Real Estate

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Real Estate: No Crash Imminent

By Dr. Steve Sjuggerud, President, Investment U
Thursday, March 13, 2003: Issue #221

Argh! I should have bought back then!

I lived in Delray Beach, Florida about six years ago. My wife and I had considered buying a place on the beachside, within walking distance from the beach. At the time, large two-bedroom townhouses were going for between $130k and $170k. We had even made a few lowball offers, which weren’t accepted. I ended up moving to Baltimore. But friends of ours did end up buying places we looked at, and my parents also bought as an investment.

Wow. They sure look smart now.

I was in Delray Beach last week for our Investment U seminar, and I couldn’t believe what’s happened. Friends who I know paid around $135,000 (because we looked at the same unit they bought) are putting that place up on the market for $450,000. The unit next to my parents just sold for about triple the amount that my parents paid. Good for them – they were in the right place at the right time. (And we did well in Baltimore also; there’s a real estate boom going on there as well.)

Two Reasons A Real Estate Crash Is Not Imminent

A boom in Baltimore? A boom in the town known as “Dull-ray” Beach? You’re probably asking, “Steve, how can you say there’s no real estate crash imminent?”

There are two things to point to: value and buyers.

In the last year or so, homes have been more affordable than they’ve been in over 25 years. Today, a household that makes $50,000 a year can easily afford a $150,000 house. At 5.5% interest, a 30-year mortgage would cost less than $900 a month – or about 20% of monthly income.

That’s extraordinary. Take that same family in 1981. To buy the median house back then (which was only $130k when you adjust for inflation), it would have cost $1,630 a month in today’s dollars – nearly twice as much as right now and about 40% of income. This is because mortgage rates in 1981 were 15%.

Low mortgage rates have changed the buying dynamic. Families that used to rent are now buying. Low mortgage rates have caused a dramatic increase in the buying pool.

As for value, it may be hard for most to believe, but even if we ignore mortgage rates, the fact is, housing prices in the U.S. are still at about 1989 levels when you adjust for inflation. Since 1989 stocks have tripled (the Dow is up from 2,500 to 7,500 today, after nearly reaching 12,000 in January of 2000). Meanwhile home prices in that time are flat.

Another way to look at value is by EARNINGS. Just as we look at the price-to-earnings ratio of a stock, you can look at the price-to-rental earnings ratio of a house. Stocks would have to fall by about 50% to return to being “in line” with the average price-to-earnings ratio. Meanwhile, a study this month by the Federal Reserve Bank of San Francisco (http://www.frbsf.org) shows that housing prices would have to fall by 11% to bring the ratio back to its long-term average. This may be a little worrisome, but it’s not the end of the world. The author of the study expects that home prices may not even fall, rather rents will simply catch up by 2005, bringing us back to fair value.

According to this week’s Economist magazine (http://www.economist.com), home prices in Ireland have risen 203% since 1995. In Britain and the Netherlands they’re also up triple digits. The U.S.’s 5.76% annual gain over that period seems downright paltry.

Similarly, in Australia and Spain, home prices rose by about 18% in 2002. Meanwhile, in the fourth quarter of 2002, U.S. home prices only rose at an annual rate of 3.3%.

Demand From Buyers And Supply Is Tight

For the many years that I have been writing about investing, I have never predicted a crash in U.S. real estate. Yes, there are some “bubble” areas in the U.S., and you know them if you live near them. But I don’t think on the whole, real estate is wildly overvalued. The gentleman from the San Francisco Fed may be close, suggesting that home prices are a little overvalued. But that definitely does not mean that the bull market in real estate can’t continue. Stocks were overvalued for many years and kept rising until the crash came in 2000.

The facts (as reported by the Housing Affordability Index) say that in the last year, homes have become more affordable than they’ve been in over 25 years (primarily due to lower mortgage rates). At the moment at least, there is demand from new buyers, and supply is tight. Prices could move higher.

I don’t have all the answers, of course. However, there is one more point I’d like to make.

“Real estate is expensive,” and there’s unanimous agreement on this fact at cocktail parties. Of course, in late 1999, there was unanimous agreement at cocktail parties that the way to instant riches was through tech stocks.

Whenever the cocktail party crowd reaches a unanimous conclusion about an investment, it may pay to consider the opposite possibility

Good investing,

Steve