By Mark Bern, CPA CFA
The answer may be a little of yes and a little of no. I realize that U.S. real estate market activity has been sending positive signals for several years now. There are a few things that give me concern. And one statistic that troubles me more than anything else. That statistic is the percentage of single family homes being purchased in all cash transactions. On the face of it, this statistic seems to be very positive since excess inventory is being removed from the market. That is a good thing. But all cash transactions generally tend to be investor purchases of homes. That, in itself, is not bad. But as the average home price rises to levels above that which produce adequate positive returns on invested capital, those large institutional investors will probably stop buying single family homes. Since this group represents something like 40 percent of the market, where will demand come from when demand from institutional investors dries up?
A healthy real estate market has closer to 80 percent of buyers that are individuals, not institutions or investors. Traditionally, all cash purchases represent about 20 percent of home sales in the U. S. With the number of all cash purchases double or more than normal levels, I suspect that the real estate market could turn out to be more volatile over the next few years as institutions play a larger role in determining the floor (and ceiling) for home prices. If the group decides to stop buying above a certain level, there is a greater risk that prices will stall at a plateau level for an extended period or possibly even retreat. With a reduction in demand of 20 percent or more, inventory could begin to outpace sales and create downward pressure on home prices again.
It seems to me that home prices and rent cannot continue to rise in a sustainable manner unless wages keep pace. Since wages have been treading water for some time it would appear that the relationship is disconnected. At some point, either home prices will need to level off or wages will need to start rising to keep pace. I realize that the Fed hopes for the latter to happen. But with the amount of slack in the labor market I do not expect wage inflation to come so easily. Employers are loath to allocate more to labor without general inflation. Inflation continues to remain calm as measured by CPI.
Some will argue that inflation is about to erupt higher, but I just do not see the basis for that argument. Unless velocity of money begins to turn higher, inflation is unlikely to rise much above two percent. Therein lays the conundrum. Without price inflation we are not likely to experience wage inflation. Without wage inflation home prices and rent are unlikely to rise much further. Without an increase in the velocity of money in the economy price inflation is unlikely to rise enough to create the environment that would support continued real estate price inflation. Velocity would increase significantly as long as the economy is deleveraging and we still have a long way to go in that area. I could be wrong, but I just do not expect inflation above three percent in the near future.
My opinion is only conjecture at this point. But we are once again in new territory for our economy. We cannot use historical data to project the future since there is no historical data that resembles where we are today. It is somewhat like quantitative easing and zero percent interest rate policy. We have never in modern history experienced and measured these actions so we really have no true basis upon which we can draw to forecast the future.
There are other concerns that I have about the future strength of real estate. One is based upon the historical relationship between inflation and home prices. From the early 1960s until the mid-1990s the relationship was strong. The two did not move in perfect tandem, but the trend line for each has a similar pitch. In Chart One I have plotted the end-of-year CPI numbers from the Department of Labor Bureau of Labor Statistics. In Chart Two I plotted U.S. annual median home prices from the U.S. Census Bureau.
Chart One: U.S. CPI-U
chart created by Mark Bern; data source: BLS
I drew a line from 1964 to 2013 to represent the trend. It is not a perfect representation of the trend but it is very close. Notice that this period includes the year of high inflation that occurred during the late 1970s and early 1980s. Since 1982 CPI has varied very little from the trend. I then used the same line with the same pitch and applied it to Chart Two to compare the trend of inflation to the trend of median home prices. I find it very interesting that the trend in home prices is very similar to CPI until about 1997. Then home prices diverge much higher. The problem that I see is that the median home price has never fallen enough, not even during 2009 and 2010, to resume the previous trend relationship.
Obviously, Fed policies have artificially supported home prices above levels of equilibrium. At least, that would be my interpretation.
Chart Two: Annual Median U.S. Home Price
Chart created by Mark Bern; data source: U.S. Census Bureau
I expect that when interest rates normalize that the median home price could "normalize" also. That could very well result in a reversion to the mean, or trend line. This is not imminent since it will be at least mid-2015 before the Fed completes both the tapering and begins to raise interest rates. Once those two policy changes become reality, we will see what happens.
There is one other situation existing in the U.S. residential real estate market that has me wondering how it will turn out. This one is a matter of matching inventory to demand. The baby boomer generation is aging and most of us are beyond the age when we will trade up to a mcmansion. The more likely trend for baby boomers over the next decade or two will be downsizing. The next significantly large generation coming up to replace us is the echo boomer generation. The next most likely real estate trend for echo boomers is to buy starter homes. My concern is the possible slack demand for all the mcmansions built to accommodate the baby boomers as we downsize.
Real estate is both regional and age-influenced by nature. So, looking at the nation's inventory of houses as if each unit is able to substitute for any other is a big mistake. The root of my concern is not the overall inventory level, but rather the potential mismatch of available inventory to demand. Baby boomers generally are no longer trading up, but instead beginning to trade down to smaller spaces such as townhouses, condos, vacation properties or smaller homes on smaller lots. We want less maintenance and more time to enjoy our retirement. We also may not be as limber as we once were making many of those chores we used to take for granted less than pleasant.
The echo boomers are not ready to buy our mcmansions and we are really not ready to offer discounts to make homes more affordable for the next generation. The trade up homes will probably not be in vogue again for another ten years or more. Of course, these may be the houses being bought cheaply from the banks by investors so, for now at least, the problem isn't yet apparent. But when those of us who are not under water on our mortgages decide to downsize will there be a market for all our properties? I do not have the answer to that question either. If demand is not there over the next decade, prices cannot continue to climb on this segment of the residential real estate market.
Again, real estate is a very regional business so the impact will vary from one area of the country to another. So, now I want to look at the more positive side of this trend. A percentage of baby boomers will decide to relocate to a warmer climate. That means that there will be very uneven impacts on real estate. There is likely to be downward pressure on prices in areas from which the baby boomers want to leave and upward pressure on prices in areas to which they decide to relocate to enjoy their retirement years. Economic growth will ultimately follow the migration.
There should be more employment growth in areas that attract retirees. There may also be a significant increase in demand for new housing units in these areas. Many service jobs will be created to serve this influx of new inhabitants and infrastructure investments will also be necessary. But there could be a mess left behind in the wake.
The specific point I want to make from all of this is that we are now entering a time when we must be very cautious in selecting investments in industries that are dependent upon the housing market. I am staying away from homebuilders that have too much exposure in colder climates of the U.S. I also suggest staying away from those homebuilders that focus on the upper end of the trade up market. I do not see sustainable demand for houses between 2,500 and 4,000 square feet. That is the market that baby boomers created during peak trade up years. We are nearing the end of that era, in my opinion.
Selectivity is always key, but never more so than now.
As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.