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Tuesday, November 29, 2005

Real Estate 

The press and financial wise people are increasingly beating the drumbeat of a real estate bubble. I, for one, am doubtful that we have a generalized bubble in the asset class as we did in say, internet stocks, telecom stocks or, once upon a time, tulips. This is not to say that, like in anything else, people aren't making some poor real estate investments today, or that there couldn't be a setback in the market. But let me give offer some observations, and see what people think.

1) As opposed to some of the other assets which have become subject to bubbles, real estate often comprises the vast majority of a normal person's wealth; the income used to support carrying that asset often comprises a sizeable fraction of a person's income. The underwriting standards, therefore, that individuals apply to their investment decision tend to be high, as do that of banks. Much higher than the standards which many use to buy a stock, usually a far smaller portion of one's wealth; and certainly higher than margin loan underwriting standards.

Thus, the likelihood that the majority of Americans, and their lenders, are committing a substantial majority of their wealth and income to an irrationally priced asset class as a general matter seems to me unlikely. Most people do consider rental alternatives as a benchmark against which to weigh their real estate purchase. People do make rational decisions with their money and with their decisions to live someplace.

2) It is not uncommon for the New York real estate market, to use one example, to be thought of as an irrationally exuberant market. Prices seem exhorbitant. Competition can seem crazed for apartments. Even high earners seem to be priced out of the most attractive locations.

Yet, if you measure New York real estate by global standards, it is not insane. In fact, it is cheaper than comparable global cities, such as London, Paris, Milan, Tokyo and Hong Kong, to name a few. In addition, the New York real estate market tends to be moved by income...and New Yorker's income is increasing markedly, not decreasing.

And keep in mind that NY not long ago was subject to a violent attack which killed 2,000 of its inhabitants and made living downtown, well, not so great. That, coupled with a recession, was as good a test as I can imagine short of a dirty bomb of the resiliency of a market. It has sprung back to life extraordinarily.

3) Interest rate increases. Another excellent test of real estate financing markets has been the last 12 Fed meetings, which have resulted in an increase in the Fed Funds rate to 4%. The simple prediction is that an increase in mortgage rates should reduce the affordability of real estate unless prices adjust down. In some measure, again, this has occurred, but not dramatically so.

Again, absent a movement in rates to historically high levels from historically low levels (which would cause lots of other problems), I don't think rate increases will move the needle here.

So I think the general market is probably okay. Marginal locations are probably overpriced and will surprise people to the downside in a correction, but good locations wil hold value (a time tested cliche, of course).

Here is where the whole sector could get bombed, and if it happens, look out below. If the Congress messes around with the mortgage interest deduction, you will have a massive, generalized bear market in real estate, bubble or no bubble, good location and bad. If you are long real estate, write your congressperson...this is the financial nuclear weapon which would detonate on all real estate and really hurt us folks....

7 Comments:

By Blogger Charlottesvillain, at Tue Nov 29, 04:36:00 PM:

Good analysis. My own view is that, while we may not be seeing a bubble of extremes, the RE market is certainly demonstrating some speculative froth, which is usually indicative of a market top. The fact that a website entitled condoflip.com is an example of what I am talking about. At the same time, in certain markets, there is plenty of evidence that increasing prices are justified.

Whether or not you believe that mortgage underwriting standards are sufficient to keep default rates low, the morgtgage market has changed significantly since the last major real estate slump in the late 1980s. In the last several years a large percentage of the mortgage market has been converted to interest-only adjustable rate loans, which offer the lowest payments, and therefore make expensive properties affordable, at least temporarily, to people who would not be able to afford the same property with a traditional 80 LTV 30yr-fixed rate mortgage. I have read that these loans now make up as much as 30% of outstanding residential mortgages.

I think the wide spread adoption of this product has introduced "cliff risk," for lack of a better word, into the residential home market. The adjustable rate feature on the mortgage makes these loans vulnerable to increases in interest rates, but because they are non-amortizing for up to ten years (and usually high LTV) even moderate decreases in property values could wipe out the equity in these homes pretty quickly, sharply leading to an increased probability of default. One can easily envision a scenario where a spike in interest rates leads to an increase in default rates, creating a drop in housing prices, and a corresponding increase in defaults among underwater home owners who face the spectre of having to refinance their loans. Let's hope it doesn't happen.  

By Blogger Cardinalpark, at Tue Nov 29, 04:59:00 PM:

I don't disagree, though in that difficult event, I think you would see lenders adjust principal and keep payments level, in effect allowing for a debt restructuring which would mitigate an individual borrower's risk insolvency so as not to force a large supply of property onto the market at once...  

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