Most of you guys know that I bought a new house last summer. I spent two years looking at properties with the lovely (and patient!) Mrs. Concord, and eventually we found one that had what we were each looking for.
My #1 criteria was value. Not price, but value. My primary goal was for this new house to not hurt us over the coming decade, and the house we wound up buying was one of the ones that I felt had a sufficiently low probability of doing so. So that meant shopping at the extreme end of the value curve. We wound up with a bank-owned home in a neighborhood that buyers were irrationally avoiding, but in the last year we were able to rehabilitate it inexpensively and have watched buyers swarm back in, forgetting all about the fears they had a few years ago. So far, so good.
If you’re in the market for a new home or investment property, you’ll want to look at similar local inefficiencies. But you’ll also want to run through some fairly standard analysis. So today, let’s take a data-driven look at housing. I’ve been singing essentially the same song for a couple of years now, but after looking at the data of today, I think it warrants a bit of revision.
There are tons of charts to come, so if that’s your thing you’ll be in hog heaven.
We’ll kick this party off by looking at biggest possible picture.
It’s the Case/Shiller Index over time:
Don’t get too hung up on that red trend line. Big, long-term charts like that beg for trend lines so I had to oblige.
Rather than add a simple linear or exponential trend line, I got a little creative. Over the long, long-run, real estate goes up by an amount equal to the [inflation rate] + [a little bit]. The “little bit” is more or less equivalent to real wealth expansion, in the neighborhood of 0.25-0.5% per year. If you think about it, over the long, long-run, real estate really can’t go up more than that. Home prices are dependent on the general price level and what buyers can afford to pay.
Obviously, mortgage rates and lending policies inject a lot of noise, but over the long, long-run, that stuff tends to even out. What you’re left with is basically inflation + real wealth expansion.
And if you want to argue that real wealth expansion has been flat or negative and will be for some time, I certainly won’t argue with you. When I run this study again in the year 2050 or 2100, perhaps all we’ll be left with is the inflation rate.
I have a much longer-term data set on this home price index, so maybe that will be helpful too. I adjusted my “real wealth expansion” plug a little bit to incorporate a larger window of time:
In case you don’t believe me that over the long, long-run real estate appreciates by an amount equal to the [inflation rate + a little bit], you should now be sufficiently convinced.
And if you want to reinterpret that to mean that over the long-run there is no better hedge against inflation than real estate, you will receive zero argument from me.
When it comes to real estate, this is one of the fundamental truths that you need to understand. At its core, it’s an extremely boring asset. So when the market starts getting excited or panicked about it, you should pay close attention.
Where are we at today?
All that history is great, but what you’re interested in is what’s happening right now. This summer, real estate has been a relative bright spot for the economy. One of the few!
Check it out:
- New home sales are at a 2-year high.
- Existing home sales are at a 2-year high.
- Essentially every major market in the country has gone up in price all summer long.
- Through July, the Case/Shiller is up 4% since the March low. That’s an annualized rate of just over 8% (seasonally adjusted, too).
- The median existing home price is up 14% since March and 20% since it bottomed last February.
- Home builders are beating estimates right and left.
Personally, I’m excited to see this. You should be too. As I wrote last week, the economy will not recover until the housing market normalizes. So I’m encouraged to see more data that decisively supports that, especially since I’ve been relatively optimistic about real estate and its slow trend away from the post-bubble apocalypse.
That being, said, it’s foolish to expect the enthusiasm of this summer to continue.
We’re looking at median home prices now, which is a substantially more volatile data set than Mr. Case & Mr. Shiller’s index. But it’s also a little more helpful over the short run — and with real estate, the “short run” is a period of a year or so.
When assessing the value of real estate, the single most important thing you can do is relate it to incomes. Incomes are what support price (with the assistance of mortgage rates and lending policies, of course).
Per NAR, the median existing home price was $188,100 in July. Median family income is still around $61,000 which is basically where it’s been stagnating for years. That’s a price/income ratio of 3.08.
When you look at the historical data, there’s no other way to say it: median existing home prices are expensive relative to current incomes.
Obviously, that doesn’t imply that your local market is necessarily expensive. Nor does it even mean that the market as a whole is expensive. It just means that the homes that people are buying this summer are expensive relative to incomes. The median home price can fluctuate based on all sorts of different trends that range from available inventory (fewer distressed homes on the market today) to tastes & preferences (buyers are more comfortable now with bigger, nicer homes than they were a few years ago).
It’s still a great data point, though, and one that you can put to use. You can run similar studies locally. Figure out what a normal price/income ratio is for your home town and see what kind of homes are selling today.
In the meantime, I’m betting on a decline in the national median existing home price in the coming 6-12 months. I could be wrong, but I’d be shocked if this wasn’t back in the $170k range by January. Your local market will vary, but if your time horizon is only a couple of years, I’m not convinced this is the best market in which to buy a house. You might get hurt. Be extra careful on the value curve.
So how do I make money?
While I’m bearish on existing home prices and price trends over the short-run. I remain quite bullish on real estate as an investment over the long-run.
My reason is simple: it’s absurdly cheap to buy relative to rent. Whether you used the NAR’s biased “housing affordability index” or something you derive on your own, the data all tell the same basic story.
This next chart is easy. All I’ve done is take the current existing home price, figure out how much a monthly mortgage on that costs using current rates, and then relate that the current rents. Yes, there is plenty of other data you could feed into a study like that, but this is a ratio and what matters is which way the line moves. Ignore the axis if you choose.
Here’s what that study looks like over time:
Now, I understand why potential buyers are choosing to rent instead. There’s all sorts of baggage that goes along with buying a home, and besides, who wants to put down 20% on a new house? That’s a lot of money, particularly for nervous consumers.
But that’s the kind of opportunity you get during historically aberrant conditions like today. Everyone is terrified to buy. Uncertainty is high. But prices have normalized and mortgage rates are lower than anyone has seen in their lifetime or their grandparents’ lifetime.
Even using a median sale price that’s probably too high relative to today’s incomes, it’s still an incredibly good deal to buy rather than rent. You have 3.6% mortgage rates to thank for that and you can see why the Fed is targeting Mortgage-Backed Securities in this latest “Q-Infinity” program.
If you’re buying a home to live in it, this is the kind of study you want to run.
If you’re an investor, you’re looking at a different set of factors. You’re relating what you can rent the property out for to what it costs own. Rents have been very strong in recent years and there’s a lot of demand for that market. It’ll probably stay strong unless national mortgage lending polices loosen up. If you can find a property in your market that pencils out at a 7-9% cap rate and you can minimize your risk with a cash purchase, that’d be the type of opportunity I’d want to look closer at.
The home builder side
You can also make money on this in the stock market. I started writing about the home builders last year, just after the price bottom in February. Obviously, I had no clue that would be a bottom; my timing was dumb luck. But I wrote an article at Seeking Alpha back then about why these stocks could be an interesting long-term investment. It’s had a whopping 49 pageviews in the last year!
Home builder stocks fell off a cliff last summer (along with everything else) when the market was freaking out about the debt ceiling. But since then, home builders have been on fire. The XHB home builder ETF has outperformed the market by around 40% over the last 2 years. It’s beaten the market by over 60% in the last year.
After this, I find myself asking if I’m still bullish on this sector?
And Toll Brothers, which is more representative of the luxury end:
It’s been a long, bumpy road, but all of these stocks have finally broken out to new highs.
So are these stocks good values? These companies have been losing so much money for so long that it’s a little awkward to perform any kind of fundamental analysis on them. It’s weird to see them profitable again. These companies didn’t go out of business despite an economy that probably should have killed them. But they adjusted their business models for the trends ahead and they’re in better shape now. That should give you more confidence that they’ll still be standing a decade hence.
How much is a company like Pulte or Toll Brothers going to earn in 2015? I honestly haven’t a clue. That data point is heavily dependent on a million different factors, many of which are macroeconomic in nature and impossible to predict with any hope of accuracy. Analyzing the home builder stocks isn’t like projecting Wal-Mart’s earnings or Microsoft’s.
That makes me uncomfortable. Not uncomfortable enough to avoid the sector completely, but uncomfortable enough to only wade in when it’s obvious that their prices are distressed and the technicals suggest reversion to mean. But that’s just me. I know a lot of investors are comfortable playing the hot hand and don’t care about the long-term fundamental outlook. If that’s you, maybe these stocks are a momentum play. Otherwise, I’m taking money off the table right now. There’s still plenty of risk factors in the housing market, plenty of things that could cool this sector off a little bit.
No matter what you do with these home builder stocks, this is the chart you ultimately come back to:
New home sales.
If you think that chart will return to normal, you probably want to own home builder stocks (though try and buy them tactically on a big dip if you can). If you think the economy is going to be worse than bad in the coming years and that real estate will stay depressed, you avoid them.
Either way, home builder stocks are a very long-term proposition.
Where’s the risk?
All the usual economic risks apply with real estate. If the economy dips into recession, that’ll certainly be bad for the housing market. But that’s a cyclical risk. With a longer-term investment like real estate, I’m more concerned about secular risks like interest rates.
In fact, I think this is the biggest risk of them all in the years ahead. What happens if rates rise? Higher rates mean higher monthly payments and higher monthly payments mean buyers have to lower their price threshold.
Let’s say the 30yr mortgage rates rose 1% to 4.6%, which is still a fairly reasonable rate. On an median existing house today, that’s a payment of $771 vs. the $683 you’d get thanks to Ben Bernanke & Fannie Mae. Remember the days of the 7% mortgage? That’d be a payment of $1000/month on today’s median existing house.
So you can see how big a deal today’s rates make.
A $683 payment is 31.7% cheaper than a $1000 payment. Would an increase in mortgage rates to 7% translate to a 31.7% drop in home prices? Not exactly. It could. This is all extremely fuzzy math, but you get the point. The vector should be suggestive.
On a tangential note, if the median existing home price did drop 30% — to $126k! — just imagine how awesome that property would be to rent out! Depending on your locale, that’d easily be a yield in the mid-teens. That’s super attractive to investors with a bit of cash on the sidelines. Even if rates do go up, one has to wonder where that price floor really is. At what point do more people start ignoring mortgages altogether? At what point do investors really jump in to this market?
Take a look at the percentage of homes that are owner-occupied. The number is basically the same as it was in 2005. We’ve built quite a few new houses since then, and in aggregate, many of these units that would have been owner-occupied are being converted to rentals. The composition of the market is changing because of the economic and price shocks. Investors are playing a stronger role.
Anyway, these are just a few of the many different dials that control home prices.
And this is why when it comes to investing in real estate, I’m much more on board with the idea of paying cash for your investment properties. It mitigates a lot of risks. I understand that there’s significant opportunity cost associated with doing it that way, but seriously, where else are you going to put your money?
By paying cash you avoid the omnipresent risk and pain in the ass that debt represents, and you also lock in your property’s yield. There’s still the risk that local rents collapse. But those are much less sensitive than things like mortgage rates and if you can mitigate a lot of price risk while you’re shopping, you’ll decrease the probability of getting burned.
The final, local caveat
What we talked about today was the national picture. Remember that all of these opportunities and risks are local. This data may be representative of your neighborhood or it may not.
This is a useful exercise nonetheless. When you’re evaluating your local investment market, go through the same steps. Look at historical data. Look at trends. Compare rents to what you’d pay on a mortgage. Worry less about what the market will do next year and more about where it’ll be in 5-10 years. Because of the transaction costs, you have to approach real estate with an investment horizon of at least 3 years.
I may have given you a basic template, but unfortunately, you’re going to have to do the legwork and crunch the numbers yourself. The good news is that between sites like Zillow or Trulia and your local Realtor’s access to the MLS, you can get your hands on some pretty awesome data without a whole lot of hassle.
Wanna know what I did last year when I was buying my new house? I actually broke MLS data out by neighborhood. I recorded every single sale in just the neighborhoods I wanted to live in. I did it over a period of as many years’ data as I could get my hands on. I charted data by sale price and $/sqft. I made scatter plot charts to try and find the optimal square footage in terms of value. I got income data from the state and demographic data from the city. I looked at rents in various neighborhoods and compared them to different types of mortgages. I went back as far as I could into the past and ran some regressions. I ran regressions!! Mrs. Concord looked at me like I had three heads.
The data was ridiculously clear. Prices had not only stabilized, but had actually started to slowly trend higher. And this was during a period when the town was still completely freaked out about real estate. Buyers were reluctant to buy and nine out of every ten people on the street would tell you that they were expecting prices to keep dropping. Even Realtors were cautious.
One year later, it’s a totally different story.
This is why we look at data. Data is what tells the truth. It isn’t always the truth you want to hear and sometimes that data will contradict the narratives swirling about. It can create disharmony in your brain and it takes effort to process. But being able to look at it honestly is what will help you spot the secret opportunities and avoid the cleverly-disguised pitfalls.