Monday, April 28, 2008

More on Catching the Bottom in Housing

Last week's entry Want to Know When Housing Has Bottomed? Here's How (April 23, 2008) garnered 109 Reddit recommendations, causing readership to spike 10-fold from roughly 3-4,000 per day to over 30,000.

After hastily arranging for additional bandwidth from my longtime web host, Busix, I read the 150+ comments logged on reddit. (A number of other readers had emailed me directly.)

As you might imagine, many readers questioned the entry's validity, while others raised specific issues which had been left unaddressed in the entry. Since real estate is a complex subject, these important topics deserve to be addressed. So here goes.

Many readers questioned whether a rental-property valuation had any bearing for an owner-occupied house/condo, while others questioned whether such a valuation made sense in high-priced areas like New York City, Vancouver B.C. and San Francisco.

Others felt my analysis was misleading because it ignored the accumulation of equity, tax breaks and the fact that paying down a mortgage's principal every month was not an expense like paying the interest.

All good points, all valid, all important--so let's dig in.

1. Homeowner vs. rental property investment. While it is certainly true that buying a home carries tax breaks (the mortgage deduction) and the possibility of equity appreciation, the fact that home ownership offers these merits does not, at least historically, translate into prices being propped up beyond a property's value as a rental.

Rents are set by supply and demand and by wage growth or decline; regardless of the property's assumed value, people can only afford to pay a percentage of their income as rent. The same is true, of course, of owner-occupied housing; if wages have been stagnant, as they have for the past 25 years, then the ability of potential buyers to pay higher monthly payments places a limit on the value of housing.

This constraint is lifted, of course, by low interest rates, which effectively drop monthly mortgage payments, enabling more people to buy houses. Unfortunately, the market responds to this new surge of demand by raising the price of homes. In the big picture, historically low interest rates enabled more people to become homeowners--and speculators.

Nonetheless, in the longterm, housing valuations remain tied to the population's income and the fair-market rent the property fetches--a number which is also tied to income. Here is the same price-to-rent data plotted slightly differently:

Please go to to view the charts.

Simply put: any increase in housing's valuation beyond the increase in income disappears when prices revert to the historic mean. In terms of purchasing power, income for most Americans has been stagnant for decades. While household income has climbed from the late 1960s as women entered the workforce, most of the income gains have flowed to the top 20%.

2. Housing prices won't drop much in high-value cities. First, please refer to my entry from June of 2007, Yes, Real Estate Prices Can Drop in Half--Even in Manhattan (June 8, 2007). If you read the academic paper cited in this entry, there is simply no way to claim "high-value areas can't go down." They have, and will again.

Just personally, I have friends who bought homes in the S.F. Bay Area in 1996-97 (the last bottom) for $145,000 to $165,000--perhaps 12-13 times annual rent or 120 times monthly rent. These homes were in a highly-sought after small city with excellent schools, and they shot up to $600,000 by 2006.

Will these homes decline in value to $150,000? Adjusted for inflation, if history is any guide, it's very likely.

3. A good reason to buy a home/property is the accumulation of equity. This has certainly been the case during the decades-long boom in real estate in the U.S. and other Developed nations, but it is by no means guaranteed. The fly in the ointment of this "rising tide raises all ships" scenario is Japan, a nation where property values outside of central Tokyo (and even there prices are softening again) are still declining almost two decades after the top of their real estate boom.

I know the usual arguments against this model occuring in the U.S., and they might have some validity, were it not for overriding financial realities. The most potent argument for the "real estate will always rise in the U.S." is population growth: Japan's population is declining while the U.S. population is rising.

There are two problems with this argument, both of which I have covered here in the past.
A. Population density can rise and fall. The same number of people can fit in a much smaller number of dwellings if times get tough; many more people can fit into a city without any more housing units being built. As I showed in Brain-Dead Predictions about Housing (January 2, 2008), San Francisco's population rose by almost 7% in a few years during the dot-com boom even as very few new dwellings were added in that timeframe.

And San Francisco has only moderate density compared to other cities--including low-rise Paris: The Downside of Density (November 7, 2005)

It should also be noted that there are literally millions of empty dwellings in the U.S.--and not all are scattered vacation homes. Density per dwelling is also historically low in the U.S. To say population couldn't grow as the number of existing dwellings remained constant is to ignore realities--most especially the millions of empty units/homes in the U.S.

As I documented in How Many Foreclosures Will Hit the Market? (May 1, 2006), about 40% of all dwellings sold in the bubble years were to investors. Those are by definition "bought to let/rent" and many, if not most remain empty even as hundreds of thousands of existing homeowners ababndon their homes due to foreclosure.

Over a year ago their were 2.1 million empty homes seeking buyers; and that was just what was listed for sale: Can 4% of Homeowners Sink the Entire Market? (February 21, 2007) Now millions more will be dumped on the market--or remain empty for future habitation.

U.S. Foreclosures Jump 57% as Homeowners Walk Away (Dan Levy, 4/15/08)
"About 2.5 million foreclosed properties will be on the market this year and in 2009, Lehman Brothers Holdings Inc. analysts led by Michelle Meyer said in an April 10 report."

Another factor is that immigration has been strong because the economy has been "strong" (even though it was an entirely debt-fueled "prosperity"). Once the recession really starts eroding incomes, jobs for immigrants will vanish and many undocumented workers will return to their home country as their own jobs/income has disappeared. Immigration may not be the force it has been over the last 25 years of prosperity.

B. The purchasing of real estate depends entirely on the availability and low cost of borrowed capital. Valuations mean relatively little, as very few people can afford to buy real estate with cash. If money dries up--and I believe historic cycles of debt accumulation and repudiation support a long cycle of higher interest rates and a paucity of available capital--then real estate falls in value regardless of "pent-up demand."

Bottom line: if the cycle of cheap, readily available money for borrowing has ended and a new cycle of rising rates and tight money/raised sensitivity to risk has begun, equity could actually shrink for 10-20 years.

Inflation could also ruin the rosy expectation of rising equity. If a property's value rose in nominal terms 4% every year, but real (purchasing power parity) inflation rose at 6%, at the end of 30 years the owner would have little net equity. Perhaps in nominal terms, the sum would appear substantial, but again, the only real measure of equity is inflation-adjusted--and with official inflation calculations so obviously rigged, then we would have to look at purchasing power as the only believable/accurate metric.

In other words: if equity is nominally $100,000 in 20 years, but a Big Mac costs $100, then how much is that equity truly worth?

If deflation reigns for the next generation as many believe likely, then purchasing a house for $300,000 and finding that it's worth $150,000 when you pay off the mortgage is a possibility. Now that might still be a worthy investment compared to renting, but perhaps not.
In this scenario--not at all unlikely in my view--then the renter who invested their money in other assets might accumulate more equity than the homeowner, who is sinking their money into an illiquid capital trap.

Several readers made the key point that real estate can be highly illiquid. In times of declining values and tightening lending, real estate has the unfortunate distinction of being hard to sell--unlike precious metals and stocks, which can be sold at almost all times in a few minutes.
A point no one made is real estate's high transaction costs. People move a lot in the U.S., and one's equity can be severely impaired by constant buying and selling. If you moved four times in eight years, then the transaction costs (roughly 7.5% - 10% of each sale, 6% commission plus closing and mortgage costs, including points), then up to 40% of your equity was eaten up by transaction costs--a staggering loss compared to the low transaction costs of selling bonds, precious metals or stocks/mutual funds.

For all these reasons, it might be true that someone who buys a house today and pays off a conventional 30-year mortgage might have a healthy pile of equity in 30 years' time--or they might not, depending on long-cycle macro-issues beyond our control and predictive powers.

3. Is GRM (gross rents multiplier) a valid valuation method? There are many ways to value property--income (net), comparable sales, etc.--and the GRM model is by no means the last word in valuing real estate. Nonetheless, it has the admirable qualities of atime-tested rule of thumb/heuristic, and can be a useful "test" of valuation reached by other means.

For more on the methodology and other valuation methodologies. I recommend Chapter Nine of California Real Estate Principles. GRM is covered on pages 247 - 249. (NOTE: I am not a real estate professional or in the business of finance, etc. I am merely a property owner and taxpayer.)

Another GRM rule of thumb is "100 times monthly rent." A property that rents for $1,000 would thus be worth $100,000.

These GRM rules are standard considerations in multiple-unit properties, and may not apply to all homes in all places. But regardless of GRM, any investor has to consider income as the key evaluation metric. If you're not making money on day one, then why are you risking capital?
Some readers objected to my insistence on "making money on day one." My reason was simple: you can put your capital to work in Treasuries and earn a return on Day One; why should anyone put their capital into real estate for some future promise of return, while absorbing losses with no foreseeable end? The answer would be: the future return promises to be much larger than that of a T-bill. But for the reasons stated above, such future returns in real estate may be less sure than widely assumed.

In general, at true real estate "bottoms," properties can be purchased which return a net profit from Day One.

4. You can't count mortgage principal as an expense. As astute reader Mike V. observed:

Your point that housing prices will reach an equilibrium when houses can be rented at a profit seems like a good one. The 6X to 10X "rule of thumb" for evaulating a rental property could be spot-on (I'm certainly not an expert), but, I found the example math you presented a little misleading. To find the point where Costs = Revenue when renting an apartment, you use the formula:

Mortgage payments + Other Costs = Rental Income

A mortgage payment is not strictly a cost. The interest paid on the loan is a cost, but the principal you pay is money you are exchanging for an equally valued asset (the house). That money isn't being spent, it's just changing forms, and shouldn't be treated as a cost.

A more accurate equation would seem to be: Mortgage Interest + Other Costs = Rental Income
There are (of course) many of factors that still aren't accounted for - increases in value of the home, the opportunity cost of not investing your money elsewhere, etc - but that seems like a more reasonable evaluation than the one you presented. Maybe the omission is what you meant by "making a profit from day-one", but I think rental property investors would certainly include the equity in the home they are paying for when evaluating an investment. Mike is absolutely correct, as anyone who has to fill out Schedule E (real estate rental income) knows. However, an investor may well want a positive cash-flow, in which case the entire mortgage payment would be considered. Also, if the investor refuses to count on future equity appreciation in "real" terms (not just nominal appreciation), then generating a net income from day one might still be the goal.

Investors get to deduct depreciation on buildings and major improvements, and of course this figures into their taxable net income.

This discussion raises the issue of leverage. One way to figure net income is to set aside the entire mortgage and ask: if I bought this property for cash, would the income minus expenses be positive? And if so, would it justifiy the investment of so much capital?

5. Using P-E ratios. As knowledgeable reader Andy S. noted, perhaps the better metric would be to calculate the price-earnings ratio (P-E) as is standard in analyzing stocks.

You state your rule of thumb in terms of a purchase price to gross rental ratio, but really the more classic way to compare returns on a property investment vs. expected returns on other types of investments would be to restate the ratio in terms of price to _earnings_, or, alternatively, it's reciprocal, yield. So, can you tell me what your rule of thumb comes out to when restated as a P/E ratio? (I have tried to search on phrases such as "historical investment property P/E ratio" on google and so far haven't come up with much good advice yet in terms of how to price property fairly in comparison to, say, for example, stocks, which have tended to exhibit long-term average P/E ratios of around 14-16.) The key to calculating PEs in real estate is to consider the leverage of borrowing. If an investor bought a building for $1 million in cash, and the building generated a net profit of $10,000 a year, that would be a paltry 1% return: not very appealing. This would result in a PE of 100.

But if the investor purchased the property with 10% down, then the $10,000 income would be in relation to capital invested, $100,000, resulting in a PE of 10--much more attractive.
Real estate fortunes have generally been built on just this leverage. In contrast, stocks can only be leveraged 50% via margin borrowing.

This raises another important issue: if buying will become so cheap at the bottom, why would anyone rent?

6. Why rent when buying is so cheap? Capital is the one-word answer. If we are indeed returning to a risk-averse, tight-money era, then buyers will need to pony up 20% down in cash (30% for investment properties). Not everyone with sufficient income to buy will have the 20% down (capital) to invest.

If the housing market continues to spiral down for years to come, would-be buyers might hesitate to sink their precious capital into an illiquid capital-trap which is losing value every year. (Again, maybe the house value remains stable in nominal terms, but if inflation is roaring ahead then the owner is losing value each and every day.)

Another reason might be that people expect to move within a few years. As noted above, transaction costs can eat up a big chunk of one's capital. Meanwhile, the transaction costs to buy and sell T-bills is negligible.

Lastly, would-be buyers may have read the headlines about property taxes skyrocketing as municipalities face declining tax revenues. Yes, their landlords will be passing along those increases--if and only if the market will bear it. In other words, Mr. Market will still set rental valuations, and property taxes only bear marginally on the market's price-setting; the incomes of the renters is the key variable.

On the other hand, cash-strapped, desperate cities/counties/states have no such market restraints. If they jack up property taxes by 20%, there is no restraint on their action except a political one, i.e. a Prop 13-type rebellion by the cash-strapped taxpayers.

I enjoyed the discussion and emails: thank you, readers, for adding to our collective knowledge.

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Thank you, D.M.T., ($20), for your generous contribution via mail "from somewhere in the South" to this site. I am greatly honored by your support and readership. All contributors are listed below in acknowledgement of my gratitude.

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