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
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:
This chart shows the progression of
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
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
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
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
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
(Image courtesy of wirednewyork.com/