Tuesday, July 7, 2009

Don’t Expect a V-Shaped Recovery in Real Estate Prices

Anyone who knows me is aware that I have a unique perspective on real estate. My family is in the commercial real estate business and I worked in the business for a number of years before becoming a securities analyst. However, even as an analyst I have continued to follow the sector very closely. Not so much the REITs as the regional banks. If you think about it these banks are not much more than real estate companies. While their main business is not to own properties (at least not by choice), a large percentage of their loan books are tied to real estate. Aside from some business or what are known as C&I loans, the majority of the loans on the books of the banks I follow are tied to commercial real estate, residential real estate and construction.

In addition, if you read my contributions to Seeking Alpha or follow my blog you are keenly aware that I am not so bullish on US real estate right now. My bearishness even extends overseas as I have come to the conclusion that the Australian and New Zealand housing markets could be on the precipice of a large fall. Of course, there is no shortage of housing and commercial real estate bears. My friend Whitney Tilson of T2 Partners has done a fabulous job in documenting where we are in terms of the housing bust and warning investors that there are a number of factors that will continue to put pressure on prices. On the commercial real estate side, Deutsche Bank Analyst Richard Parkus has been the most outspoken bear, recently proclaiming that New York City real estate is in for a tough stretch.

However, I want to look past of all the near term uncertainty in assessing the prospects for real estate appreciation over the next decade. Over the next few years foreclosures, interest rate resets, CMBS refinancings, and short sales could very well push prices lower or prevent any significant uptick in values. But for someone interested in commercial real estate investments and who may soon be in the market to purchase a residence, it is important to understand the history of real estate appreciation directly after a bust has occurred. I am fully aware that there is no credible way to call a bottom or a top in the market. Nevertheless, it is important to have realistic expectations regarding how long it could take for prices to recover from their recent falls on both a nominal and inflation-adjusted basis.

On that front, this first chart and the associated data are not particularly promising:

Chart and data courtesy of http://bubblemeter.blogspot.com/

This chart shows the progression of New York City metropolitan house prices from January 1987 to February 2009 on both a nominal and inflation-adjusted basis. First, median prices hit a nominal peak of $184,798 in August of 1988. Then, as a result of the commercial real estate bust and the early 1990s recession, prices began to fall, dropping 15.4% to $156,173 in March of 1991. This fall was not particularly dramatic in comparison to what we have seen nationwide in the US over the last 3 years. However, the scary thing is that it took until April of 1998 (when the median price reached $184,755) to get back to the 1988 peak level. For anyone counting it took nearly 10 years for someone who bought in August 1988 to see his or her house worth the original purchase price. In the meantime this hypothetical person was likely paying interest on a mortgage that valued the house at well more than it could be sold for. That extra interest is not trivial and represents a real cost to borrowers whose houses have dropped in value.

The data on an inflation-adjusted basis is even less encouraging. Specifically, real house prices hit a peak of $322,866 in November of 1987. From there prices bottomed at $229,659 in February of 1997, representing a 28.9% fall. Unfortunately, it took until October of 2001 (when real prices hit $323,353) to get back close to the 1987 peak. It appears that inflation caused the recovery process to take significantly longer as 14 years passed before someone who bought in 1987 was fortunate enough to have his or her house worth the original purchase price. I think it is also important to note than even if someone had bought at the bottom it still took four and half years to get back to the 1987 plateau but during that time the house would have appreciated 40.7%.

So, the next logical question is where are we now in terms of NY housing prices? Well, according to the Case-Schiller Composite 20 Index, prices peaked at 215.83 in June 2006. As of the April 2009 data the index was at 170.33, signaling a 21% drop. In fact the index in April was back to near where it was in May of 2004 (170.52). In comparison, from the peak in September 1988 of 85.54 the NYC index bottomed at 72.29 in April 1991 (a 15.5% drop). It then took until May of 1998 when the index hit 85.52 for prices to return to the 1988 peak levels. That’s a little less than 10 years and the drop back then was not as severe as the current fall has been. You can only imagine how long it could take for prices to get back to the 2006 levels if history were to repeat itself, especially if prices have further to fall as Deutsche Bank Analyst Parkus is calling for (his current prediction is that they will fall 40% more).

Before anyone who owns a piece of New York real estate or who bought in the last 3 years decides to jump out of the window, I think I should make a few points. First, New York City is a much nicer place to live now than it was in the late 1980s and early 1990s. Murder rates are way down. There is not a person waiting at every intersection willing to clean your windshield for a few dollars. The gentrification that has occurred on the Lower East Side, Alphabet City and the Upper West Side over the last decade has been astonishing. What this means is that the flight to the suburbs that occurred when the City was a much tougher place to live may not occur this a time, a fact that could mitigate the magnitude of a housing bust. Furthermore, New York still attracts wealthy Americans and foreigners who want to live in such a vibrant city. At some point that demand could also help limit the ultimate fall in prices. In truth, all of these factors lead to the supposition that the fall in prices may not be as dramatic as the doomsday forecasts indicate and that the subsequent recovery in prices may be faster than that of the country as a whole.

Chart courtesy of T2 Partners

The above chart illustrates just how far off the long term trend line US houses deviated from roughly 2000 to 2006. Whether you favor the Lawler or Schiller data, the data indicates that the subsequent depreciation has brought prices back near the trend line. Could prices “overshoot” and go below the trend line? Absolutely. However, as I argue above there are a lot of fundamental reasons why NYC real estate will recover at a faster rate than the national housing market.

Having said that, I see a couple of risks that investors and potential owners of real estate should keep in mind. First, buying the recent dip in housing prices could prove to be disastrous. As many value investors learned in 2008, buying stocks at each dip did not produce the returns that strategy had garnered in previous market downturns. These value pretenders as Seth Klarman calls them temporarily lost sight of intrinsic value and became anchored to previous prices. Just like stocks, housing has an intrinsic value that can be measured. In February, a very smart guy I know named Jeff Bernstein of UrbanDigs posted an analysis of the appreciation in real estate prices in certain Manhattan neighborhoods versus the rise in equivalent rent. He took data from the website of real estate appraiser and consultant Miller Samuel and tried to determine if prices had deviated from an inflation-adjusted equivalent rent value. I will spare you the nuances of the data and you can read more about the way that Jeff went about the process, but I think this chart says it all:

Chart courtesy of Jeffrey Bernstein and UrbanDigs

The chart clearly shows that prices in these neighborhoods have run up at a much faster pace than that of owner equivalent rent. If you look at house prices to owner equivalent rent kind of like a price to earnings ratio on a stock, it appears that the New York City housing market is trading at a lofty earnings multiple and that prices have increased much faster than earnings. Except for an aberrational period during the tech bubble, most stock analysts would agree that history has proven situations like this one to be unsustainable. What this means to me is that even though prices have fallen it may still be very risky to purchase NYC housing real estate. When the apparent high valuation is combined with how long prices have taken to recover on a historical basis, it seems to me that caution should carry the day.

In addition, there is another, almost unspeakable precedent that investors should keep in mind. I can’t even begin to count the number of times I have heard arguments that there is no way the US’s experience during this crisis and subsequent recovery (or lack thereof) will be as severe as the situation that has persisted in Japan from the early 1990s until today. I have no particular insight into whether or not the US real estate and stock markets are doomed to repeat the Japanese experience. I am certainly not an expert on Japan and understand that there are many differences between the two countries and their markets. However, as a value investor I think it is always important to understand the potential downside. So, here is what I see as just about the worst case scenario for New York and US real estate prices:

Chart Courtesy of PIMCO

I have to admit this chart is absolutely stunning. The dramatic rise in real estate prices in the 1980s, the peak around 1991, the equally prolific fall and the complete lack of subsequent recovery provide a horrific case study of what can happen when prices decouple from the fundamentals. In effect, real estate is Japan has not appreciated at all since 1980. Even worse, a person who bought at the housing peak of around 200 on the index in 1991 still looks to be down over 50% eighteen years later. Now, what should a US investor take from this? I think we all need to remember that no tree can grow to the sky and that prices are not guaranteed to return to their previous levels in short order or even ever. Consequently, it is very important for people to assess current real estate prices in terms of historical values and income metrics and avoid becoming anchored to previous prices.

I will conclude this article with some insight from Mark Hanson of Field Check Group (hat tip to Whitney Tilson). Mark writes a blog called Mr. Mortgage Live and seems to have his nose to the ground when it comes to the housing market. In a piece dated June 26th, Mark discusses a recent phenomenon he has seen among owners of mid-to-high end houses:

Because of the epidemic negative equity across the mid-to-high end, a large percentage of high-leverage exotic loans still in place, and the belief amongst the upper-crust (or severely over-leveraged depending upon how you want to look at it) many are resorting to renting vs. selling. In every case, the homeowner or Realtor managing the lease says “we want to wait a year or two until the market comes back”.

Why in the world would there be such an overwhelming sense of hope among the mid-to-high end homeowners that the prices of expensive homes would come roaring back? If not for interest only loans, Pay Option ARMs, stated income and 100% HELOCs the mid-to-high end would have never got there in the first place.

Mark highlights a pervasive optimism that the real estate markets will just jump right back up to their previous highs when the current downturn abates. However, anyone who analyzes the data I have presented would be skeptical and likely believe that this optimism is wholly unfounded. The history of New York City housing prices suggests that it takes many years for prices to reach their previous peaks and that anyone who is waiting to sell until they see a full recovery will likely have to be very patient.

(Image courtesy of wirednewyork.com/real_estate/)