A recent article in the Financial Times (link) got me thinking about real estate prices. The article was about AIG (AIG) considering getting back into the mortgage market by buying the mortgages it is insuring, the logic being it can set up a "known" risk profile of mortgages. I am not going to even try to pretend I understand the complexities of such an approach. I am surprised though. I do believe house prices will continue to fall for a couple of reasons (reducing the value of the collateral on those mortgages).
I believe residential lending standards will return to more traditional practices in regard to down payments, borrower's debt, and income levels. With unemployment still above 8%, there is not going to be increasing demand for single-family residential housing. Those with jobs are not seeing huge pay increases year to year; therefore, the "affordability" of housing is not changing.
There is a generation of future home buyers graduating from college right now that are having a tough time finding jobs, and their only real knowledge of home ownership has been what's happened over the last few years. I am sure there are plenty of young buyers completely turned off from home ownership (lack of future buyer demand), which may not be a bad thing. Twenty-somethings will be staying in rentals longer, giving themselves much more mobility in regard to employment and avoiding the cumulative incidental expenses associated with home ownership.
I do believe the lack of employment mobility of the current workforce is one aspect holding back the current economy. Workers who are upside down with their mortgages can't sell (without bringing large sums of cash to the closing) and move to where the jobs are.
There is another side of the equation: the mortgage interest rate. Rates are currently at historical lows. Which way are they going to go in the next one to five years? If I was a betting man, I would guess up.
Here is a simple example of what the current affordability looks like for a dual-income married couple:
- 2x Median Household Income: $104,000 (source: Link)
- Taxes: 40.65% (28% Federal [CY2000 rate for married filing jointly], 6.2% S.S., 1.45% Medicare, 5% State) (source: Link)
- "Take-Home" Salary: $61,724
- 15% of "Take-Home" for P&I: $9,259 (yearly)
- Down Payment: 10%
- 30-Year Fixed Rate: 4.00%
- Maximum Purchase Price: $177,888
Here are some scenarios that support my hypothesis that single-family residential house prices will continue to fall:
1. Baseline Example: Dual-income married couple with a rising salary of 3% per year and a non-changing interest rate. Purchase price increases 12.55% between 2012 and 2016.
2. Same scenario as #1, except the interest rate increases to 5.0% for 2013, 6% for 2014, 7% for 2015, and 8% for 2016. I know the Federal Reserve has promised to keep interest rates low until mid-2013 to late 2013. However, 8% by 2016 seems reasonable assuming inflation should raise its ugly head at some point. Using these assumptions, if this married couple stayed in a rental until 2016 and tried to buy a single-family property at that time, the purchase price would have to drop by -26.73% because they will be able to afford only a ~$130k house.
3. Same as scenario #2, but even more dire. This scenario assumes the average annual salary increase is only 1% per year. With this new twist, if this married couple stayed in a rental until 2016 and tried to buy a single-family property at that time, the purchase price would have to drop by -32.25%.
4. Finally, readers will notice I am using 2013 marginal federal tax rates for 2012 (assuming the 2013 marginal federal rates are the same as the 2000 marginal rates, which, as of April 8, 2012, they are because the Bush-era tax rates are expiring and there is no bill in Congress to set a different rate). If I use 2012 marginal federal tax rates for 2012, the situation is much worse. The purchase price drops -39.89%.
Anecdotal support of my hypothesis can be found in this graph complied by James Parsons (source: Link).
Even though this graph shows housing price reverting to the mean, because of unemployment, pending inflation, stricter lending standards, and "shadow" inventory of foreclosed and bank-owned homes, prices should overshoot (or undershoot, if you will) the mean before reverting back.
How should an investor wanting exposure to real estate react to this information? Invest in multifamily housing. I believe the prices for multifamily housing have bottomed or are close to bottoming because their demand is from investors. There is demand from investors because there is demand from renters. Multifamily housing prices are close to bottoming because investors are able to make this long-term investment with historically low interest rates while rental rates are increasing (source: 1st Link, 2nd Link). If one were to buy a multifamily, she or he should treat it like a business. An investor needs to ensure there is positive cash flow from day one (after all expenses) and that the positive cash flow (on an annual basis) is a proper percentage of the out-of-pocket cash to acquire the property. When treating a multifamily like a business, over the short term, the investor should not necessarily care what the cost of the property is, as long as there is positive cash flow at a required rate of return. The value could fall 10%, 20%, or 30%, and it would be transparent to the investor as long as the rental rate remained the same or climbed higher. Here is a nice Seeking Alpha article comparing real rental properties and REITs (article).
An equity option would be to invest in apartment REITs. Here are the five largest apartment REITs in the NAREIT index (source: Link). These are not buy recommendations, but some equities to do your own fundamental analysis with. Percentage yield and company description are from Yahoo! Finance. The price/AFFO is calculated using the April 10, 2012, close price and the FY2011 AFFO. Financial data is from the respective 10-K.
1. Equity Residential (EQR): Yield of 2.20% and Price/AFFO of 12.92x
Equity Residential, a real estate investment trust (REIT), engages in the acquisition, development, and management of multifamily properties in the United States. As of December 31, 2007, it owned and invested in 579 properties in 24 states and the District of Columbia consisting of 152,821 units. The company qualifies as a REIT for federal income tax purposes. As a REIT, it would not be subject to federal income tax to the extent that it distributes at least 90% of its taxable income to its shareholders. Equity Residential was founded in 1966 and is headquartered in Chicago, Illinois.
2. AvalonBay Communities, Inc. (AVB): Yield of 2.80% and Price/AFFO of 35.54x
AvalonBay Communities, Inc., engages in the development, redevelopment, acquisition, ownership, and operation of multifamily communities in the United States. As of January 31, 2009, the company owned or held a direct or indirect ownership interest in 164 operating apartment communities comprising 45,728 apartment homes in 10 states and the District of Columbia. It also held a direct or indirect ownership interest in 14 communities under construction, as well as held rights to develop an additional 27 communities. The company's markets are located in New England, the New York/New Jersey metro area, the Mid-Atlantic, the Midwest, the Pacific Northwest, and the Northern and Southern California regions of the United States. AvalonBay Communities has elected to be taxed as a real estate investment trust and would not be subject to federal corporate income taxes if it distributes at least 90% of its taxable income to its stockholders. The company was founded in 1978 and is based in Arlington, Virginia.
3.UDR, Inc. (UDR): Yield of 3.30% and Price/AFFO of 20.71x
UDR, Inc., formerly United Dominion Realty Trust, Inc., operates as a self-administered equity real estate investment trust (REIT). It owns, acquires, renovates, develops, and manages middle-market apartment communities. The company targets young professionals, blue-collar families, single-parent households, older singles, immigrants, and non-related parties. As of June 30, 2005, the company's portfolio included 263 communities with 77,289 apartment homes nationwide. As a REIT, the company would not be subject to federal income taxes to the extent it distributes 90% of its REIT taxable income to its stockholders. UDR, Inc., was founded in 1949 and is headquartered in Highlands Ranch, Colorado.
4.Essex Property Trust, Inc. (ESS): Yield 2.90% and Price/AFFO of 34.12x
Essex Property Trust, Inc., a real estate investment trust (REIT), engages in the ownership, operation, management, acquisition, development, and redevelopment of apartment communities primarily in the West Coast of the United States. It has a 90.9% general partner interest in Essex Portfolio, L.P. As of September 4, 2008, the company owned interests in 133 communities comprising 26,790 units, as well as had 1,658 units in active development. The company has elected to be taxed as a REIT and would not be subject to federal income tax on the portion of its income that is distributed to stockholders. Essex Property Trust was founded in 1971 and is headquartered in Palo Alto, California.
5. Camden Property Trust (CPT): Yield of 3.40% and Price/AFFO of N/A
Camden Property Trust operates as a real estate investment trust (REIT) in the United States. It engages in the ownership, development, construction, and management of middle- to upper-market multifamily communities. As of December 31, 2006, the company owned interests in, operated, or was developing 197 multifamily properties containing 67,631 apartment homes located in 13 states. Its properties principally consist of mid-rise buildings and two- and three-story buildings with various amenities, such as swimming pools and a clubhouse, whirlpool spas, tennis courts, and controlled-access gates. The company has elected to be treated as a REIT for federal income tax purposes and would not be subject to federal income tax to the extent that it distributes at least 90% of its REIT taxable income to its shareholders. Camden Property Trust was founded in 1993 and is based in Houston, Texas.
Disclosure: I am long VNQ in a taxable account and long VGSLX in a retirement account. Continually reviewing multifamily houses in my area.