Most people are attracted to real estate because they perceive it to be a high-powered game. They envision building empires the way that most of us have done on the Monopoly board. People like real estate because it is a sexy investment. FULL ARTICLE by Fred Buzzeo
Source link: http://archive.mises.org/15296/the-allure-of-real-estate/
The Allure of Real Estate
Previous post: The College Football Conundrum
Next post: They Chose Liberty
{ 29 comments }
I see the biggest problem in the fact that real estate is overbuilt. I’ve read that it’s estimated that there are enough empty homes, apartments, and condos to satisfy an additional 100 million people we don’t have living here. With the rate of population growth, it may take 40 years to work through the existing oversupply. Certainly, the construction industry is going to be dead for a very long time while the backlog is slowly reduced. Additionally, I don’t see how we can realistically call home resales productive activity that should contribute to GDP. Constantly shifting around existing assets without any productive output isn’t a sign of a strong economic system, it just shows that people are moving around.
Contribution to GDP isn’t really that relevant – if someone goes from a tiny apartment to a single family home, where their lives are better every day, AND that they can afford, that’s what matters. But, of course, you are correct about malinvestment in real estate and people wanting the next bigger house just to have it.
I was not referring to resales as productive activity. Although, there is statistical evidence to suggest that when people move, even to an existing home,that also spend money on a new car, furniture,and contractors to fix their “new” used home.
New construction is certainly a”capital” industry and is so classified.
The Austrians like to point to the 1920-1921 recession, and it’s brevity, as proof that the free market works to bring an end to these economic downturns. But we also hear from the Austrians that the 1920′s were a period when the early Fed was pumping up the money supply, eventually causing the great depression. So which is it? Did the pump end the early 1920s recession or did the free market? Or was it a combination of the two?
I hear that often. I would love to hear an explanation or be pointed to a relevant rebuttal. I prefer to use the recovery from the Panic of 1837 to make my case.
The crash in 1920 and 1929 were both caused by the same problems. What Austrians like is the government response in 1920 – slashing government spending 50% and wholesale eliminating entire regulatory agencies. The Great Depression wasn’t caused by the pumping of the money supply, it was caused by the uncertainty of the Hoover and Roosevelt administrations that constantly experimented with everything.
J. Murray,
You are spot on with your explanation. I would also add — perhaps an extension of your explanation — that protectionist economic policies were heavily detrimental to trade. Yes, thanks to the Smoot–Hawley Tariff and other regulations in other countries, trade simply broke down.
As for what Dave and Jim are getting at, well, the crash itself was largely spawned out of the Fed’s actions during the middle of that decade. The reason this crash morphed into the worst depression in recent memory is that the actions of the government were not only inhibitors to economic growth and well-being, but these actions also created what economist Robert Higgs has decidedly referred to as “regime uncertainty.” In short, the respective congresses, the Hoover administration, and the Roosevelt Administration successfully created a business environment that was so poor, volitile, and unpredictable that many businessmen and entrepreneurs simply were unwilling to invest or risk their capital.
When you add it all up, these many entities helped create deplorable economic conditions; however, it was certainly the Federal Reserve that started it all. FDR, Hoover et al simply took the crash and transformed it into something far, far worse.
Letting the real estate market work its own way out of its problems is very solid thinking.
HOWEVER, there is one major fly in the ointment: state and local governments, which have been spending like drunken sailors based on the absolutely unreal increase in appraised value of real estate over the past 10 years or so. They were quick to raise appraised values, but they will drag their feet every way possible when those valuations OUGHT to be declining, and they will fight like tigers to keep any- and everthing that maintains the high valuations.
There is no doubt that state and local governments have been spending like drunken sailors. However, tax revenue does not automatically increase when vauations increase. Local governments issue a levee for the amount of money they wish to spend, the county treasurer divides the levee by the total assessments to get a tax rate, which he applies to each individual parcel. If property values increase, but governments do not increase their levees, the tax rate goes down and the dollar amount of property tax bills is unchanged. The problem is not primarily one of local governments spending a windfall of revenue from increased valuations, but rather one of local governments just spending too much.
Excellent article Fred and I also liked your previous article on commercial real estate. I, however, do think that single-family homes are reaching a “bottom” in general. Of course, home markets and values are not homogenous considering both location and price level. The compression of values started as the bottom fell out and has been working its way up the food chain to high-end homes. The low-end home market is likely at a bottom and the stuff in the middle is getting there, while the high-end home market is still catching up. Basically the stuff that was over-built the most (high-end) had the farthest to drop.
The low-end home can now be purchased and rented out at a rate that provides a profitable return to small investors. The flippers are gone, but the old-fashioned rental property model is alive and well with more renters coming down the pike as they get foreclosed on. High-end homes don’t provide this escape hatch and will continue to drop in value. This means that indexes showing price averages will continue to be skewed even after most of the market has hit bottom. The banks have not and will not unload their massive inventories because it would undermine their remaining REO portfolios as well as the incentives of people still paying their mortgages. But the banks will begin to lend again as they steadily sell off their inventory causing a rejuvenation of the “animal spirits” along with the multiplier effect of all these massive bank reserves. These changes will bring about another credit money expansion and illusionary boom that will be described as “back to normal” on the way to possible hyperinflation. Real estate is one of the few commodities that can provide a cash flow, so will return to favor more quickly than is believed by many.
The number of existing foreclosed homes is large and may continue growing for some time longer, but in the end this number is finite while the amount of credit money pumping can approach infinity. Eventually irresistible forces with infinite resources overwhelm immovable objects with finite resources. It’s always a good time to buy (low) an investment with a positive cash flow with the potential to see significant value increases on the horizon. We may not agree with the wisdom of money pumping, extend and pretend policies, etc., but don’t underestimate the ability of bankers to do it all again using the same smoke and mirrors. They should be careful what they wish for though.
Thanks, Mark. I agree. The higher priced market is where most of the building and speculative activity took place. I think that these high end homes are still overpriced. The lower priced homes are probably closer to a “bottom.” Also, we are in line with the bankers. The last speculative housing boom was in the 80s. It took the bankers about 10 years to forget. By 2000, they were making it even easier to secure a mortgage than it was in the late 80s. They will do it again. There is a lot of money to be made processing all those loans.
Fred
Some people have learned from this bubble. Bigger is not better. Free and clear with property taxes that amount to pocket money is better.
Yes, we have 10.5 months supply of houses, but that is based on current consumption. Just a slight increase in sales off these low levels will cut that number rapidly.
Next, please don’t base the current state of real estate on the Case Shiller, it is a backward indicator. You get October’s data late in December.
I find it interesting that it is hard to find a good deal in the short sale and foreclosure market. You have the ability to recognize value and is smart enough to pass on these deals, whereas the majority of the buyers are just looking at the price which in many cases is not a great deal. In my area I can build a house for less than most of the foreclosed deals, yet people buy the foreclosed house.
So far this quarter, builders are beating expectations on earnings. Lumber prices have increased 20%. And current pending home sales have continued to increase since the October low, even during the slow holiday sales season. Basically, the current indicators I watch have the construction industry making a turn. Furthermore, my basket of construction stocks have beat the current rise in the S and P.
What you have today is a group of buyers, fed by the media, trying to buy at the bottom. The truth is only a very few will catch the bottom and most will be surprised how fast prices move up.
For me, we may not be at the bottom, but I see very little downside risk.
I don’t usually agree with Jim Cramer, but he just finished saying most of the points I just made.
HiGreg:
I am not suggesting that peopel buy at the bottom. No one can determine when we really hit bottom. That is one of the points that I was trying to make. I would rather buy on the way up. Why buy at the bottom and hold on to a non-performing asset. However, inventories are still high in many markets, Miami for example. In addition, there are stil a number of homes underwater and still no significant job growth. This is not what you need for a strong housing market. But real estate is still basically a local business and different markets will show different signs of strength and weakness. Also watch out for strong growth in commodity prices. If they go up, will you be able to pass on that cost increase? In a market with little pricing power, an increase in commodity prices does not seem beneficial to me.
Do youthink this will be the end to real estate bubbles. Seems to me that it is a recurring cycle: people forget, bankers become more creative, and the next thing you know everyone is talking about a real estate bubble. I saw this in the 80s and the same scenario played through in 2006.
In the last two years we have purchased 8 properties. Of the 8, 6 have been sold and 2 are under construction. We are a small business focused on providing quality housing, located in good school districts, to the first or second time home buyer market. Here is how we are making it work: Locate a property that a retail buyer will not buy. We then structure the deal to acquire the property using someone’s IRA. The IRA must be placed with a custodian (Equity Trust or similar). The IRA makes a loan to our company to buy and improve the property. The IRA has a first mortgage position in the property. If something goes wrong, the IRA forecloses and sells the property. After the property is improved it is listed for sale. Upon the sale, the principal plus interest is returned to the custodian FBO IRA. We keep the profits for our business. So here is the financial side: The realtor who brings us the deal makes a commission when we buy the propety; the IRA loaning us the money makes a return (8-10% simple interest), the contractors who work on the job make a paycheck, the suppliers make sales on the materials and a realtor makes a commission on the sale. The buyer receives a nearly new house at a very favorable interest rate. We pay taxes on the profits and start all over again. This is our only source of income so we have to make it work. I realize this is a very small % of the market but I thought someone should say people are still making real estate work.
So instead of mortgage banks providing capital, it’s schleps with IRA’s. Nice.
Not sure what you mean by that comment. Mortgage banking is traditionally done for the take out loan not the construction loan. Construction lending is done by banks but they really are not looking for real estate construction loans or at least not the ones that I spoke with about our business. The end buyer had a mortgage to buy the house so thanks for reminding me about them.
Wayne, thank you for working to create winning situations for you and your investors and actually doing something to improve the economy. Ignore the static and keep developing these creative and ethical methods to buy, rehab and sell. I also educate my investors on the possibility of investing with me in my real estate ventures by utilizing their self-directed IRA funds and I know many more who do the same. Real estate is just numbers, and there are some very good numbers out there today as you and your investors (as well as mine) have discovered.
Construction lending is done by banks but they really are not looking for real estate construction loans
Good point. Banks are obviously overlooking the great opportunities in new construction, considering how under-built and under-priced the US housing market is. The people you get to turn over their IRA’s to you are gonna clean up. The thought had occurred to me you’re squeezing a commission out of the final suckers left to fleece but I’m sure that’s not the case.
It’s not new construction; it’s renovation or rehab financing. FHA has a program for OO’s who want to do it themselves but you have to use their approved contractor and the amount of improvements are limited to $35K (in our market). As for those with the IRA’s, the investors don’t turn over anything, they simply make a loan from their IRA. The term is for less than one year with the option to pay it off sooner. They receive simple interest calculated as follows: [principal amount multiplied by interest rate] divided by 365 and then multiplied by days outstanding. There isn’t a commission associated with the deal.
but how many of the actual stock is really on sale?.In real state you are willing to sale when you think you make a good deal,other sales are forced ,seeking-for-cash ,because you’ve borrowed to the hill.Otherwise,and that’s the point with past real state downturns,you just take out the stock from the sale list or just put a non-sense price(that is the same).I think that forced sale due to borrowing are already done because of high LTV ratios, those were made quickly in real state time-terms.Who is “really” selling now?.There’s a sort of “rigidity” in prices on the supply side.You don’t have a factoy of houses,if you sale what do you do with the money?.Buy raw land?.
REO investing became so popular due to the 10-25 percent return for the average ‘investor’. Without a vibrant RE market there is absolutely no way anyone earning $50k-$80k/yr can save enough money for retirement. Inflation eats up the 401k/IRA gains.
You can’t have it both ways, Fred: you can’t, on the one hand, plead for no interference in markets by politicians (whose only objective is to get re-elected) and on the other, say that real estate prices are too high. The latter is a judgmental; it suggests that really, in your heart of hearts, you feel that a “correction” should be made. Prices are set by the market and they, therefore, are what they are – merely one factor in the decision-making interplay between buyer and seller. And, just as the law doesn’t allow contracts to be impacted by non-signatories to that contract, the non-signatories have no business interfering in that contract.
Wouldn’t it be great, though, if it were acceptable for the government to interfere? I’d make sure every contract I sign abrogates its risk to the government and I could go on making profits!
Whoops, I just realized – that’s what happened, isn’t it?
Hi Bill: Not sure of your point. Prices are too high- that is judgemental. All investment decisions are judgemental. Building a rate of capitalization is judgemental. An acceptable return to you may not be acceptable to me. A class of investment may be acceptable to you but not to me. In addition, I am not seeking any government action. I am simply making the point that you can not stop the inevitable. No matter what policies are inacted, prices will be soft until people have jobs and money to spend. The only way to a strong real estate market is through strong job growth- a situation necessary to have willing and able buyers.
Fantastic article. It was refreshing to read it knowing that it came from someone in the industry who works with people in real estate every day. Thanks Fred. The Canadian Real Estate Market seems to be still defying the laws of gravity.
William
Thanks William. The US market also defied gravity for some time. I am not familiar with the Canadian market. But reality always sets in at some point,
Fred
Hi, Readers
Want a Career in Real Estate? Why Not Mortgage? Why not Both?
Spencer School of Real Estate can help Spencer is the Nations Largest Real Estate School with Locations in Every Major US City. So Check Spencer out today at http://www.spencersschool.com and get started on your Real Estate path today!
Comments on this entry are closed.