In a previous report, Headwinds for Housing, I examined structural reasons why the much-anticipated recovery in housing valuations and sales has failed to materialize. In Searching for the Bottom in Home Prices, I addressed the Washington and Federal Reserve policies that have attempted to boost the housing market.
In this third series, let’s explore this question: is housing now an attractive investment?
At least some people think so, as investors are accounting for around 25% of recent home sales.
Superficially, housing looks potentially attractive as an investment. Mortgage rates are at historic lows, prices have declined about one-third from the bubble top (and even more in some markets), and alternative investments, such as Treasury bonds, are paying such low returns that when inflation is factored in, they’re essentially negative.
On the “not so fast” side of the ledger, there is a bulge of distressed inventory still working its way through the “hose” of the marketplace, as owners are withholding foreclosed and underwater homes from the market in hopes of higher prices ahead. The uncertainties of the MERS/robosigning Foreclosuregate mortgage issues offer a very real impediment to the market discovering price and risk. And massive Federal intervention to prop up demand with cheap mortgages and low down payments has introduced another uncertainty: What happens to prices if this unprecedented intervention ever declines?
Last, the obvious correlation between housing and the economy remains an open question: Is the economy recovering robustly enough to boost demand for housing, or is it still wallowing in a low-growth environment that isn’t particularly positive for housing?
Factors Affecting Housing Demand
The demand from investors can be roughly bifurcated into two distinct camps: those buying distressed homes to “flip” them for a profit as market conditions improve, and those buying homes and multi-unit buildings for rental income and future appreciation.
The “flippers” are counting on continued demand by non-investor buyers, such as first-time buyers. The rental housing investors are counting on continued strong demand for rentals from those who lose their homes to foreclosure and must now rent, as well as from household formation resulting from population growth.
Both lines of reasoning are implicitly based on continuing Federal and Federal Reserve support of the housing market via first-time buyers’ incentives, such as low-down payment FHA and VA-backed mortgages, and the Fed’s continuing support of mortgages via low interest rates and the roughly $1 trillion in mortgages that the Fed purchased in 2009-10.
The assumption behind any forecast of improving demand and higher prices is that private demand for housing and mortgages will slowly replace government-stimulated demand.
If either of these conditions deteriorates — that is, if government support of the housing/mortgage markets declines due to the rising pressure to trim fiscal deficits, and private demand does not appear to replace it — then the forecast of steadily improving markets weakens.
While direct government support of the housing market via ultra-low rates and guaranteed FHA/VA mortgages is well-known, the rental housing market is also implicitly supported by government transfers; i.e., cash distributed by the federal government in Section 8 rent subsidies, extended unemployment benefits, etc.
These transfers now make up an unprecedented share of household income, as this chart shows:
Common sense suggests that the pressure to trim unprecedented (in peacetime) Federal deficits — roughly 8%-10% of the nation’s gross domestic product (GDP) for four years running — will eventually impact all government spending, including transfers and housing/mortgage subsidies.
Combine the prospect of declining government transfers with the deterioration in household disposable income since 2007, and the household income picture darkens considerably.
Why these factors matter to investors is self-evident: If households receive less income, then they will be less able to afford either a mortgage or high rent.
The fact that inflation has outpaced disposable income should also give real estate investors pause. If rents have by and large kept pace with inflation (rental markets are local, so any national figures are generalizations that may not apply), then this divergence between income that has flat-lined and rents that have risen with inflation suggests a future convergence: Either incomes rise to align with higher rents, or rents decline to align with flat-lined income.
Though most believe the Fed has the power to counter deflationary forces, it is worth recalling that in the early 1930s, rents declined by roughly 40% as demand and incomes fell. Prudent investors should ponder the possibility that incomes won’t rise to align with higher rents but that rents will decline to align with flat-lined income.
The general expectation in the real estate market is that whatever declines in home and rental prices could happen, have happened. This is reflected in this composite chart of the home price futures market:
Clearly, the futures market is anticipating a bottom in home prices in mid-2012 and a gradual improvement in home valuations from then on.
On the “not so fast” side of the ledger is the possibility that both home valuations and rents have been artificially inflated or propped up by government intervention and stimulus, and that the positive effects of those gargantuan transfers of cash and risk have run their course.
Though the Fed has publicly stated its goal of keeping interest rates near-zero until 2014, investors should ask what might happen when that prop under the housing market is removed; i.e., what possible consequences might flow from higher mortgage rates?
Some believe that housing demand will surge as rates start to rise, driven by potential buyers who were waiting for the bottom in prices and rates to re-enter the housing market. Once the bottom is clearly in for mortgage rates, as this line of thinking goes, these buyers will flood back into the market.
Others worry that rising rates could crimp affordability, especially if housing prices resume their climb, as anticipated by the futures market.
Though the general assumption is that the Fed can engineer super-low rates essentially forever, investors should be wary of assuming that an omnipotent Fed can control the mortgage market. The Fed only sets the Fed Funds rate; it does not directly set mortgage rates. Its only other lever over mortgages is direct purchases of mortgages and mortgage-backed securities in order to prop up the market, and many observers believe there are now political limits on what the Fed can do. In other words, the Fed could theoretically buy another $1 trillion of mortgages on top of the $1 trillion it already owns, but the unprecedented expansion of the Fed’s balance sheet is already drawing criticism.
Thus the future trend of mortgage rates is an unknown. If housing values take another dive, then the availability of mortgages may decline even if rates stay low. Buyers of mortgages will have to factor in the risk of default and/or declining rental income, and that calculation is especially sensitive when the rate of return is already paltry.
The thesis for higher demand for housing and rentals is based on these assumptions:
- The economy is on a sustainable uptrend of growth
- Employment is also on a sustainable uptrend
- Inflation will remain low
- Household income will soon resume an uptrend
- The Federal government will continue issuing unprecedented amounts of cash transfers to households
- The Federal government will continue to fund housing subsidies and mortgage guarantees
- The Federal Reserve’s plan to keep interest rates low for the foreseeable future will also apply to mortgage rates
- The MERS/robosigning Foreclosuregate issues will all be settled without disrupting the housing market
- The bulge in inventory will be liquidated as new supply (i.e., newly built homes) stays well below demand (sales)
- New household formation will drive demand for rentals and homes
While it is widely assumed that new household formation parallels population growth (which is remarkably consistent), the following chart reveals that household formation is more correlated to recessions and periods of prosperity.
We can see that peaks in household formation correspond rather well with peaks in economic growth, while the valleys correlate with recessions or periods of slow, uneven expansion.
While household formation has returned to the trendline, the long-term trend is clearly down. Other than the euphoric outlier of the housing bubble, the series displays the classic signs of a downtrend — lower highs and lower lows.
If the US economy turns out not to be decoupled from the sagging global economy, then this chart suggests another bout of recession could cause household formation to fall below its 2008 nadir. That would not be supportive of demand for housing, either home purchases or rentals.
The picture for housing is decidedly uncertain, and confirmation of the ten trends listed above will be needed to establish a clearer forecast.
In Part II: Key Insights for Those Buying Real Estate as an Income-Generating Investment, we inspect the specific factors that most frequently determine whether a real estate investment is successful or not.
Too often, when buying real estate for its income-generating potential, small investors make costly underestimatations or miscalculations that materially handicap the returns on their invested capital. In this type of sector, being forewarned is forearmed.
Click here to access Part II of this report (free executive summary; enrollment required for full access).