“Wealth Creation and Preservation”

Getting Real About Real Estate

I have and will continue, with even more conviction than before, to encourage our clients to sell their real estate, immediately! Do not wait because prices are heading down and interest rates are heading up. This is not a good formula for selling. The capital gains tax is heading up as well as the taxes on the recapture of depreciation.  The reality of real estate is not good.  There are proven alternatives to rental and vacation real estate that generate more income for you and that income is tax free! There will be real estate buy back opportunities in the future once the real estate markets collapses completely.  Be sure to ask one of our Wealth Architects to conduct a real estate income alternative analysis for you.

Aftershock Newsletter reports:

With the recent rebound in new home construction as well as in the Case-Shiller home price index, there’s been a lot of talk recently that real estate is beginning its recovery in earnest, or at the very least we’re seeing the bottom of the downturn.   Leading the cheerleaders on this front are some big names, including most notably, legendary investor Warren Buffett, who said that the housing market is turning a corner, and put his money where his mouth is.  Buffet is investing a large amount in what he believes are undervalued single-family home mortgages.

Now let’s begin by pointing out that Buffett is a very smart investor and has obviously been very successful for a long time. But even he will admit that he doesn’t get everything right. In fact, in February of this year he admitted that he was “dead wrong” about the housing market rebounding earlier. Though he still maintains that real estate has to rebound eventually, and he apparently thinks that now is the time. Let’s take a look at his rationale and then give you our perspective.

The first big reason for Buffett’s optimism is that new home construction in the US is the lowest it’s been in five decades—a pretty startling statistic. Why would this be good news for housing? Because theoretically, if construction is already that low, the only way left to go is up, especially since the population has grown in the last few years and continues to grow. Essentially, the idea is that this is a buyer’s market, and sooner or later buyers are going to catch on to this.

The second reason for Buffett’s optimism is the Case-Shiller index we mentioned at the beginning of this article. A few weeks ago this index showed home prices rising 0.9 percent in May, the largest jump since 2009, representing the fourth straight month of increasing prices. To many in the investment community, this signals that home prices have seen the worst and are now on a virtuous upward climb—as they should be, of course.

The third reason for Buffett’s optimism is that price-to-rent ratios have fallen to 1998 levels. This ratio is the price of buying a home compared to the rental price of the same or equivalent home. This is significant because if the price of buying a home falls low enough relative to rental prices, renting a home loses much of its incentive. After all, why rent and lose your money when you can own something without spending too much more?

On their surface, these reasons do make sense. And if we weren’t in a bubble economy, they might be legitimate reasons to predict a major rebound in real estate. But if we look at each one in detail, and the fundamentals behind them, we see that the picture is not as hopeful as many investors might think, even ones as smart as Warren Buffet.

First, the low level of new home construction is something of a non-starter, because all it really reflects is decreases in sales due to a struggling economy. The assumption that new construction must have bottomed out comes from the idea that there must be a lot of pent-up demand just itching to buy a new home. But we see no evidence of this. If pent-up demand were really the case, then the rise in home prices and new home construction should be rapid and dramatic, rather than a little uptick here and there. There is simply no law that says because new home construction has reached a historic low it must now begin to rise. If the demand isn’t there, it isn’t there.

As for the Case-Shiller index, we talked about this a little bit last month. Given all the support from the government, stimulating the markets with low interest rates and slowing foreclosures, we would expect to see some uptick in home prices. If anything, what’s notable here is just how small the rise has been compared to the massive amount of stimulation we’ve seen. Imagine where home sales would have been in 2007 if we had had 3.5 percent mortgage rates!

Finally, the price-to-rent ratio simply reflects the fact that while home prices have fallen, rents are stable because so many people either have trouble getting mortgages in this new environment or are afraid to buy given all the uncertainty out there. This isn’t a sign of a rise to come—it’s a sign of a troubled, timid economy, with no signs of real recovery ahead.  Plus, the lending environment has become permanently altered to be a bit more reflective of the real risks in mortgage lending, especially with so many people with much worse credit than during the housing boom.

And yet the cheerleading continues. If you’ve been following us (or the financial news) for a while, this should all seem pretty familiar. After all, we had a “rebound” just about 18 months ago. Whatever happened to that? Not much. And the reason is that there are always going to be minor fluctuations in the market. Sometimes the fluctuations will be positive; sometimes they will be negative. But the point is that the fundamentals that are driving real estate in the long term are getting worse—much worse.

So what are those fundamentals?

First of all, there’s the price of homes. The reality is that home prices are not going to rise significantly and steadily unless the economy improves. As we have discussed, that isn’t happening. In fact, the economy is getting slower. And unlike in 2006 and 2007, we don’t have a glut of sub-prime and “liar” loans being extended to push up home prices. (Most people would say stricter mortgage policies are a good thing, but it doesn’t help home prices rise.)

Secondly, because interest rates are artificially low right now—thanks to the actions of the Fed—it covers up a problems with many existing mortgages held by homeowners who can’t really afford the homes they live in. What happens when inflation hits, as we know it will, and they can’t make the payments on their adjustable-rate loans?

Of course, historically low rates do make homes more affordable now, which takes us to what we’ve been saying all along:   This can continue until we see inflation hit significant levels. Assuming there isn’t a major problem in the stock market, and interest rates are kept low, we can expect real estate to hold up and maybe even rise over the next year or two in many areas. The fundamentals in real estate may be terrible, but along with stimulus from the Fed, a temporary suspension of disbelief in the investment community can keep things going for some time.

Imagine, having a “peace of mind” protected retirement plan. You deserve better. Believe in a better retirement!

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