Real Estate: Out Of Whack

by: Acting Man

I have previously stated that real estate is very slow moving and predictable. Specifically, I am referring to single family residential housing. I would now like to retract that statement. The real estate market is totally out of whack and predictability is now a plaything of unpredictable intervention.

Wall Street has never participated in single family investments before. With its seemingly unlimited resources, it is changing the landscape significantly and I suspect it is for the worse. Historically, investors cannot compete with owner occupants because the latter are always willing to pay a higher price for a "home" compared to the price the former are willing to pay for an investment. This is especially true when financing is easily available at low cost. How is it that the owner occupants are being squeezed out under current circumstances? Not only are investors willing to match their price, they are paying cash.

The logic behind this is puzzling. So today investors squeeze out the owner occupants, forcing them to rent in order to generate a nice return. Then after a few years, the investors intend to make a profit by selling the same homes to the same owner occupants for an even higher price to complete the full wealth transfer cycle from the 99% to the 1%. Does that make any sense? Does it make sense that Freddie and Fannie, under government conservatorship, are actually trying to accommodate investors by pretending that 'REO to Rentals' is a good idea?

However, not all is rosy for a fat cat investor. Here is an example. Say, as one of these Wall Street investors, my goal were to have a modest 10% return per year and I would be willing wait five to ten years to achieve it. Under what circumstances can my investment targets be reached?

First, I need rental income during my holding period, then I need price appreciation to provide the remainder. After my initial search, I conclude that I can get a better than 5% cap rate in the really junky markets, maybe squeeze out around a 5% cap rate in mediocre markets and cannot even come close to that rate in top markets. I would need more than 5% appreciation per annum in order to meet my goals. Is that realistic for the foreseeable future?

Furthermore, if there is little or no appreciation over the next few years, then I would need a bubble during the later years. Is that realistic?

Maybe I should set my entry point at a big discount, say 20% below market. That may be feasible if I am only buying a handful of properties in a large market. If I am trying to build a portfolio of hundreds of properties in each sub market, then I am the market. Not only would I have to pay market price, I may actually end up driving the market price up. When there are multiple fat cat buyers in a market, there is little doubt that I will have to pay an inflated price instead of the discount that I am looking for.

Viewed from a different perspective, investors have been supporting many of the more popular markets in California, Arizona and Florida. Owner occupants have been squeezed out, and have often been forced into inferior deals such as new homes. This in turn is artificially supporting the builders, as if there were real demand or an actual housing recovery. Listening to the recent round of builders' earnings conference calls, the impression was that while most are wildly optimistic, not one of them has the confidence to aggressively raise prices. If buyers are still having a tough time qualifying for a sub 4% mortgage, it is a warning sign, not something to cheer about.

Historically, smart money in the income property arena exits when REITs, using other people's money, are actively buying. Is this also applicable to single family homes?

There has been plenty of analysis and and plenty of opinions regarding renting versus buying, most of them bullish. While it is true that the simple math may suggest that it is indeed cheaper to buy than to rent in many markets, in reality, that may not be a good reason to buy. For many households I think it is not even a choice. In spite of favorable financing, many may not even have the minimal cash required for a 3.5% down payment for an FHA loan, or have sufficiently clean credit to conform even with today's very relaxed underwriting guidelines.

An investment in IBM (NYSE:IBM) or Apple (NASDAQ:AAPL) requires nothing more than a few key strokes and about $10 in commissions at a discount broker. You can be in and out of that financial commitment in seconds. As a renter, a 30 days notice to vacate can terminate a rental commitment in the event that your personal conditions change. A real estate purchase can easily cost 10% for a round trip transaction and it may be months before one can exit the position. That may result in a negative equity position or a substantial loss if, say, a 20% down payment was used to finance the purchase, and assuming the value of the asset did not go down.

More unpredictable is the future behavior of millions of households now trapped in very low interest long term mortgages, all in the early years. If rates are higher in the future, where are the trade-up buyers going to come from? Equally unpredictable is the behavior of an entire generation of baby boomers that are suffering from a retirement deficit. What happens when they realize that their housing expenses are too high relative to their diminished income at retirement?

'QE3' is now reality. In the six weeks since the announcement, the Fed has purchased $98.1 billion in MBS. I assume this is the $40 billion per month according to the QE3 plan plus about $20 billion per month of repurchases as the MBS purchases from previous 'QE' iterations are prepaid. So far, the results are negligible. If the intent is to drive down mortgage rates significantly, the chances of success appear to be pretty slim.

The fiscal cliff is upon us. Regardless of the outcome, it is almost certain that our budget deficit will remain at over $1 trillion per annum for years to come. QE3 and just the purchase of MBS may not be enough to hold mortgage rates down if treasury bond rates climb. Will Bernanke end up having to purchase all the treasuries that the world cannot absorb?

Finally, take a few steps back and look at the big picture. There is no doubt that we had a huge subprime bubble. There is no doubt that the government has been intervening while the Fed has been pouring in trillions of dollars, all in the futile attempt to re-inflate the bubble. As a result of all these efforts, the market barely budged. That is reason for optimism?

In conclusion, previously applicable guiding principles in residential real estate are being tested with the outcome uncertain. Before buying a house today, I think it is prudent to consider whether the down payment is well spent and the mortgage debt obligation something that one really wants to take on.