Reflexive Changes in Real Estate

While much has been written about the housing market recently, it is Paul McCulley's PIMCO October Piece that had some key insights into price momentum. It is a very important point that the housing market is "reflexive" -- to use the term that George Soros coined.

That is, increases or decreases in prices are based upon expectations for the future, not necessarily on fundamental reasons like percentage of income devoted to mortgage, interest rates, scarcity of land. If people "think" that prices would go higher, that will justify paying more than the intrinsic value. The exact same can be the case when and if people "think" that real estate is not a good storage of value.

Think of the NASDAQ bubble and the justification for Amazon (AMZN) or Cisco (CSCO) at 3-4x current share prices. In hindsight we can see that prices were ahead of the fundamental reasons for owning those stocks. However, because enough people thought the price appreciation would continue, the price traded as high as it did. Reflexivity made the price the level that it traded.

This same process could be driving a portion of the Google (GOOG) or Apple (AAPL) price action after earnings. Or maybe the current reflexive state is a correct estimate of future returns.

The PIMCO piece points out that the same reflexive price action is even more the case with residential real estate. The small decline this summer could just be a short term break before prices keep moving higher for another 5 years. It could also be the start of people thinking that the real estate is no longer the safe and secure storage of value that once was thought.

Maybe the bull market of the last 4 months in stocks and bonds is the first wave of capital exiting the residential real estate and into other asset classes. We might need 20% returns in stocks for the second wave and third wave of dollars to come out of the housing market. Rental prices have spiked 20% in San Francisco in the last 12 months. This could show that the marginal buyer has lowered expectations of future valuation and might be the start of a shift in sentiment. I would argue that momentum has shifted for the long term and might not reverse for 4-5 years. Conversely, lots of residential properties are selling at current asking prices which argues that not everyone has given up on real estate as the best present day investment class.

Bottom line: Fundamental valuation is only a proxy. Keynes' famous quote, "Markets will remain irrational longer than you remain solvent" alludes to the large gyrations away from fundamentals. In the case of residential real estate, looking at what the masses are thinking could be more important than the fundamental direction of interest rates and income levels.

Eventually, we will likely gravitate back to a mortgages at less than 25% of income. However, it could be take years to shift what people think the return on investment of a house will be. As their return expectations shift, the valuation will move dramatically. Wage pressures could push affordability back in line, or home prices will come down. In the meantime, we just have to look to what the masses are thinking in terms of future return expectations.

Comments

[Paul Meisel:]

The basic theme seems to be sound, but there are important differences between real estate and the financial markets.

In the financial markets, there is always a buyer, and everyone knows it.. so the "need to sell" impact on pricing is usually less volatile than it can be in real estate.

Second, much real estate is held for reasons of location, sentiment, and life style -- the value is completely irrelevant until a life event dictates a sale. Similarly many purchases of real estate are made for the same reason... the price is irrelevant if you can afford it.

Not all real estate is fungible. Unique or relatively rare locations command unique value and increased speculative interest... on the other hand, in most areas starter homes and income properties move all the time. And geography is a major factor -- not just regionally, but micro-geography like which side of town the new wife prefers to live on.

The bid and ask spreads on stocks are "real" -- people actually expect to make a trade at that level soon. On the other hand, many times an asking price on a piece of real estate is "just seeing if some fool wants to pay that" and homes on the market for many months are often just testing to see what kind of offers they may get.

For these reasons real estate is harder to fundamentally value than stocks, and we will see many discussions on whether the market has bottomed, bubble has burst, etc. because we will all view the market a little differently. Like the blind men describing the elephant.

2006 Oct 23 05:26 PM

[jardine:]

Good comments Paul, especially on the liquidity of a residential property. The need to sell or need to buy impact exagerates price swings(away from fundamental value) when return profile expectations are at extremes. Hence paying through the asking prices that was prevelant in 2004 and ability to buy just under the asking price now. We have yet to see the forced seller that is in panic trying to get out. We might not see him for a long time.

2006 Oct 23 06:14 PM

[Mike Mosieur:]

Eric; there are many markets where the "Panic" sale is beginning to manifest itself.

A good site to see this is forsakencraft.com, amoung others.

The slide has begun and who knows when but real estate will bottom out.

I think Pauls comments apply in either direction.

2006 Oct 24 08:06 AM

[Paul Meisel:]

I got a kick out of that site. It is mostly California, where real estate inflation is best known outside of the island of Manhattan....

In less inflated areas there is less panic, but I still hear from realtor friends quite regularly about someone who is selling to avoid repo, and there have been a couple on our block in the last couple years in our modest neighborhood, although the developer made a deal with the bank to buy cheap and keep it out of the paper.

Mostly it still seems to be people who made poor purchase decisions, but isn't that what people mean when they talk about Mr. Market?

2006 Oct 25 03:21 PM