Housing: Too Much Cash Waiting for Investment for the Market to Fall Sharply

Many headlines and cable news programs are touting a pending real estate bubble. Sure this helps increase their ratings, but there are too many factors in favor of real estate to worry about the naysayers.

All you have to do is look back to the early `90s. In the early part of the decade, prospects for real estate investments were looking about as good as they are today. After Japanese investors paid extravagant prices for Hawaiian hotels and Los Angeles office properties sent the real estate market climbing, the `80s real estate boom was topped off when a Japanese consortium purchased the iconic Pebble Beach golf course for $500 million.

Real estate prices in the U.S. were getting outrageous. Once the U.S. economy tumbled into recession, the real estate market was the first to take the hit. From the early '90s real estate debacle came a new class of real estate investors, Real Estate Opportunity Funds [REOFs].

While real estate prices were plummeting in the early `90s, savvy investors and investment houses started opening up new businesses to buy up real estate and acting as a buyer of last resort. Here's a chart listing a few REOFs:

That's more than $57 billion in assets held by just five REOFs. There are dozens more. Also, big investment, financial and banking institutions have their own REOFs. Goldman Sachs, Morgan Stanley, Blackstone Capital, GE Capital, and Credit Suisse all have REOF segments just waiting to pounce on any significant weakness in the real estate market.

Many of these companies saw the millions in profits made during the last real estate downturn and appear poised to not miss out on another opportunity. Sure there are going to be a few losers in the real estate game, but there's also going to be a great opportunity for savvy investors to get in while everyone else is selling.

But there's another area of concern as well. The examples above are just a few of the national real estate players. On the local level, I know there are thousands of individual investors and real estate speculators that have been piling up cash while waiting for housing prices to begin to fall. Once they start falling, these investors are going to have to outbid each other to get their hands on these depressed properties.

One final point is that houses have utility value. That's economic parlance for a tangible use. After all, you can live in a house. Other examples of items with utility value are a hammer (because it can hammer nails) and a washing machine (because it washes clothes). These items have value as tools to make your life easier.

Stocks have no utility value. They have economic value in that they can be exchanged for money as long as someone is willing to buy them and they represent ownership in a company, but they have no other use. This is how shares of stock can become totally worthless. I have some Enron shares that prove this concept true.

A house will never be given away for free. It has too much value as a home and as a shelter.

As a result of the utility value of real estate and houses, REOFs and thousands of individual investors waiting for a decline in housing prices, I can't foresee a 1929-style stock market crash hitting the housing market. Watching housing prices fall 50% or more in a few months or over a few years is simply not going to happen.

Granted, we may be in for a correction of 10-15% in housing and real estate prices over the next year or so, but there is too much capital waiting on the sidelines for housing prices to fall much further than that. Just look at the history of real estate: When housing prices fall, a lot of buyers come out of the woodwork to buy up the properties with depressed prices.

Comments

[Thomas Moro:]

I'm a little confused. From your analysis, it would seem that Goldman Sachs is waiting on the sidelines to buy a 4 bedroom house in phoenix at $500 psf. Also, it would seem from your analysis that if Goldman doesn't want to buy the house, a large number of investors who are on the sidelines "waiting for a decline in housing prices" (b/c I'm assuming they believe prices are now too high) will all of the sudden believe the house is a screaming buy at $450 psf (a 10% correction) so that they can a) lose money on a monthly cash flow basis given price levels and interest raates and b) hope to make money by selling the same house (which they thought was overpriced at $500 psf) in a few years for $500 psf.

Try taking a look at the ratio of house prices to rents. I think you'll see that house prices are a lot more than 10-15% overvalued.

2006 Sep 15 12:04 PM

[paul shaheen:]

I think the argument is flawed. Yes, its true that they have hordes of cash waiting to invest. However, large real estate investments firms are savvy enough not to start buying until they feel the market has bottomed and is now poised for a new growth stage, just like stock investing. It is not intelligent investing to jump in as a market is plummeting. They will wait cautiously on the sidelines until everyone hates the real estate market and is completely avoiding it like the plague. Then they will pounce.

2006 Sep 15 12:51 PM

[John Doyle:]

Quote: "As a result of the utility value of real estate and houses, REOFs and thousands of individual investors waiting for a decline in housing prices, I can't foresee a 1929-style stock market crash hitting the housing market. Watching housing prices fall 50% or more in a few months or over a few years is simply not going to happen.

Granted, we may be in for a correction of 10-15% in housing and real estate prices over the next year or so, but there is too much capital waiting on the sidelines for housing prices to fall much further than that. Just look at the history of real estate: When housing prices fall, a lot of buyers come out of the woodwork to buy up the properties with depressed prices."

My best guess is prices will fall 25-30% at least.

Do you realise how many home owners will then be under water?

Have you considered the "ARMS" resets that are to come in the next 2 years?

This current real estate boom is global, and is the biggest boom the world has ever seen (refer "the economist" publication)

I shudder to think what could happen to institutions that hold the mortgage paper.

Oh well, we'll see.........I'll just keep liquid until we get near the bottom in 3 to 4 years time.

I'll e-mail you again then and compare notes.

Kind regards

2006 Sep 15 10:22 PM

[tew:]

Where to start with the flaws? First I'll nitpick, then I'll get on to the "big picture".
Some nitpicks:
The author contends homes price don't go to zero. Yes they do. A home is a depreciating asset, but the land may appreciate. In neighborhoods that go south, often the homes are sold for a pittance.

Also, stocks represent ownership in a business. A company with a good operating history has utility as evidenced by its profits. It also has real options to expand and diversify.

Lastly in the nitpick category - we should clarify that even if the author's contention that real estate may only fall 10-15% is true, that doesn't make it a good investment currently. If the price of your investment falls 15% over the next two years and then climbs 4%/yr thereafter then it will take you 6 years to break even in nominal terms. (If inflation goes at 3%/yr then in real terms it takes just under 9 years.) And cap rates are really low...

In looking at the "big picture" it's often useful to compare an asset class aggregate value against GDP. For GDP represents the output of the nation. Mortgage debt as a percentage of GDP shot up from below 50% of GDP in 2000 to about 70% in 2005 (a 40% increase!). (Adjusting for the 1986 Tax Reform Act this ratio had held fairly constant for the previous 40 years.)

Nonprime lending rose from 11% to 33% of all originations just from 2003 to 2005. Within the nonprime category "non-traditional" (IO and "pay option") lending grew from ~10% to ~50% of new loans in that period. Put another way, prior to 2003 nonprime non-traditional loans were negligible. By 2005 they made up 1 out of every 6 new loans. (The preceding two points are based on published FDIC reports.)

Also, if you plot aggregate housing valuation vs. GDP since WWII a decided "spike" like the late 90s stock bubble is *very* obvious. Yet even with this, home equity hasn't budged and indeed household balance sheet debt-to-equity has spiked up 50% since 2000 after being range-bound since the 1950s!

I could go on and on. Long term interest rates have completed a secular 25 year decline and a post-WWII low fed funds fueled speculative lending in ARMs, IOs, etc. in 2003-2005. Lending standards have declined precipitously as securitization has exploded. Home "ownership" rates are at an all time high (meaning less buyers on the sidelines for residential properties).

Structural changes, legislative actions, demographics, and finally psychology have layered on one another during the past 30 years to create increases in real estate values that are not sustainable long term. Just like the 20 year bull market in stocks (80s, 90s) lulled many to sleep on the back of expanding PEs, so have the non-repeatable drivers of post-WWII - and especially post-1980 - real estate valuations.

2006 Sep 18 04:44 PM