Is the time finally right to get back into the residential real estate game? And what are the broader implications of trends in housing on the overall economy and financial markets? Let's take a look at the arguments and data.
The Case for Investing in Housing
Mortgage interest rates have come up a bit recently but are still near historic lows and appear attractive.
U.S. 30-Year Mortgage Interest Rates
(click to enlarge images)
Note: Chart data only runs through early 2010; if updated through 2011 the chart would show a recent increase in interest rates to around 5%.
We're also entering the comparatively slow home buying season and prices, after a post-bubble popping uptick, have been retreating recently. There may be some sweet deals to be had over the next several months.
And perhaps most importantly are the following two considerations: a) the overall economy is showing increasing signs of life and b) the risk of deflation appears to be subsiding as commodity (e.g., oil) and food price inflation is taking off globally. Real estate has historically been considered one of the best ways to protect oneself against broad inflation.
Add it all up and it would appear that housing could in fact be a prudent investment right now. Are there good reasons for holding off?
The GSE Problem
To understand the reasons for why investing in housing may still not make sense we have to take a step back from the above short-term considerations and look at several historical and political factors.
The recent financial reform bill, Dodd-Frank, covered a lot of ground. But it steered wide and clear of the 800-pound gorilla in the room, the GSEs, or Government Sponsored Enterprises Fannie-Mae and Freddie Mac.
You may recall that on the proverbial fortnight before the high-water mark of the financial crisis (Lehman's bankruptcy), Fannie and Freddie had to be placed into 'emergency conservatorship' by the U.S. government.
What that meant, in effect, was that the GSEs had been temporarily nationalized by the U.S. Treasury (although curiously without adding the GSEs' debt obligations to the U.S. government's own balance sheet, a point we'll return to shortly).
Why didn't Dodd-Frank address the GSEs? In short, intractable political disagreement. The U.S. Treasury called a conference last year to discuss the future of the U.S. housing market, and government mortgage finance took center stage. To make a long-story short, nothing of substance could be agreed upon by the key players in the U.S. mortgage market. Of note, however, was the fact that he world's largest bond investment fund manger, PIMCO's Bill Gross suggested that the U.S. government should nationalize mortgage finance.
From Gross's testimony:
To suggest that there’s a large place for private financing in the future of housing finance is unrealistic. Government is part of our future. We need a government balance sheet. To suggest that the private market come back in is simply impractical. It won’t work.
Gross went on to describe specific consequences of the government leaving the housing market. Without a government guarantee Gross said that housing lenders would be forced to apply arduous loan terms, such as 40% down payments.
Geithner and the U.S. government rejected Gross's suggestion. The reason? If you add Fannie's and Freddie's $5.5 trillion debt to the U.S. government's $14+ trillion and growing debt, then the U.S.'s Debt-to-GDP ratio rises well over 100%, or in line with Greece's and Ireland's nose bleed levels. Greece and Ireland may seem far away from the U.S. right now, but Harvard Professor Niall Ferguson is predicting a U.S. fiscal crisis within the next 2-4 years.
Housing is clearly an important government priority, and there are good arguments that positive social goods can come from home ownership.
Having said that, housing clearly takes a political back seat to other political priorities, such as entitlements (e.g., Medicare, Social Security) and defense spending (e.g., Afghanistan). Funding for these politically more important priorities will come under increasing budget pressure as U.S. deficits' continue in the $1+ trillion range. And contrary to the anti-private sector rhetoric you sometimes hear, the current administration is anxious to reduce government's role in the housing market.
Lo siento, Señor Gross.
Housing's Future Sans Uncle Sam
The reality of today's housing market is that home buyers must take into consideration the U.S. federal government's finances when considering future home prices.
If you believe that the government can continue handing out goodies to the housing market indefinitely, then yes now may in fact be a wise time to buy.
But if you accept the notion that government finances are not unlimited, and that housing may take a political back seat to other priorities, then the housing market may still be in store for further significant price declines.
What would the value of housing be if the U.S. government was unwilling (or unable) to continue subsidizing it?
Instead of our current housing market with 0-20% down payments, 30 year mortgages, and mortgage interest tax deductions, etc, we may (as Gross suggests) find ourselves in a world with 10-15 yr. mortgages, 40% down payments, and a reduced or no tax deduction for mortgage interest. The effect on home prices of any one, or a combination of these changes would be dramatic.
Something prospective home buyers may also wish to keep in mind is demographics. It's unclear at this stage what baby boomers plans are for their still valuable homes. Boomers just began retiring en masse this year. Some may try and get more liquid over the next several years and downsize to smaller homes, or perhaps rent. This could increase housing supply and bring even more inventory into a still over-saturated market.
My own prediction is that we need to see another 20-30% drop in national housing prices before purchasing a home could be considered a financially safe investment. The below 120 year housing price chart based on data compiled by Yale economist Robert Shiller lends some support to this view.
There are many reasons to consider buying a home, not all of which are strictly investment related. It's important to also note that local, or other case specific factors such as distressed sales, could make a particular home purchase compelling.
However, if you do view your home as an investment and you aren't interested in trying to time short-to-medium term swings in real estate prices, then it's important to keep in mind the big picture and, in particular, the future role of government when assessing the prospects of the U.S. housing market.
In terms of the financial market, arguably the two best ETF pure plays on U.S. residential real estate are the SPDR S&P Homebuilders ETF (XHB) and the iShares Dow Jones U.S. Home Construction (ITB). As you can see from the below chart, over the past two years both ETFs have maintained a high correlation with the the S&P500. More detailed information about these two ETFs can be found here.
If the housing sector is in fact entering a double dip, and recent data suggest this may be happening, then there is a real question as to whether housing ETFs like XHB and ITB can continue to follow the overall market upwards. Investors interested in making a divergence play while hedging overall market exposure may wish to employ a long/short strategy trade.
As Goes Housing, So Goes the Economy?
The other question which should be on every investor's mind are the possible implications of a double dip in housing for the overall market and economy. Professor Robert Shiller for one believes "the economy has serious reasons to worry" and that the government should step in and support housing again. Support for the housing market previously came in the form of a U.S. Congress homebuyer tax credit, passed in February 2009, and the Federal Reserve purchased $1.25 trillion in mortgage backed securities.
But will this new Congress, given the anti-deficit climate taking shape in D.C., be as quick to hand out taxpayer goodies to home owners? As Shiller points out, any government support for housing represents yet another subsidy by non-homeowners for homeowners. Is this fair?
Putting aside that question, I think the government will not step in again for three reasons. First, as noted previously the government fiscal situation has deteriorated dramatically since the first housing bailout. Second, housing price declines during the double dip phase are likely to be more measured and not prompt as great a rush to action as during the 2008-2009 crisis phase. Last, there has been an acknowledgment since the expiration of the homebuyer credit on the part of policymakers and even members of the housing industry that the government can't continue propping up housing prices forever.
The bottom line: Housing weakness creates a serious headwind for the overall economy, and it is unlikely that Uncle Sam will step into the breach to support the housing market in the same way as before.