A General Hypothesis on Real Estate Prices

Mar.15.09 | About: iShares Mortgage (REM)

Introduction and a Personal Perspective

As I have been surveying many Real Estate Investment Trusts (REITs) over the past few weeks, I thought I’d take the opportunity to present my underlying macroeconomic beliefs in regards to real estate prices. For the record, I have never personally owned a home and there is a reason for that. For years, I believed that real estate prices were too high above their inherent values in the areas I lived in and there were too many risks associated with buying. As a consumer, I saw little value in owning a home at that time.

I have lived in three different markets where I believed housing prices were on the ridiculous side: the Atlanta metro area (2003 – 2005), the DC metro area (2005 – 2006; 2008 - Present), and the Baltimore metro area (2006 – 2007). While, one reason I chose not to buy a home was because I wanted greater flexibility and did not want to deal with the hassles of home ownership at the time, this macroeconomic analysis was also in the back of my mind, guiding my thoughts, just as it is now when I analyze REITs as an investment vehicle.

Real Estate and Its Commodity-Like Properties

When you think of commodities, you probably think of agricultural goods or industrial metals like copper, zinc, and platinum. Commodities have always fascinated me because of their volatility. In times of excess supply, prices drop sharply and can even temporarily fall below production costs as suppliers take anything they can get from the market. This situation rarely lasts all that long, however, because if companies are unprofitable, they will either lower supply or exit the industry.

Conversely, in times where supply is low and there is excess demand, commodity prices can skyrocket. This is because many commodities are necessary goods that the marketplace cannot go without. You might be able to do without a new PC or iPod, but no one can ever go without food. Similarly, many metals are absolutely vital to the functioning of our economy, so demand will always be present.

Real estate is similar in some ways. While it may seem odd to compare real estate to commodities, I believe it functions in a similar fashion on some level. Certainly real estate prices will never be as volatile as commodity prices because very few people buy real estate and then sell it off within less than a year. Real estate is generally more of a long-term asset. However, real estate is absolutely necessary in our society (just like food, oil, and base metals) and prices can spike upwards dramatically over its inherent value based on supply-demand dynamics.

An Inherent Value

Prices for goods and services are obviously influenced by supply and demand, but on a base level, I believe that all goods have an “inherent value.” This is a fictional price where, all things being equal, there is a perfect supply-demand balance and prices are at a level where companies can still make sustainable profits, but not be able to take any abnormal earnings. You might say this “inherent value” is slightly above the costs of production and factors in replacement costs.

At a base level, real estate prices should be defined in relation to their inherent value. Due to the nature of land and property, real estate prices will be, on average, slightly above “inherent value” in any urban and most suburban environments. However, there are factors that can drive real estate prices up much higher.

Factors Influencing Real Estate Prices

The primary factors influencing demand dynamics in the real estate market are wages and employment. If wages in a particular area are high and unemployment is likewise low, this can drive the price of real estate above its inherent value if there is a lack of supply.

In a small city environment where lots of open space is present, builders may have little difficulty expanding supply to meet demand and because of this, prices may never actually increase significantly over the inherent value of real estate properties. On the other hand, in a crowded, large-city, urban environment, supply can be limited and housing prices can spike dramatically above inherent values. There might be other factors influencing supply, as well, such as geography. Island and coastal environments can limit the availability of property to build on, thus, creating a supply-demand imbalance.

Now that we’ve established why real estate might sell above its inherent value, we should look into some of the reasons why prices may decline. I have identified three major causes:

  1. Builders slowly find ways to create more supply, normally by building upwards. This should ease prices a bit over a lengthy period of time, but would probably not cause a dramatic decline back towards inherent values, barring a huge technological advancement that might allow high-rise buildings to be created with much greater ease and at a much lower cost.
  2. The underlying economic conditions in the real estate market change. If high-wage jobs that drove the market upwards suddenly disappear, that could drive prices down dramatically. Likewise, spiking unemployment could put significant pressure on real estate prices.
  3. Real estate becomes a speculative investment vehicle. If this happens in a particular area, prices can become more volatile and be subject to more dramatic swings. Remember, one of the things providing real estate prices with stability is the view that it is a long-term asset. If buyers are turning it into a shorter-term vehicle, that would create more volatility. As tends to be the case with markets, people will be more likely to buy on the way up when the outlook is sunny and less likely to buy on the way down when the outlook is grim.

Of course, given the current real estate crash, I should mention the role of interest rates in all of this. There’s no doubting that low interest rates (coupled with tax incentives by the Federal government) help drive prices upwards, while high interest rates will limit the number of buyers. All the same, I’d suggest the interest rate factor would be ancillary to factors #2 and #3 as low interest rates would stimulate demand (since they affect the economic conditions) and might be the result of speculation on part of lenders (who believe there are lower risks than in reality).

The Most Vulnerable Markets

Based on the hypothesis I have outlined, the most vulnerable markets are the ones where real estate prices are the highest compared to inherent values. Of the most vulnerable markets, the ones that were affected by one of three factors I outline would be the most adversely affected.

To illustrate this via chart form, I have looked at hypothetical rent prices for a 2 bedroom townhouse in various cities. Keep in mind that you would also need to look at purchase prices to have a more complete picture of a real estate market, but for purposes of illustration and because I am most familiar with rental prices for 2 bedroom townhomes, this example will do.

As you can see in the chart, the “inherent value” when applied to rental activities for this structure is $500 per month. Landlords in City #1 demand $800 per month, a 60% premium in price over the inherent value for this particular townhome. In City #2, landlords demand even more – they want $1400 per month, or a 180% premium over inherent value. We move our way over to City #4 where landlords want $2500 per month in rent for this particular property. That’s a 400% premium over inherent value.

In the example, City #4 would have the most vulnerable real estate market since it is the one priced with the greatest premium over inherent value. This would not necessarily mean that City #4 was the worst real estate market to invest in. If economic conditions and underlying wages improved even more, it’s possible that City #4 could eventually demand a 900% premium. However, in this abstract example, City #4 certainly has the greatest level of risk since it has a further distance to fall back to inherent value than the other three cities.

One of the reasons behind the current collapse in the real estate market is that many people had essentially convinced themselves that in City #4 (in the example), the inherent value of the property (in terms of rent) was $2500 per month rather than $500 per month. You can translate that to purchase price if you like, but the basic thing here is that people believed the price floor for the properties they purchased was the price at which they purchased it at. In essence, they deceived themselves about the risks.

Vulnerable Markets in Action

Detroit’s real estate collapse over the past few decades is one of the best examples of this hypothesis in action. While real estate prices were going upwards across most of the nation, Detroit’s property values have been going downwards for a considerable period of time. The reason why Detroit is at odds with the rest of the nation is because Detroit’s property prices had advanced well beyond their inherent values and the city’s economic situation has deteriorated significantly. This has changed the dynamics of the Detroit market creating a vast amount of excess supply that might even drive properties below their inherent values.

Based on this analysis, the worst real estate markets to be invested in are those priced significantly above inherent values that have deteriorating economic fundamentals. While Washington DC’s real estate prices are well above their inherent values, they can remain there so long as the employment/economic situation stays relatively stable. Before the current recession, the DC job market was one of the hottest in the nation and its fundamentals have not deteriorated significantly, particularly in relation to other metropolitan areas across the US. This does not mean DC prices will not drop; simply that they might not drop as much as they would in a more challenging economic environment.

New York City might be the most frightening market to invest in right now. With the collapse of the financial system, a lot of the high-paying jobs in NYC have been eliminated. Hence, the factor driving property prices to absurd levels over their inherent values has been weakened significantly. While I do expect NYC to remain one of the financial capitals of the world, it may never be quite like it was in the ‘90s and the ‘00s ever again. I would not be surprised if NYC is undergoing a paradigm shift, so to speak, just like many old industrial boomtowns in the “Rust Belt” have over the past half century. This means it’s completely possible that prices still have a significant ways further to fall and that prices could continue to decline for a decade or even longer in NYC.

There are several other areas where I believe there are major concerns. Many parts of Florida could also see long-lasting decreases in real estate prices. My basic view behind this is that Florida housing values have never fully compensated for the risks involved with being situated in an area with a high probability of highly destructive natural disasters. Insurance companies do not want to insure Floridan homes any more precisely because the risks are so great to them; slowly, Florida property values will begin to trickle down as a result of this.

Florida also suffers another issue in that as a vacation destination for many Americans, a long-term economic downturn or a weakening of American economic base could drive prices lower for at least a decade, if not much longer. Las Vegas, Nevada is also in the same boat as Florida on that. Water supply concerns in places such as Las Vegas may also help contribute to decreased pricing in real properties.

That brings me to California. The California markets have a wide range of dynamics affecting them. While California continues to be an innovator in many different industries, providing it with a large number of high quality jobs, this has also made it more susceptible to downturns. The San Francisco/Bay Area real estate market has the distinction of being priced the furthest above inherent values in the nation. However, so long as the Bay Area economy remains strong, this situation can continue.

There are other problems afoot in California, unfortunately. The state’s recent financial woes and near bankruptcy suggest that the California economy could experience even greater hardships in the future. This adds a little bit more uncertainty to an already uncertain situation regarding America’s economic future.

The Los Angeles market, both because of geography and economic dynamics over the past few decades, is not priced above inherent values quite as much as the Bay Area market, but real estate still sells at a significant premium to inherent value. Downturns in quite a number of high-paying industries could affect LA dramatically. In the near-term, however, Los Angeles would appear to be in better shape than most areas of the country; but I’d also classify it as more risky than most markets.

Markets with Some Potential

I do not believe that real estate prices will soar again anytime soon; at least, not in the same way they did in the ‘90s and the early part of this decade. I expect prices to level off some after reaching a bottom, before slowly rising more in line with historical norms. However, there all a lot of different factors influencing this, so it’s wise to take that with a grain of salt.

The areas that I would identify as having the greatest prospects of seeing improvements in real estate prices are those that (a) have potential for creating a substantial number of jobs as a result of improvements in a particular industry and (b) have infrastructure in place that reduces other costs for consumers. B might seem a little big vague, as it should, since I could not possibly anticipate all issues that could arise in the future. However, my biggest concern in this regard is a rise in gas prices (among other commodities) and the availability of public transportation.

Areas that are highly condensed and have effective public transit systems might benefit significantly in a resource-constrained world. Keep in mind, there are always other dynamics that could affect cities that fit this description (such as the collapse of the financial system in NYC), but I can think of some cities and some parts of other cities that are priced closed enough to inherent value right now, that it’s probable that prices will benefit significantly in the future. There are also a number of industries that could pop up and increase real estate values in certain places. I will not speculate much on which cities fit this set of standards in this article, but there are probably a few out there.

As Applied to REITs

The primary reason I found myself writing this article was that in evaluating a particular REIT, it appeared that my macroeconomic analysis had overwhelmed the microeconomic considerations of one particular company. Before long, I realized that this macroeconomic analysis was an entire article to itself.

Rental prices tend to lag behind real estate prices since those who bought real estate at a lower price than the current market value can afford to rent at a lower price. Likewise, those who bought real estate at a higher price than the current market value have more difficulty being able to afford renting at a lower price. That is one reason why REITs still might be an intriguing investment medium.

But in general, the further real estate prices drift away from their inherent values, the more vulnerable they are to slight changes in the overall economic situation. REITs operating primarily in markets where property values are at a significant premium to inherent value need extra protection to make me feel comfortable as an investor. For instance, if all others things were equal, I might be willing to invest in a more levered REIT that focused its activities in the Triangle region of North Carolina (Raleigh/Durham/Chapel Hill) than a slightly less levered REIT that operated primarily in the Bay Area of California, even if I did not believe the economic outlook was necessarily unfavorable in the latter region. This is because there is a greater margin-for-error in the former region than in the latter.

Concluding Thoughts

I would not ever recommend real estate as a pure “investment” to any individual buyer who was not looking to create rental properties. However, I believe there are times when it is wiser to rent and times when it is wiser to own a home. While a lot depends on the situation of any particular individual (e.g. need for flexibility, long-term goals, etc.), right now might be a good time to buy in a few markets if you’re looking to stay in it for the long haul.

If you live in a small city market where prices never spiked all that much to begin with, prices can still fall a bit, but they are unlikely to fall all that dramatically. If you’re in a large city market where there are legitimate reasons to believe the economic fundamentals might continue to deteriorate, I don’t think you’d want to buy now. If you’re in a large city market where prices have been hit hard but the long-term economic fundamentals might improve, buying now might be a really good decision.

After renting this entire decade, I am now finally starting to consider owning a home if the right situation avails itself. I fell in love with Baltimore row houses when I lived there in 2006 and 2007. Now that I’m seeing some of them at prices 30% - 50% below prices a few years ago, I might have a good opportunity to build my dream home in the next few years. While I do not view a home as an “investment”; I would prefer to see its value rise rather than fall all the same, as that provides me with more flexibility.

But whether you are buying a home, buying rental property, or investing in a Real Estate Investment Trust, I believe it is prudent to think about all the fundamentals driving the process and how that may impact the value of those properties. For every company I analyze, this general hypothesis on real estate prices is in the back of my mind.

Disclosures: Author holds no real estate related investments at the present time.