Real Estate 2003 - Boon or Bubble?
I am all jacked up today because I get to talk about a subject near and dear to Fundamentals Guy's heart - real estate! Candidly, I don't know how real estate is going to do this year. And I'm not even sure that a calendar year is an appropriate measure of time when talking about real estate due to its general lack of liquidity (except for REITS, which trade like stocks on an exchange). But let me lay out some of the critical factors that are going to determine the bigger picture for this sector going forward.
Veteran readers already know this, but for those subscribers recently joining the OIN community, Fundamentals Guy (me) was a commercial real estate broker for 17 years in a former life. As a commercial broker, life centered on discovering - perhaps uncovering - the fundamental profit-earning abilities of nearly any kind of business under the sun. The reason for the fundamental research was that in order for a tenant to pay rent, there had to be profits to pay the rent after the cost of goods was subtracted from revenues. Can't make a profit? Can't pay rent. I discovered then that selling custom made sandwiches in volume was likely a better business proposition, and thus a better rent risk for the property owner than, say, a Cabbage Patch Doll adoption agency. (No joke - somebody actually thought that was a great idea for a sustainable business.)
Of course, there are not-so-subtle nuances that can get the rent paid but still not afford the business a profit. This works because real estate, at least commercial real estate, is for the most part required to produce income. Manufacturers need a place to build; sales people need a place to office; travel agents generally need an office in order to serve the public; neighborhoods need grocery stores (as a matter of extreme convenience) lest we go hungry.
The point is that in order to operate a business, real estate rents or mortgage loans need to be paid to keep the doors open. Uncomfortable as it is, reality dictates that companies are most likely to lay off staff and default on other obligations before they default on the leases or loans. When the going gets tough, I'd rather be the landlord than the creditor office supply salesman or vending machine attendee. The latter are extras. Real estate is generally not.
From that, we can conclude that real estate loans and lease payments are more likely to be paid back first, which makes them more akin in pecking order to bond payments than equity dividends. Dividends are paid from the profits; rent and mortgage are paid from revenues - much higher up the food chain in terms of security of payback. That's why dividends from a REIT are so much more appealing than dividends from widget manufacturers. Payback is more certain. While business struggle harder for profits every day, I'm not as worried for the landlords as I am for shareholders. While corporate defaults may rise in coming months or years, there is an added measure of insulation to the real estate investor.
Of course, I've only mentioned commercial property here, which is a bit more insulated, though not immune, from severe economic difficulty.
For instance, if deflation turns out, in fact, to be a major menace - and that is a real and likely possibility (see Options 101, January 16th, 2003 click here ),
rents could begin to fall too. That would spell bad news. However, while I see business struggling for profits, the mistakes made by builders and developers in the 1980's and early-1990's seem well remembered by anybody who can spell F-S-L-I-C, or R-T-C. And thus, despite the seemingly "free money from God" available for commercial real estate loans, lenders have remained fairly prudent in their underwriting criteria for commercial property. To my way of thinking, there is not an overbuilt supply of space, but rather the likelihood of predictably declining demand.
In short, I do not believe there is a commercial real estate bubble, thus no ability to "pop". But that does not mean that the market can't see some serious setbacks if business remains in decline, as I expect it will. However, I would suggest any decline will not be sudden, unforeseen, unpredictable, or without plenty of warning.
In any case, "severity" will likely be gradual, measured, and plainly visible, especially to "incubator space" primarily used by mom and pop, or otherwise small business. It's dicey on the multi-tenant small spaces and less risky on the larger commercial spaces leased or owned by larger corporate tenants who rely on Dunn and Bradstreet not to trash their debt ratings. But that's the way it's always been.
Residential real estate is a whole 'nother matter. That's where the bubble is big and still expanding. What makes it different? A not-so-coincidental coziness between publicly-traded national home builders and Wall street money men that encourage the speculative building, plus the easy-money credit policies enabled and encouraged by a Federal Reserve determined to inflate the economy with home mortgage money intended to be spent by the ever increasingly debt-ridden U.S. consumer. Remember the case for inflation?
The consumer is the last, great hope to save the U.S. economy from deflation through spending home equity money as fast as it can be inflated and borrowed against. The Fed is enabling Americans to borrow themselves rich with the hope that they will spend that equity created from nowhere on trinkets, doo-dads, material possessions, along with other goods and services in order to keep the rest of us and our neighbors employed and spending our brains out. The downside is that debt has to be paid back, which becomes increasingly more difficult as jobs are lost to a slowing economy.
I'll say it again, "We cannot borrow ourselves rich". Just like a game of musical chairs, one day the music will stop. It always does. The consequence is that as borrowing slows to a trickle, spending slows to a trickle. As spending slows to a trickle, goods and services remain "on the shelf", which reduce sales, which further reduce profits, which enable a new round of layoffs. And the process repeats itself.
Unfortunately, Americans have exhibited increasingly worse saving habits over the last 40 years to the point that the U.S. savings rate is a mere 2% +/-. Should deflation take an even bigger grip on the economy, which would spell bad news, as a greater percentage of an already deflating take-home pay would be required to service the constant debt.
Just imagine our income shrinking 3% per year. Eventually our income would approach zero. Meanwhile, say our mortgage debt has remained flat at $300,000 because we are struggling to make "interest-only" payments. Connecting the dots (and taking this to a literally logical, though improbable conclusion), we are gradually going to reduce our income to a point where it exactly equals our interest payments, then decreases more next year. Voila' - debt we can no longer pay off because our income shrunk.
Dire and wacky? Consider the following as relayed by The Daily Reckoning:
"Since the '60s, the consumer has added to his debts...first, cautiously in the '70s...and then recklessly in the in '90s. While GDP rose 283% during this period, consumer debt shot up much faster - by 473%."
Here's more fresh meat from a recent Barron's article. "If the U.S. debt bomb ever explodes, the detonator probably will be the residential mortgage market," asserts Barron's Jonathan R. Laing. "Home prices have nearly double the impact on consumer spending than does the 'wealth effect' from rising or falling stock prices. And home prices have been on a tear, rising nearly 50% nationwide over the past six years. Consumers have tapped this surging equity value through wave after wave of cash-out mortgage refinancings, transforming homes into ATMs."
"If the housing bubble bursts, instead of gently deflating, the nation's economy could be in for a major meltdown," Laing concludes. "In essence, then, the American home is a bulwark for the economy. As long as housing values stay high, the nation is sheltered from a detonation of the debt bomb." That is the one thing the Fed is counting on to happen (with it's breath held and fingers crossed).
Also note, "Gary Shilling [money manger and well-noted Forbes Magazine Columnist] calculates that 39% of U.S. homes are owned free and clear," writes Laing, "and that the remaining homeowners have debt burdens exceeding 80% of the value of their homes. In other words, many Americans have little margin of safety should home prices level off or should they fall as much as 20%, as they did in many overheated areas in the late Eighties."
But wait, there's more from Doug Noland, a financial strategist for the Prudent Bear Fund. He notes in a Daily Reckoning Column today of a recent Dallas Morning News headline: "Home Foreclosures are Casualties of Economy". Writer Steve Brown comments: "A bleak economy hit home in North Texas last year, putting thousands in danger of losing their homes. The number of homeowners threatened with foreclosure in Dallas County jumped 32%. And in Collin County - which has been ravaged by layoffs in the high-tech and telecom sectors - home foreclosure postings soared by 73% in 2002...January foreclosure postings for Dallas County were up 43% from January 2002. And in Collin County, foreclosure postings for the month were up a staggering 94%."
My take isn't so much that there is a real estate bubble. It's that there's a mortgage bubble, which is still attracting the U.S. "borrow and spend" consumer. When will that end? Hard to say whether it is 2003 or later. I just don't know. But I do know this. It WILL end. It always does. But by then, maybe we'll have a new bubble to jump on that will keep us afloat for another few-year period until it pops too. We can dream irresponsibly, can't we?
Just like an aircraft whose engines have slowed the otherwise capable bird to nearly a stall - with stall warning horns a- blazing - she'll still fly. But once stalled, recovery is difficult at best, and sometimes not possible. Planes don't function well without a smooth flow of air over the wings to produce lift. Neither do economies without a reliable source of REAL money and a stone-carved reliable monetary policy. The affect is the same. Walking away unscathed is seldom possible.
Now, lest you think I'm predicting a mighty crash, I'm not. In fact, there are some signs that a major mortgage bubble catastrophe could be largely averted. The biggest indicator is that the inflation-adjusted bond market is telling us that inflation is picking up ever-so-slightly. The bond market never lies and can smell inflation light years ahead on the horizon. In 2002, the TIP rate was telling us that inflation had been reduced to just 1.47 percent. But recently, that spread has jumped to reflect anticipation of 1.83 percent - a slight increase, but the bond market doesn't lie, and it sees some inflation on the horizon.
If inflation is to re-assert itself, even ever-so-slightly, it may have the effect of holding home prices steady if not increasing slightly rather than declining in popped-bubble style. That's not to say that the Fed will win the "Inflate of Die", inflation/deflation war. But there are signs that the electronic printing press so favored by Federal Bankers may be marginally inflating the U.S. economy out of deflation.
While I do not profess to know what will ultimately come to pass for the real estate market. I am well aware that deflation will hurt the real estate/mortgage spending market badly, and thus the economy. So will inflation hurt the economy, but housing may be spared the deflationary death sentence.
But there is, in my opinion, a safer way to insure our financial futures and protect ourselves against either inflationary or deflationary scenarios. It's an insurance policy, which, in a bear market is a good thing since nobody makes money consistently in a bear market. In most laymen's' instances, bear markets are not about what you make, but how much you don't lose. Hmmm - ugly thought. Mr. Rogers asks, "Can you say 'gold', boys and girls? Sure, I knew you could."
We'll visit Mr. Rogers' neighborhood next week! Until then, make a great weekend for yourselves!