Real Estate: Out of the Shadows

Includes: DIA, QQQ, SPY
by: Jeffrey Dow Jones

Slowly but surely, clarity seems to be developing in the real estate market.

At this point, we've all seen the Case/Shiller data and now we can all agree that prices stabilized off the lows back in 2009, and in recent months prices have started to slowly drift lower again. If you remain unconvinced of this, we have an in-depth investigation of this and each of the 20 metro areas that Case/Shiller tracks in our weekly newsletter.

Out of the Shadows

But Case/Shiller isn’t the only housing data set out there. There is also CoreLogic, which is what the Fed uses. Their price data shows similar patterns, but what's really interesting is their recent work on shadow inventory.

They recently estimated the “shadow inventory” at about 2.1 million properties. “Shadow inventory” is a deliberately vague term and it means different things to different people. But it’s important to understand the concept, and CoreLogic’s definition of shadow inventory is really simple and very precise: it’s the number of properties that are seriously delinquent (90+ days) on their mortgage, already in foreclosure, or are bank owned and not on the MLS. It’s basically all the properties that, if the market were normal, would be put back out on the market for sale.

Here’s what current home inventory looks like, which you can see is already very high.

With the shadow inventory, that makes for around 6 million homes that are officially for sale or would be in a normal market. That’s an inventory about 50% larger than what buyers actually see.

Here’s an overlay with both:

What disturbs me is that the shadow inventory is increasing. That means more and more people are having more difficulty paying their mortgages and falling further behind. More homes are getting foreclosed on. Just how big is this shadow inventory going to get?

Another disturbing thing is that when something from the shadow inventory comes out of the shadows and finally gets sold, it means somebody somewhere takes a big loss. Odds are, it’s a bank, Fannie Mae, or the taxpayer. As those losses add up, it becomes a drag on the real economy. This will be a structural headwind for a long time.

As we saw on the price charts, the bulk of the damage in terms of headline price seems to be done. But anybody can see that under the surface there is plenty more pain to come.

The catch is that it’s not going to come all at once. The banks aren’t going to dump 2 million homes on the markets right now. That would be catastrophic and would run totally counter to their interests. These guys control the supply right now, or at least a pretty significant chunk of it. So think back to your Econ 101 class and the lecture on monopolies. The goal of the monopolist is to maximize net revenue and it does this by charging the highest price to the largest number of people. Most businesses are price takers and can’t do that. But monopolists control the supply and can therefore affect where those supply/demand curves intersect. If you controlled those curves, wouldn’t you make them intersect at the point that was most advantageous for your bottom line?

So while this concerns me, I’m not at all worried that the shadow inventory is going to crash the market. Instead it’s just going to cap the upside in housing for a long time as this supply slowly burns off.

I’m not sure how long that will take. But I know someone that has an idea.

How to Make a Fortune

I first heard about Bill Ackman’s presentation at the Value Investing Congress last month. The title was obviously catchy, “How to Make a Fortune”. But I was dying to know exactly why this guy — one of the most highly respected individuals in the hedge fund industry — was so bullish on a market that is so universally reviled. Like many of my other heroes in this business, Ackman is a sharp, contrarian thinker and I wanted to understand the fundamentals of his case.

His actual PowerPoint deck didn’t leak until earlier this week, so if you want to check it out I stole a PDF copy which is now hosted over at our website.

I'll summarize the key points here.

As we just discussed above, the shadow inventory and near-record supply overhang mean that the housing market is in an obvious state of short-term distress. Ackman cites that roughly 30% of sellers are in or approaching foreclosure and the below-market price of these distressed homes are dragging down the price of all the homes around them. I know we had a massive bubble and I know we’re dealing with the consequences, but keep in mind that this is nowhere near an environment that is historically normal.

On the demand side right now, it’s almost as ugly. Unemployment is high and incomes have stagnated. But rates are at record lows and home affordability is near an all-time high whether you use the NAR’s metrics, Ackman’s metrics, or my own favorite, simple Price-to-Income ratios.

The kicker, I suppose, is that not everybody is in a position to take advantage of these favorable prices and cheap financing.

It sucks for housing right now. But this won’t last forever. Eventually the supply will normalize and long-term demand will come back online. Household formation is at a cyclical low right now and the Census Bureau is forecasting much more normal growth in the number of households in future years. We’re not Japan yet, folks. Our population is still getting larger and people are still immigrating here.

If you do the math, you can calculate annual home demand by multiplying the number of new households that are formed by the homeownership rate (which is falling but is finally back at more normal levels). Based on the Census projections, the result is a long-term demand of between 1.1 and 1.25 million new homes per year. I know there’s plenty of inventory at present, but I’m telling you: eventually that supply will deplete. And right now there are nowhere near enough new houses are being built.

I drew a red line at the level of current projected long-term home demand. You can see that homebuilders basically stopped building houses a few years ago, and they were right to do it. One day those guys woke up and prices were falling and they had way too much inventory on their hands. They lagged the market the entire way down. And you can bet your bottom dollar that they’ll lag the market on the way back up, too. It takes time to get a development approved and new houses built. These guys aren’t going to preempt that and they won’t risk a move until they’ve got legitimate evidence that a recovery is well underway.

Right now, long-term increases in demand exceed long-term creation of supply by a pretty significant amount. Think back to your Econ 101 class about what that could mean for prices and what it means when this condition finally clears. There will come a point — eventually — when these builders are racing to catch up. The irony will be that relatively few will live to see it. So keep your eyes on the new home starts numbers.

My favorite part of Ackman’s thesis is that housing is totally out of favor. I love stuff that everybody else hates. And everybody hates this market right now. No doubt you have read plenty of articles like these, “15 Signs that the US Housing Market is Heading for Complete and Total Collapse“. Odds are you don’t need articles like that to hate housing because your own house has probably burned you and all of your friends badly enough. As a final anecdote, in the comment thread over at BusinessInsider where I first saw this presentation, nearly every single comment was negative, calling Ackman an idiot (or worse) for being bullish on housing. I love that. Looove that.

Anyway, I think you have a window. Interest rates won’t be low forever and at some point these inflationary risks could trickle into prices. Ackman thinks you can make a fortune. I’m not sure I completely agree — you have to really know what you’re doing — but it’s worth asking the question about what happens if he’s wrong.

What exactly is the downside in housing?

The biggest risks facing the housing market

There’s still a lot of risk out there, risk that in my opinion is linked to two questions:

  1. What happens when the economy hits its next slow patch?
  2. What happens when the artificially low interest rate environment adjusts to a more normal level?

There’s no doubt that a slow patch in the economy would be bad for the housing market. But economic factors like that are cyclical and I don’t think they alter the long-term outlook very much.

As for the interest rates, we all know that one of the things that drives the real estate market is how big a monthly payment a homeowner can afford. Low rates mean smaller monthly mortgage payments which means people can afford to pay more for a house. And what we have nowadays is an artificially low interest rate environment. Don’t believe me?

There, now do you believe me?

These interest rates are unprecedented in modern history. Since the Fed launched its quantitative easing programs — where they buy bonds and push interest rates down– mortgage rates have fallen almost a full percent in the last year. This translates to lower monthly payments for new mortgages.

And this is what matters. The monthly payment and its relationship to income is what ultimately drives the demand side of the market.

Let’s say your income supports a $1,000 monthly mortgage payment. You’ve got good credit and some cash saved up for a healthy down payment and so you can get one of these sweet 4.5% mortgages. Your income supports a home that costs $250,000. Nice!

Now let’s say that the economy stabilizes a little more and the Fed backs off on its purchase programs because we all know they can’t keep printing money and buying bonds and forcing down interest rates forever. Mortgage rates drift back up to the 5.5% range. That’s an average for the last few years. Your income hasn’t changed because, hey, who’s getting big raises in this economy? So you can still afford no more than a $1,000 mortgage payment. The problem is that now you can only afford a house that costs $220,000. That’s 12% lower. If you’re trying to sell your house, the purchasing power of your potential buyers has gone down and you may have to react accordingly by lowering your price.

I understand that this doesn’t translate one-to-one. I’m not saying that a 1% rise in mortgage rates will directly produce a 12% drop in price. It’s really difficult to measure the exact effect of this phenomenon. The point, however, is that it means something. Higher rates are a drag on price. Lower rates make prices go up. This isn’t rocket science.

Going all the way back to our Case/Shiller home price chart at the beginning of this newsletter, we’ve seen a pretty clear rise in price in the last year or two. Ask yourself how much of that is due to a mortgage rate market that fell (artificially) from 5.5% to 4.5%?

In my opinion, this is the number one risk facing the housing market right now. You can see that it could mean another 10-15% downside in price. A drop of that magnitude would also bring the my raw price/income ratio to levels about where one would expect a typical “over-reversion through mean”. This goes against the current policy objectives, namely a government that will do anything it can to support and stimulate this market.

I’m not inclined to fight him.

Part of me wants to scream “go out and buy a house!!!” Take advantage of this historically aberrant condition. You may never get another chance like this in your lifetime. But you need to be careful. You need to pay below market value to protect against a subsequent drop in the market or to keep you safe from the price fallout if and when interest rates drift back up. That may mean you won’t have the luxury of being picky with the exact property you buy. Forget about your perfect dream home. Be opportunistic and snatch up the one that’s the best value.

Or don’t. I know people don’t buy homes this way. Go ahead and pay full market price and get exactly what you want and deal with the risks. The risk isn’t that bad, either. Worst-case, I think it’s a loss of 10-15% for non-distressed properties and it’s unlikely any loss like that would happen quickly. More likely, it will be one more factor that mutes the market for a while. Your odds of buying something and re-selling it in the next few years at a significant profit are small. As a final caveat, remember that real estate is regional. I’m not convinced that every market has fully corrected from the initial bubble. Southern California, I’m looking at you.

So if you’re just the average guy and you’re eyeing real estate right now, make sure that whatever you buy is something you plan to live in.

If you know what you’re doing, have capital at the ready, and can keep a long term perspective, go ahead and follow Ackman into the real estate market. Pick up some distressed properties and rent ‘em out while they slowly appreciate and the market normalizes. It’s hard work. The days of easy money are long gone. But I think there’s opportunity out there if you’re hungry enough for it.

Author's Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.