By Ramsey Su
Brave New World
Real Estate 101 taught me to use household formation and job creation as the basis of analyzing housing supply and demand. Chapter two taught me to refine my analysis with seasonal adjustments and factor in inflation.
The reality is that adjustments are much harder today.
For the purpose of this analysis, I have broken down the modern era into three periods. The Baby Boom period is from after WWII to 2001. This is the period where growth was somewhat steady, both in terms of the economy and population. The second period I labeled The Lost Decade, from September 2001 through the Lehman collapse of 2008. Finally, we are now living in the third period: The Brave New World.
It should be obvious that comparing these three periods without making some adjustments is meaningless. Most reports today extrapolate data randomly from each of these periods to support their bullish or bearish views. Anytime I see the word "historically," I immediately question what period the author could be comparing the present day to.
How do you adjust for the change in demographics? Not only do we have change in population numbers, all the underlying factors are different. Today, we have record high youth unemployment compounded by record high student loans. Should we expect the same housing demand from this group at a rate similar to that of their grandparents' era? We have always had government intervention in real estate, but never at today's level. As an example, how do you quantify the impact of QE3/4 on, say, existing home sales ?
Anyway, I digress. I am not thinking about how to quantify these adjustments of the fundamental backdrop, which I have no control over. I am focusing on adjustments to our individual investment decisions, something that we can control.
Housing is a necessity that we all participate in, even when it is just by renting an apartment. For example, I personally benefited from real estate investments during the Baby Boom period. The Southern California market was so generous and so forgiving that a caveman could have made money investing in real estate. I missed out on the long side during the Lost Decade but later benefited from shorting the sub-prime lenders. What should my strategy be today?
Needless to say, an appreciating market such as the sub-prime bubble tends to hide all flaws, and as long as everyone is making money, albeit bubble money, no one really cares about why. This rant is more concerned with what happens if the market goes down.
Of the thousands of Fed-speak speeches that Greenspan gave during his way-too-long tenure, I can only remember one statement that is unequivocally true: Real estate is not liquid.
During the Baby Boom era, liquidity was not much of an issue. An investor could make the worst mistakes and could always count on getting bailed out by the ever appreciating market in a couple of years. The Lost Decade showed us that price depreciation is possible, trapping millions of households in negative equity mortgages. However, exiting is as easy as just walking away. The consequences are limited to a bad credit score for a couple of years and perhaps a dented ego. Since there were little or no down-payments involved, trapped borrowers should net out positively by not having to pay for housing during the foreclosure period.
Since there were no institutional investors in the single family arena before today, they were obviously not a factor until now. Blackstone and other bulk investors have been in the news, gobbling up tens of thousands of single family homes in select markets. If real estate turns sour, it will be impossible to exit their positions without taking a huge hit.
First of all, aside from Bernanke, these institutions are the main driving force today. Even if they just stop buying, the markets that they are active in would have plenty of inventory for sale. Selling into these conditions would be quite challenging.
Secondly, these purchases are usually not financed by individual mortgages. They are financed by corporate debt or equity investment from investors. Unlike in the case of a homeowner, the losses are not limited to just the down-payment (I know there is full recourse in some States, but it has been largely ignored). Just walking away from a little equity is therefore not an option.
Thirdly, if economic conditions deteriorate and rent becomes an issue, who are policymakers going to demonize this time? There are no more sub-prime lenders and robo-signing servicers, so the big investment funds may become easy targets. Why should the Blackstones of this world be allowed to collect rent when they took advantage of poor borrowers and "stole" their houses in the first place? I am of course being facetious, but it is easier for local municipalities to change eviction laws than change foreclosure laws.
As a small investor, it is impossible to exit a real estate holding when the tide is going out, without being taken out as least part way. The marketing and escrow periods alone may exceed 90 days. In today's flash crash market, 90 days is like a life time.
Home builders have been performing fantastically well this past year. They are however even more committed than the institutional single family investors. It often takes years for them to monetize the land they purchase today.
In summary, the strategies are pretty straightforward.
If you are bullish, going long the stocks of home builders is definitely the way to go. It has all the same potential returns but none of the risks of owning single family real estate outright. If the market turns against you, exiting is just a matter of a few keystrokes instead of a long escrow period. There is no reward to buying single family houses, suffering hassles with tenants, being responsible for repairs and maintenance and bearing the risk of not being able to exit.
If you are bearish, I cannot think of anything apart from waiting. I do believe that many of the builders may be great shorts when the market turns. Note though that it took the sub-prime bubble four years to burst.
Finally, the fact that real estate is not liquid may not be all bad. Back in 2006/2007, I was giving hypothetical advice to a few imaginary clients. My advice was: if you know you may be facing financial hardship in the near future, go buy the biggest house that you cannot afford. At the time, it was an option available to everyone, because the prevailing practices were “nothing down and no qualifications needed.” That worked out really well for those imaginary clients, who subsequently received free housing for years. Those who really learned how to game the system may still be living rent free today. To add some icing on the cake, they have been repeatedly told that what they did is no fault of their own and that they are victims of fraudulent practices by everybody else.
Today, that hypothetical advice is still applicable, though it is more difficult to execute. The option is limited VA with no down or FHA with 3.5% down, and in addition the borrower actually has to qualify. The key however is to simply lock oneself into ownership with little or no money at risk, while waiting for the government to intervene on one's behalf. At the moment, the government is even considering forgiving one's debt if one is deemed to have paid too much for one's house.
As for those who saved up money and just want to buy a home to live in, I wish you the best of luck.
The echo bubble in the housing index HGX – via StockCharts – the best means of playing both a rising and a falling real estate market
(click to enlarge)