Suggesting that real estate is or is not currently a good investment is fools errand.
Much has been written already about a
possible real estate bubble yet clients are
asking about the White Oaks view on the
issuer and what should be done and therein
lies the purpose of this paper. Suggesting
that real estate is or is not currently a good
investment is fools errand, however, with all
investments whether they be real estate,
bonds or stocks there may be times when
the holding periods may be excessively long
due to an excessive price being paid. Time
indeed does heal all wounds yet experience
has taught us that many investors assertions
that they are long term investors does not
live up to the multi- year test of buying at
high prices. When prices are clearly high a
prudent action would be to exercise caution.
Clearly the media has caught on to the
concept that residential real estate may be
reaching unsustainable pricing levels
particularly in some markets. The significant
appreciation in real estate since 2000 has
been attention grabbing to say the least.
Some might argue that this is a result of the
baby boomers reaching and nearing
retirement age and the trend will likely
continue for some time. Others are warning
that the trend is unsustainable and a crash
would likely cause havoc economically on a
global basis.
We should start out by stating we have a
strong bias for investing for the long-term
and believe that under-valued asset classes
have the highest probability of delivering
returns above historical averages. The longterm
historical average for real estate is
slightly more than the inflation rate. With a
long-term inflation rate expectation of 3%-4%
this would suggest an appreciation of real
estate of 3.25% to 5%. Of course, to have an
average you would have returns above the
range and below the range. Therein lies the
next big question. Are the above average
returns going to continue and for how long?
Are these above average returns due to
long-term investment/ demographic trends or
speculative activity like the internet craze of
the late 1990's? How long will it take to work
out a bubble if in fact there is one?
Sir Isaac Newton (we believe a very
smart guy in his time) who was one of
the investors in the South Sea bubble
remarked ? I can calculate the
movement of the heavens but not the
madness of people?. So what is a
bubble and what does it look like? There
have been several instances in history
of investment bubbles. The Tulip Bulb
Craze in 1593, the South Sea Bubble
(mentioned above), The Great
Depression, The Crash On 1987, and
the more recent Asian Crash and Dot
Com Bubble. The Florida Real Estate
Bubble of 1926 might be instructive.
Hot Topic for the Hot Investment Idea at the cocktail party:
It's not unusual for the conversation at
social events to turn to investing. The
conversation goes something like this.
Wow! We?ve really done well on this
property (stock/fund etc,) and it was
sooooo easy! This serves to bring in
others to increase demand. It is easy to
feel you ?getting ahead? of the curve but
current purchasers may find the curve
was well formed before you arrived on
the scene or they are the curve.
Lots of media coverage
Don't buy what's on the cover of Money
Magazine is a common phrase in the
financial advisor community. Case after
case can be found that investment
advice reported is historical information
and that those seeking an easy ride are
likely too late. Another take on this is the
notion that a golf pro like Tiger Woods
does not read Golf Magazine to find
ways to improve his game.
Cash flow and relative value is ignored
One way to examine whether property is
a good long-term value is to compare
the proposed purchase with renting the
property. At the highest phase of a
speculative boom renting may be much
more attractive than owning. The ongoing
expenses of a real estate property are
significant and need to be considered
when calculating your return on
investment. If designed for rental and
you determine developing adequate
cash flow is a stretch how would a
passive investor view this purchase and
what would they pay?
It's different now:
Probably the best sign that a bubble is
forming is the phrase ?It's different this
time?. Somehow the rules of valuation
and investing were turned upside down
and what previously was a bad
investment is now a great one. Careful
historical perspective is critical to
understanding what real value is. The
most money in real estate is made after
a period of over-valuation and prices
again make sense. Of course, one must
also recognize it may not be different
this time and a good investment
opportunity is indeed before you.
Careful analysis will bear this out and by
filtering out anecdotal information.
Is all real estate valued at crazy levels?
No, for example, commercial properties
in general are not over-valued at the
time of this writing. Adequate cash flows
are frequently being generated in
commercial industrial properties (5-7%)
and there is little or no (none in
Minneapolis according to a recent JP
Morgan analysis) speculative building
activity. Lenders are requiring a new
building be 30-50% leased before
releasing funds for new construction.
The East and West coasts seem to have
the most extremes in financing and
explosive prices. Low interest rates and
creative financing have had the impact
of allowing more marginal buyers into
the housing marketplace. More home
ownership is a worthy objective from a
social policy standpoint, however, the
supply and demand equation may be
impacted if marginal buyers who
qualified with low interest rates and/or
marginal credit buy increased
sales/foreclosures or more ?doubling up?
by taking in renters in order to make
ends meet. Banks traditionally pull back
during tough times and the new credit
standards may disqualify many who
might have been qualified under current
guidelines. The resulting reduction in
demand would likely soften the real
estate process.
What are the catalysts that could pop a real estate bubble?
Rising Interest Rates:
Interest rates on mortgages are a major
cost for most real estate purchases and
is a prime consideration for affordability.
If interest rates rise less people can
afford to purchase or upgrade their
home or vacation residence. Mortgage
lenders have been very creative in
offering adjustable rate mortgages that
allow for the possibility (or probability in
the current environment) of increasing
interest rates (costs). In some markets
interest only or negative amortization
(designed to pay less than the interest
charged causing the remaining interest
to add to the mortgage balance) serve
to increase the affordability to purchase
the home but place the purchaser at risk
for higher costs when interest rates rise.
If interest rates were to rise overstretched owners may be
forced to sell or worse yet to
face foreclosure.
Overbuilding:
It has been very common for real
estate developers to over-estimate
demand at the end of a real estate
cycle. Faced with the reality not
being able to put product on the
marketplace fast enough the
developer decides to build a couple
of properties (known as 'spec?
houses) ?in advance? of a purchase
agreement. Of course, the first few
go well and then being convinced
he/she was right builds a few more.
Of course, over time all developers
decide this is the way to go and
eventually over-supply kicks in. The
consumer is faced with an
abundance of choices and prices
stall and in some cases decline.
Over-confidence:
There are two aspects of overconfidence,
the developer and the
consumer. The dynamics for the
developer are outlined in the overbuilding
section above. The
purchaser also participates due to
their fear of missing out on a great
opportunity. The emotions of fear
AND greed play a big role here.
Investing without emotion is the
prescription for rational investing.
What will be the first signs of a bubble pop?
First, will the time on average to sell
a property increase due to sellers
being not willing to price their home
to the market. Sellers use their
neighbors who sold as guidelines
for what they should receive. If the
market softens the average listing
times will increase. Upper bracket
homes are in this stage now in
many areas. Second, impact is
that the appreciation rate will likely
stall. Third, over stretched property
owners are forced to sell or face
foreclosure, then prices will either
fall or be in a multi-year holding
pattern.
While this may be seem to give
the property holder a long time
to take action the realities of
real estate and the time and
expense to sell will not likely provide any
cushion.
Potential Scenarios:
Crash In Prices:
Clearly, this has happened before and
could happen again. Examples of the
Florida Crash of 1926 above show that
Real Estate also experiences volatility
but it is usually a local event rather than
a broad based national one. Other
examples of this are the Texas and
Colorado real estate crashes during the
80's. A devastating time in those areas
and a few others left many other areas
impacted on a much lower or nonexistent
level.
One clear difference is that a Real
Estate property is not valued daily and
therefore is subject to LESS emotional
selling than the stock market is. It is not
possible (at least very unlikely) to sell
your real estate tomorrow and have a
check in three days like in the more
liquid stock and bond markets. Since
your choices are limited an investor is
more likely to hold and not sell into an
emotional blowout. If a ?crash? were to
occur in real estate our opinion is that it
would be in pockets where the market
has been the most speculative and in
other areas the appreciation would
flatten out.
Extended Period of Low or No Appreciation:
This scenario has played itself out
several times including the 70's and 80's
where the value of real estate holds its
own but appreciation is small or nonexistent.
As mentioned in the section
above the lack of a daily valuation
mechanism and the fact that most of the
property is question is owner used and
occupied that those with equity in their
properties will simply continue to live
in/use the property and wait it out. Again
the long time horizon is the investor's
friend. We think based on the history of
asset classes and the current
environment this is the most like
scenario.
Renting is More Economical Than Owning:
More investors getting into the rental
business creates more supply and
renters can negotiate better deals
whether for rental property or permanent
living arrangements. This serves to
reduce demand on two fronts. First,
people seeking to reduce costs are
selling homes to do so and second the
renters have more bargaining power.
This can lead to poor or negative cash
flow forcing highly leveraged landlords
to sell their properties in a soft market.
So what's a person to do in this
environment? Should one buy a house
now? The answer for me is yes. My
primary motivation for buying the home
is a place to live and be able to mold it
to fit my personal style. This is a
personal lifestyle decision not a longterm
investment decision. How about a
vacation home? Somewhat the same
answer, however, it may be very cheap
to rent if your personal use time is short
term. (again see paper mentioned
above) What about property for
investment? Careful due diligence
needs to be done on each property. It
would be prudent to plan for higher
vacancies because supply of properties
is likely to go up. It would also likely lead
to less appreciation than has been
experienced in the last several years.
Real Estate like all asset classes
demonstrates normal cyclical patterns.
Buying high will lead to longer holding
periods to achieve average results. It
usually takes 5-10 years for a bubble to
deflate itself and the asset class to get
back to ?normal?. Our most recent
example to technology stocks continues
to validate this rule of thumb. While it
takes the ?bubble asset? five years to
recover a well-diversified portfolio
should be able to whether the storm
quite well.
How will it affect other asset classes?
The pressing question is will a real
estate crash affect other asset classes?
Another way to look at this question is to
ask ?Where will the money flow if a
crash occurs??. In the last bubble of
technology stocks the money flowed into
cash, bonds, and real estate. Real
estate because there was a perception
a.) At least I can use it and b.) this ( real
estate) won't go down in (or always
goes up) value. As we can see from
above, item b.) is a false assumption.
This does not change the fact that the
dollars flowing into real estate now will
likely go in a different direction once the
market stabilizes or values decline.
With interest rates so low the
likelihood that more flows there will
be based on how bad the losses
might be. The fixed income market
is the safe harbor and more money
flowing there would mean interest
rates would likely decline or at least
remain stable for some time from
already low levels. If interest rates
were to decline or the expectation
that they will remaim stable the
equity market could be a
beneficiary, particularly if valuations
are attractive. Based on current
interest rates the equity markets are
20% undervalued. Even if we
assume interest rates rise to 5% the
markets are fairly to slightly undervalued.
One could assume that the
investment markets will all go down
due to the lessened ?wealth effect?
or due to shocks to the economic
system. This would likely be a
short-term issue if in fact it were to
occur.
Summary:
Economist John Maynard
Keynes once opined ? In the
long run we are all dead?. Real
estate as an asset class is always a
long-term investment. The rapid
appreciation and speculative behavior of
these markets suggest additional
caution be used when committing funds
to this area. History has proven
repeatedly that when asset classes
exceed historical norms for an extended
period of time, there will be a correction
or regression to the mean. History has
also shown that real estate has not been
an exception. Assuming there is in fact a
bubble (probable but not guaranteed)
and that above average appreciation is
not sustainable, investors in real estate
need to increase the due diligence to
ascertain their risks in the marketplace.
Real estate always has and will continue
to be based on very narrow local
influences. Attempting to translate what
happened in one area to another will
likely have adverse consequences. Not
all segments or locations of the real
estate market are over-valued. There
are likely still good opportunities where
the crowd is not looking. Comparative
value (purchasing vs. renting or cash
flow analysis) can give an investor in
real estate a sense of whether or not an
investment will produce the results
desired. We believe on of the reasons
that the perception of real estate
remains positive is that many faced with
the difficulty of selling in a soft market
forced themselves to stay as long-term
investors. Of course, this could be true
with all investment asset classes but
choices can be more freely made in
stocks or bonds that increases the
emotion of an investor's decision
making.
Alan Greenspan warned of ?irrational
exuberance? in the stock market in
1997. It took nearly 4 years before many
investors really understood what the
consequences were to their
pocketbooks. Well-diversified portfolios
offer the highest probability of success
in meeting financial goals and
speculative activity often has severe
consequences. While no one can
predict the prices or when or if a
reversal in an asset classes fortunes
may reverse valuations do count and
reversion to a more realistic value can
be painful. Careful selection is always
important but when an asset class is
?frothy? or ?irrationally exuberant? wise
investors will take a cautious route.