ICangles Investment Post…

Real estate is back. Across many regions home prices are rising. Many continue to look at real estate as a good investment. With yields from bonds and CDs at their current low rates, investors are being attracted to the ability of a real estate investment to generate income. In addition many believe that the sell off in real estate driven by the Great Recession has created some relative bargain buys. Even more importantly the comeback in real estate is helping to drive broader economic growth. Wall Street is also getting back in the game. So far this year banks have issued more bonds backed by commercial mortgages than they did at this point in 2005, and institutional investors have become a powerful buying force, accounting for example as much as 70 percent of buying activity in some Florida markets. But are investors getting ahead of themselves? Will the good times continue? Or are investors being lured back into a market that has the worst still to come?

The answer to those questions in my opinion is yes. Investors are getting ahead of themselves, the good times will continue for a while longer and afterwards worse is to come. In my original “Nightmare on Main Street” 2004 column I predicted real estate prices would continue to rise, but would see a top in the 2005 to 2007 timeframe—a forecast I later enhanced to predict the likelihood of a decline not really getting going into 2008. Today, I similarly expect prices to rise, but expect another downturn to also be ahead in the current decade. Similar to the last down market in real estate I expect the next to also be driven by a recession. I’ve been quite consistent in my predictions for a worse economic downturn still to come. Real estate prices will likely go lower and on a national basis return to inflation-adjusted price levels last seen in the nineties.

Short-term I am bullish on real estate because I expect Federal Reserve policies to help keep interest rates low, the economy to continue to improve and banks to loosen credit in response. But we are getting late into this economic recovery and these extremely expansionary monetary policy conditions cannot continue indefinitely. I would look at this period as a time to sell into housing strength. When the next recession comes it is likely to bring the double blow of rising financing costs and unemployment to the housing sector. When fewer people can afford to buy, more need to sell and the costs of financing a loan or servicing an adjustable rate mortgage start to rise, the impact on housing prices will be powerfully negative.

The economic fundamentals are worrisome, but so also is the historical backdrop for housing. Before the housing bubble burst, Yale economist Robert Shiller created an index of housing prices going back to 1890. He created this data set that had not previously existed by having researches go through classified advertisements in archived newspapers. When he analyzed the compiled data he found that over the long-term real estate prices on a national basis tended to rise with inflation. At the top of the housing bubble, prices had risen to more than double their inflation adjusted trend line. Unfortunately, prices have only completed about sixty percent of their move back to trend. In other words, just to get back to their historical growth trend line will require another big move down in prices.

This declaration comes with a few caveats. It is typical for multiple decades to see housing prices 20 to 30 percent above or under the trend line in the Case Shiller dataset. So, it is likely that the next recession will drive housing prices to either a modestly lower level above trend or a drastically lower level under trend. It is also possible that housing could simply return to trend by nominal prices trending sideways, while inflation acting over time results in real prices returning to a more normal historical level. However, the more likely scenario is that the next recession will drive both real and nominal prices significantly lower, and housing on a national basis will prove to be a poor investment choice going forward. Of course most people buy a single house as a place to live in first and foremost, and as much as a decline will be bad for those owning multiple real estate properties, it will be a positive for those entering the market for a home who have cash.