The Real Estate Boom

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The Real Estate Boom: What’s Happening to the Value of “Home Sweet Home”?

by Alexander Green, Investment Director, The Oxford Club
February 23, 2007: Issue #644

No one forecast the doubling of home prices in the U.S. between 2000 and the end of 2005. So it’s reasonable to assume that no one can tell you how or when the slowdown will end, either.

But don’t expect it to be pretty. My analysis is that we’re a lot closer to the beginning of the housing slump than the end.

For starters, this has been the wildest real estate boom in world history. Housing prices have skyrocketed relative to building costs, personal income, population growth, and inflation. With the exception of Japan in the late 1980s – which I’ll get to in a minute – no one alive today has ever seen anything like it.

While there have been notable exceptions in areas of the country experiencing heady growth, houses are ordinarily steady but unspectacular investments. According to home-finance corporation Freddie Mac, U.S. house prices have climbed 6.2% a year over the past 30 years.

Most Homeowners Didn’t Net This Much, However

To calculate bottom-line profits, you’d have to deduct the following:

Property taxes
Homeowners insurance
Maintenance costs, and
Mortgage interest

Of course, it’s those mortgage costs that made the real estate boom seem like such a good deal to most of us in the first place. After all, if you bought a $100,000 home 30 years ago, put only $10,000 down, and sold it 10 years later for, say, $170,000, it seemed like you were earning a colossal return. Why? Because the use of other people’s money (the mortgagees’) allowed you to leverage your real estate investment.

But leverage is a double-edged sword. It magnifies your profits and your losses.

The mortgage market has changed, too. In recent years, even borrowers with spotty payment histories have been able to choose among a juicy selection of no-money-down, interest-only, adjustable-rate, negative-amortization, “pick-your-payment” real estate mortgages.

The Way Americans Use these Mortgages Has Changed Dramatically, as Well

“People have literally picked up their house at the foundations and shook it upside down like a penny bank,” says Ed Smith, chief executive of the Plaza Financial Group.

Combine this credit binge with a soggy real estate market and the outcome is rather predictable. Foreclosure rates on “subprime” loans made to borrowers with poor credit records more than doubled last year. This month ResMae Mortgage Corp. became at least the 23rd subprime lender to close or be sold when it filed for bankruptcy.

But is the worst over? Not likely.

About 80% of subprime mortgages today are adjustable-rate mortgages, commonly referred to now as “exploding ARMs.” Why? According to Comstock Partners, a Yardley, PA-based asset-management company, 70% of borrowers who took out pay-option ARMs in 2006 owe more now than they did when they got the loans. Comstock estimates that 15.2% of 2005 home buyers owe at least 10% more than their houses are worth.

Rising defaults means more houses for sale in a national housing market already experiencing record inventory. Anybody who has taken Economics 101 knows that rising supply in the face of steady or falling demand eventually leads to lower prices.

For yet another reality check, take a look at the chart below by economist Robert Shiller, the man who published Irrational Exuberance at the pinnacle of the technology stock mania:

The chart shows an inflation-adjusted index of American housing prices going back to 1890. There are periods where the real value of homes fell, such as World War I and the Great Depression. And there are periods where homes appreciated nicely, as in the 1970s and 1980s real estate booms.

And then there is the current boom, beginning in 1997, where the inflation-adjusted price of a home suddenly looks like a night launch at Cape Canaveral.

No American Has Ever Seen a Real Estate Boom Like this Before

The one exception is Japan, where the price of real estate reached such ridiculous levels in the late 1980s that it became the talk of the world. Beginning in 1990, however, Japanese real estate values fell for 15 consecutive years, ultimately declining 65%.

Don’t get me wrong, though. I’m not an alarmist. I’m not saying the U.S. housing slump is the Japan bust all over again. As I said earlier, no can tell you how deep the current real estate slump will be. Or how long it will last. But I will say this

Don’t hold your breath.

Good investing,

Alex

Today’s Investment U Crib Sheet

In September, Dr. Mark Skousen had the opportunity to interview Robert Shiller. The real estate expert told readers just how much to expect home prices to fall over the next couple of years. He also offered his take on current stock valuations and today’s most attractive overseas markets. Read the full interview.
Remember to take the long view over time, stocks trump real estate. According to Forbes, from 1980 to the end of 2004, home prices in the 10 largest U.S. cities – from New York to Los Angeles – increased 247%. Not bad. But the S&P 500 climbed more than 1,000% over the same period. For even better results, buy companies that are accelerating their earnings, introducing new products, and generating unusual amounts of cash and using it to fuel future growth. Here are Investment Director Alexander Green’s top picks for the next 12 months.