“THREE THINGS ARE TO BE LOOKED TO IN A BUILDING: THAT IT STAND ON THE RIGHT SPOT; THAT IT BE SECURELY FOUNDED; THAT IT BE SUCCESSFULLY EXECUTED.”
– JOHANN WOLFGANG VON GOETHE

The residential housing market has gone through some dramatic changes in the past few years, more so than any other market in recent memory. From the bubble of 2006-2007 that was fueled by easy money and no-doc loans, to firehouse sales of foreclosed homes to today’s market of very low inventory and rising prices in various parts of the country – i.e., Phoenix. Although we are by no means experts in the housing market, we did want to share a few thoughts on housing and the potential implications for the future. Keep in mind that this is a broad perspective – we recognize that the real estate market is many times driven by local issues. Just ask Jim. He has been trying to sell his mother’s house just south of Naples, Florida for over a year. He has reduced the price substantially – by 50% of what it would have sold for six years ago – and still hasn’t received one offer.

The main reason to own a home is to have a place to live in a community and neighborhood that fits that individual’s needs. The second reason is to have an asset in which the owner can build equity. In 2006-2007, many homeowners/investors got caught up in the euphoria of a rising residential real estate market with dreamy thoughts of making a fortune. With easy credit, people were borrowing money against the equity in their primary residences and buying multiple properties on the belief that real estate prices can only go higher. We all know what happened next. For further proof of the low, long- term return homeowners typically realize on real estate, consider this fact. The history of home prices show that from 1890-2005 – before the boom/bust period in home prices – home prices rose on an inflation-adjusted basis by 103%. Annualized this translates into less than a 1% real rate of return per year. When you add in the cost of maintenance, you actually lose money when owning a home. Unless one is an expert and does real estate on an ongoing basis, they should avoid speculating on residential real estate for investment purposes.

Today’s Residential Real Estate Market:
(Keep in mind that this discussion is broadly speaking and may not be indicative of your specific area)

The real estate market today is markedly different than what it was two years ago. Two years ago, there was an overhang of real estate for sale and prices were falling. Today, there is very little inventory of homes to buy and prices have stabilized – there are now cases of bidding wars and paying above asking price. Home prices usually firm up and rise when real wages increase. So why are home prices going up when real wages are not? We suspect the huge demand from institutional investors has much to do with it.

Back in March of 2012, Warren Buffett said on CNBC that he would invest in residential real estate because he saw housing as a “cheap” asset. Other institutional investors had the same instinct and created partnerships to buy residential homes en masse. In just over 12 months, Blackrock has raised over $4.5 billion in its partnership which now owns more than 26,000 homes. American Homes 4 Rent and Colony Capital each own over 10,000 homes. Goldman Sachs ex-mortgage head has raised almost $1 billion to ultimately buy 10,000 homes. Even large institutional pension and investment funds are putting money into residential homes with the Alaska Permanent Fund investing $600 million. On one hand it is good to have money flow into the sector and help set a floor on prices. On the other hand though, home prices are being driven above their fundamental value.

Another boost to home buying has been the reuse of the “no/ low down payment loan”. Yes, that is what we said. The VA offers loans with 0% down while the FHA has a minimum down payment of 3.5%. To qualify for 3.5% financing, one must have a credit score at or above 580. For credit scores between 500 and 580, an applicant must have a 10% down payment. In other words, the FHA does provide an avenue for first time and low credit score borrowers to buy a home. These homes cannot exceed a certain dollar value which varies by location. In 2011, 46.4% of all loans were FHA/VA. This year that amount is expected to drop, but still remain above 30%.

The Future of Housing

As we have indicated, we are not experts on housing and rely on experts for their insight. During a dinner with Jim a few weeks ago, Robert Shiller – an economist with Yale University and co-founder of the Case-Shiller index on home prices – mentioned that he believed, in the short run, housing prices will rise due to low inventory, but that he expected housing prices to fall in a year or two. We agree with that synopsis. There will be pressure on home prices because of rising interest rates, less money from institutions and lack of after-tax wage growth.

The first thing that hurts real estate prices is rising interest rates. In the past two months, the 30 year mortgage rate has gone from 3.50% to 4.25%. This .75% rise in interest rates equates to a higher monthly mortgage payment of $45 for each $100,000 borrowed. Since most people buy a home based on how much they can afford, this will cause downward pressure on home prices as buyers offer less money in order to reduce their monthly payments.

The second reason we expect housing prices to fall is because of less interest by institutions in buying residential homes. With prices rising, there will be less interest by institutions because the higher the price one pays, the lower the expected return on the investment. In addition, it is hard enough maintaining one home; just imagine the upkeep on 10,000 homes. We believe that many institutions have underestimated the maintenance costs and when the experienced cost is higher than anticipated, the return expectation on these investments will fall. In addition, as homes begin to hit the rental market because they are not selling, this will cause rents to fall as more supply hits the market. Lower revenue and higher expenses is not a good recipe for an ongoing investment.

The third, and most important, reason for a drop in housing prices is lack of wage growth. In order to have sustainable price appreciation, you need higher after-tax wages so that people can pay more for a home. We are not seeing wage growth and with the tax plan that was passed into law late last year, most workers now have 2% less take home pay this year. Many employers also are hiring part-time workers to fill their needs so that they don’t have to pay for health insurance for these employees. Long-term, real estate needs a vibrant economy that provides higher wages in order for prices to appreciate.

This Newsletter is intended to be a broad outline of the residential real estate market and may or may not reflect circumstances existing in the area in which you live. A general rule of thumb is if you are going to live in a community for 5 years or longer, it is usually better to buy a home. If you plan to stay for less than 5 years, it may be cheaper to rent. As a home is many times the largest asset an individual will purchase in his or her lifetime, this decision should not be made lightly. We understand that buying a home is not only a financial decision, but an emotional one as well. We stand ready to help if you need us. Please don’t hesitate to call us at THOR if we can be of any assistance on such an important purchase.