Why Real Estate Prices Cannot Go Higher

Includes: ITB, PKB, XHB
by: Acting Man

by Ramsey Su

I am trying to present some logical arguments in this rant. In reality, we know real estate prices can, and most likely will go higher, because the Federal Reserve and the White House want them to go higher. If real estate is not behaving the way the powers desire, Bernanke can always buy even more mortgage backed securities and the Treasury controlled agencies can simply start forgiving principals (same as forgetting principles), which may be happening soon. However, policy makers and politicians need to remember that any idiot can fly a plane while it is in the air, but landing may be a little more problematic. Sooner or later, the plane is going to run out of fuel and gravity will take over.

There are three approaches to valuation: cost, income and market comparable. These three approaches seldom crossed paths in the past, as they are used by builders, investors and home owners for their respective purposes, and they are almost never used for the same properties at the same time.

These approaches to valuation are basic appraisal principles and an appraisal's primary purpose is to obtain financing. That was in the old days. Today, single family home investors raise their capital from Wall Street, from partnerships and other non-conventional sources. No appraisals are needed. Public builders float bonds or sell shares, raising cheap money from investors who couldn't care less about the cost or any other approach used to value the land that the builders buy. No appraisals needed. That leaves only the mom and pop buyers who still have to rely on conventional financing, which means government financing today, to purchase a home. The market comparable approach typically uses six comps, three recent sales and three on the market. All that tells you is what others are willing to pay, it offers no fundamental basis for valuation.

There is a strange phenomenon in single family real estate today. Properties for sale (commonly confused with inventory) have been artificially suppressed, creating a massive supply/demand imbalance. Let us use Microsoft as an example. The company has about 8.3 billion outstanding shares, that is the inventory. Everyday, there are about 50 million shares that change hands, that is not inventory, just transaction volume. If for some reason, there are only sellers for 5 million shares and buyers want to buy 10 million shares, Microsoft's stock should go sky high along with the market cap, but the value of Microsoft, the company, has not changed. Microsoft's "inventory" is still 8.3 billion shares.

Back to real estate, in major markets, it is common to have multiple offers because the number of sellers has declined substantially, albeit artificially. Then why are prices appreciating so slowly? Previously similar feeding frenzies typically resulted in a much higher and faster rate of appreciation. We can go back to the three approaches to valuation for an explanation.

The cost approach is inconsequential. Builders are buying blindly today, hoping for favorable market conditions when they are finally ready to sell. Using the income approach, unless the income increases accordingly, investors will have to sacrifice cap rate if prices continue to escalate. Institutional investors appear to be only willing to go so far.

Mom and pop have no approach to valuation. They are heifers heading to the feed lot, readying themselves for tomorrow's Big Mac. In today's market, they will pay up to whatever they have been pre-qualified for. The market comparable approach is just a reflection of herd behavior. There is no fundamental reason why the same property could be "appraised" at $500,000 back in 2006 and $300,000 today. However, it does not matter how stupid a price they are willing to pay, financing is their limit. Unless the Government brings back no-qualifying mortgages with no down payment and optional payment amounts, buyers who need financing are stretched to the limit.

So who is squeezing out whom? We heard that investors with clean cash offers are outbidding owner users but are they the winners? I am beginning to think that mom and pop are doing the squeezing. They are driving the bids higher, forcing investors to pay a price that will most likely exceed their targeted cap rates. Investors can abandon the income approach and simply rely on future price appreciation for their desired return. I think that is called speculation, which ended pretty miserably in 2006.

If the bulk investors hope to augment their income-based rate of return by future appreciation, where are those buyers coming from? The same buyers who the investors supposedly squeeze out today are not going to be the buyers of tomorrow, at a price that yields investors a generous return. These buyers have been turned into renters, renting the same houses that they had once hoped to buy. In the end, investors may have to sell their investments back to the owner users, at a price that they can afford.

So what is the driving force of real estate market today? I believe it is still mom and pop either as buyers or as tenants, and that force is weak. The fact remains that even with Bernanke's massive QEs resulting in give-away mortgage rates, borrowers are still having a tough time qualifying. It has never been cheaper to finance a house. This glaringly bearish signal is often misinterpreted as something positive. These favorable conditions require the Federal Reserve to buy over $1 trillion of treasuries and MBS per year. How much longer can this subsidy continue? With each round of QE, it has already been proven that ever larger doses are necessary to generate less of a response. I believe mortgage rates cannot go much lower, regardless of how much more Bernanke buys.

There are many markets where it is already cheaper to buy than to rent, but many still cannot qualify for a mortgage. If a household cannot qualify for a mortgage which is lower than the rent for the same house, isn't it obvious that they cannot afford the rent, and should be looking for less expensive shelter? Investors will find out that REO-to-rental is just a fad. It only works if they can buy cheap REOs, which is no longer feasible. If they have to pay market, or above market prices, they may find better opportunities in multiple-family and other types of traditional income producing real estate.

Sooner or later, we have to face reality the way the Irish, the Icelanders, the Greeks and most recently the Cypriots all did. Our standard of living is too high and unsustainable. It is higher than our income. We are consuming non-essentials while underfunding essentials such as education, retirement, healthcare and reserves.

Our current standard of living is not only underfunded, it is based on debt. Every component of our future is borrowed, with very little to show for it. The house is borrowed. The cars are leased. Education is financed by $1 trillion in student loans. Medicare today is debt to future generations. Social Security is underfunded. Public pension plans are underfunded. Households are borrowing from their 401k plans to survive. Most tragic of all, our Government is operating only because of funding from the Federal Reserve. I often wonder when Bernanke's buying of treasuries is going to exceed total tax receipts. Maybe we won't have to pay tax anymore and just let Bernanke print and finance the Federal Government.

I am so thankful that I do not have children because the next generation is going to enter the working world with more debt and obligations than they can possibly repay. To think that they can be the driving force of future real estate appreciation is simply unrealistic. That is why I believe that real estate prices cannot go much higher.