet.
Many expect it could. I am a RE Broker, and listen to everybody's input. A widely held (but very unreasonable) view is that if interest rates go up a little more, people will stop making payments, turn properties back to lenders, etc.
But since just about every homeowner has substantial equity, why would they jeopardize that, by not making payments?
A lot of unreasonable expectations; often the most unreasonable by people that don't own real estate, continuing to rationalize why they a smart to not own real estate.
Most people have been living in a home for several years and have seen an unbelievable amount of equity built up. Yes most people will be just fine.
Sure they will.
Most people bought a house, live in it and pay down the mortgage as it goes. They will be fine.
It doesn't need to be panic selling... all it needs is for the bigger fool to no longer be buying... When no one is buying prices have only one way to go... Down. You can be unpaniced as a seller all you want, but the fact is, when buyers aren't willing to pay your asking price, they aren't willing to pay your price.. period.
Real Estate suffers the same ups and downs as any market, and we have had an extended up cycle... and now its going down, and will go down, particulary in the hyper inflated areas, very quickly.. High end is already down 20% in boston and getting there in other places as well.. more modest markets that didn't see the insane appreciation during hte up times have flatlined or slightly declined...
All it takes for prices to go down, is buyers unwilling or unable to pay. And that's exactly where things are going.
Well me, being the relatively conservative guy I am, I'd be looking at mutual funds, with long proven track records, across multiple sectors.
Then liquify and scoop up the deals as them come.
No doubt things are going down, but how much power do the buyers really have? Inventory is up 150% over last year down here in No VA (as bubbly as the Boston market which I am also familiar with). Yet good properties are still selling at full price (last June's prices). Why? Because the extra inventory is speculative (tract mansions, condos), overpriced, or just plain garbage. The good properties are still in short supply - a seller's market. There's a couple of properties right by the highway in my old neighborhood with no takers because the location stinks, yet a few blocks away buyers are paying full price or at most 5% off for similar properties.
There are always local market variations.. DC is still one of the stronger areas, at this time. Lots of government spending over the last few years.... I know tech workers basically have a blank check if they are willing to move there. In ANY national trend, there are always local exceptions.
There is no doubt speculators or "appreciation sluts" are at work in DC, as with all areas that have had rapid appreciation... It draws them out of the woodwork... of course the problem is, is it draws lots more fools than truly experienced folks... and you wind up with a screwed up market. DC isn't one of the areas that's seen huge collapsing yet, and may not for a while. As you correctly recognized, excess inventory is mostly newer speculative construction.... Which when you start to get a glut of that, is when you start to see the adjustments occur.
When the new construction is vastly over existing (which happens in a lot of places, and has happened), because they can get folks in with little to no down, and everyone wants a new house.. you wind up with a huge gap between what that house is truly worth based on existing inventory, and what the folks paid for it. In my area, the gap between the newer constructed McMansions and the existing homes of similar size is as high as 30% (and in some places more). What does this mean? Simple... THere is NOTHING to justify the value of the newer construction other than "its new" and "easy financing"... When it falls (and it already is here) they have nowhere to go but down... and when the new construction drops... the existing home inventory will drop too (secondary effect)... it takes a little longer, but it happens... It won't fall as FAR as the new construction, because it has true market pricing bottoms at the lower end. Lets be realistic, I don't live in DC, I live in an area where you can get a good existing home in a nice neighborhood for $100k or less, if you want. And solid homes in safe, but not the greatest neighborhoods can be had in the 40-60k range all day long. This part of the market isn't going to move much here... up or down... so existing homes have a floor, giving them some intrinsic value vs the rest of the market.. the newer overpriced stuff sold on easy financing, and little down, has nowhere to go but down... and this is a market where in good times appreciation might be 3%.. The high end is already an "admitted 0%" which basically mean its declining... if you deal with real estate you know if they are admitting 0% appreciation its really under.
There are always local influences, that can buck national trends... but the reality is, its going down.. and in many of the hyperinflated areas its going to go down hard.
Nationally however the writing is on the wall.
You make plenty of good points: worthless new construction premium, hot DC job market, solid flyover houses for 100k, etc. But you still haven't given a reason why sellers will start marking down houses, or why buyers will go on strike until sellers come down. My office is hiring and our new hires are buying. I tell them to rent and wait, but they buy anyway. I suppose that could just add to the bubble now and trouble later. Also fed spending will be cut at some point, if that coincides with economic slowness that could be trouble. OTOH an inflationary expansion could drive prices much higher. But with things the way they are, I see nothing but small drops and rises with prices somewhat stagnant over the next 10-12 years as they revert to the long term trend.
DC is hot, and mainly because of a general influx of folks due to jobs.. but government spending as I am sure you know.. changes with the wind. When Bush's administration is over, or if the Dems should mount some kind of congressional route, priorities will shift, and spending priorities will change... or heaven forbid, a terrorist attack occurs on DC area.
As long as jobs are strong, you are right to assume your area won't go down much, all other things being equal... But therein is the rub. All other things aren't going to remain equal. Interest rates are going to hit 8 to 10%... historically that is not a high number, but 2%-4% on a 300 or 400k mortgage drastically shrinks the pool of buyers ready willing and able to pay. That $300k house someone here mentiones goes from having about an $1800 a month payment (plus taxes and insurance) to 2200 a month (8%) or 2650 a month (10%) on 30 year fixed.. and the pool of buyers shrinks with every dollar higher in payment.
Money supply will tighten, make no mistakes, its not an if, its just a when. New bankruptcy law, higher credit card payments, reduction or elimination of the home equity windfall on federal taxes... all of which are happening, have happened or are going to happen. Foreclosures are at record numbers all over the place already.
I agree that as long as DC is spending money like a sive, jobs will continue and the housing market will be somewhat stable, but as you know... its all cyclicle.
If only all those jobs would come into the Boston area. MA is the only state in the union with population loss. Even the illegals aren't flooding in there the way they are in other areas. They're very vulnerable.
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