Home Price Gains as Deceptive as Liar’s Loans: Independent Financial Advice
Housing Bulls self-deceptively wrong again
The housing bubble was caused by Liar’s Loans which obscured key income data that confused bank underwriters. That is metaphorically like the accidental obscurity of poorly organized data about home sales which falsely imply that prices are going up.
In the Wall Street Journal an article today “Home Prices Climb as Supply Dwindles” claims home prices are going up. My opinion is that if they are going up it is the work of investors buying to rent them out and not owner occupant buyers. This buying is a temporary and erroneous action.
The investors may feel that as an alternative to investing in stocks that yield 2% or corporate investment grade bonds that yield 3% why not buy a house and rent it for 8% less 3% for operating expenses to get a 5% net yield, assuming the home was bought with no debt. It may be tempting for investors to view an all cash purchase of a well-managed, diversified portfolio of rental real estate as “bond-like” because it produces steady yield (after netting out operating expenses) roughly similar to a bond.
The problem with investing in houses is that their value is tied to a buyer’s ability to qualify for a loan and that is tied to a shaky, stagnant labor market which will keep real wages stagnant.
Another big picture long term problem: if you buy today and intend to sell in ten years what if another Paul Volcker type is running the Fed in 2022 and mortgage rates are at 14% (as they were in 1981). Higher rates will drive down real estate if it is the type of property that is customary to be debt financed. So when you buy a house you need to think of the future successor buyer’s needs. If you add a room to the house that future buyers view as a waste they will not pay you for it. That is called over-improvement. And if future buyers have to pay 14% for a mortgage then they will demand that you cut the price so that the home will be affordable. As inflation rises then interest rates will rise. Rising interest rates hurt the value of bonds and real estate. If a speculator thinks he will simply sell off his real estate he may be unable to do that because the market can be illiquid and broker commissions are expensive. By contrast a bond investor who monitors the risk of rising interest rates might be able to sell off his portfolio more quickly than a real estate investor and with less cost.
Ironically the reason institutional investors want to buy homes is to get a yield in a bond-like investment, but they must remember that the “bond-like” nature of rental real estate means that its price will be discounted as rates rise.
Open the housing secrets
The thing that is deeply irritating about news stories about real state is that no one seems to publish a detailed comparison of apples to apples. The only fair way to compare real estate would be to track a purchase of a home that had a certain specific size, features, number of bedrooms and bathrooms, quality of the homes construction and maintenance and age, the same school district, etc. It is completely wrong to blindly use the average sales price for a city because during a recession only over-improved homes may sell. What if last year the only thing that sold in a town was a two bedroom house that sold for $200,000 and this year a four bedroom sold for $220,000. The way statistics are reported it would imply that prices went up 10% in that town. But to be fair prices need to be adjusted for quality. This is rarely done.
The best guess about the market is that there has been a temporary election year and consumer rights motivated slowdown of the foreclosure process which has reduced the supply of housing. But that will soon revert back to the “new normal” of a huge oversupply.
The best guess about housing prices is that the shortage of rentals will be solved by cutting a 2,500 square foot home into two with a proper permit for rehabilitating the building and either selling or renting out the two 1,250 square foot units. In addition, the new normal is one of consumers adapting to a lower standard of living and simply renting a smaller home. Eventually excess demand for rentals will be satiated by people accepting a demotion and moving into smaller quarters. Consumers often view renting as chance to save money by occupying smaller quarters and being an owner occupant as a chance to enjoy a full sized house. If consumers are forced to rent then their preference will be to consume a smaller amount of space. The huge backlog of unsold foreclosed homes will adequately accommodate their needs.
Charts showing inflation adjusted home prices imply that houses need to dip anther 10% to be in equilibrium. These charts fail to calculate that in the new era of post “Easy Qualifier” Liar’s Loans that demand for housing will be lower than it was in the past, thus housing prices may need to go even lower. Bearish economist Gary Shilling said they need to go down 20%. My gut feeling is that enough naïve investors will mistakenly buy rental houses that they may create “faith-based” bottom to housing, but for the housing market to become airborne and go up it needs consumers to get a pay raise so they can borrow more and buy a bigger house. But “real” wages will remain stagnant and actually go down.
The conundrum is that if the economy has returned to normal then interest rates need to go up to normal levels and then home buyers would find an immediate substantial reduction in purchasing power, so they would need to buy a cheaper house. Thus any recovery of the macroeconomy will hurt the housing market! Talk about a ceiling on home price appreciation! Busted bubbles don’t come back for a very long time because they are so thoroughly discredited. Have tech stocks recovered from March, 2000 when NASDAQ was 5,200 points (it’s now 3,010)?
Even though there may be some truth to the idea that real estate is “close” to a bottom and there is the possibility that stocks are 50% overpriced (using ten year PE), if (hypothetically speaking) I was forced at gunpoint to become bullish, I would prefer stocks because I could buy a globally diversified portfolio of companies managed by the world’s best MBA’s and engineers; by contrast if I buy rental real estate in town “X” then my real estate is trapped there and is far riskier because it is not diversified over the world nor is it managed by a huge pool of talented employees working at the Fortune 500 companies.
These comments refer to the national economy and not to Silicon Valley or Manhattan.
I wrote an article “Best way to forecast real estate” and “Real estate bottoming?”
Investors should seek independent financial advice.