The Conjoined Twins of Real Estate
by George J. Paulos
August 30, 2002
The hottest topic in money these days is undoubtedly real estate. In many areas of the United States, residential real estate has
enjoyed double digit price increases over the past several years. The outstanding performance of real estate has been in stark contrast
with the devastation in the stock markets. Many market pundits are now lining up to proclaim real estate a “bubble” that is about to
deflate with serious consequences for consumers and the economy. Understandably, most real estate industry sources contend that real
estate is now achieving fair value after years of relative underperformance and is likely continue strong performance because of
supportive demographic trends. Almost everybody would agree that real estate is one of the core engines of economic growth. Since the
start of the recession, residential real estate has been just about the only bright spot in an otherwise dismal economic story. As any
realtor will tell you, all real estate markets are local, but all local markets are heavily influenced by macroeconomic conditions such as
interest rates and demographics. In this article we will use those macroeconomic factors to evaluate residential real estate as an asset
and speculate on its fate.
The Home as a Financial Asset
Property assets can be divided into three distinct categories: undeveloped land, owner-occupied, and rental. Each has specific financial
properties and must be evaluated in the appropriate way.
Undeveloped or raw land is a capital gain asset. It is purchased with the intention of either developing it or selling it in the future at a
profit. Raw land is easy to hold. It requires little or no maintenance and has negligible carrying costs (taxes on raw land are usually very
low). Raw land typically generates no income (farm land can be considered developed) so the only way to profit from raw land is to sell it
for a profit. Raw land for resale is typically a very long-term investment. Many fortunes have been made by purchasing lands in areas just
outside cities and waiting for growth to extend city boundaries into to undeveloped areas. But this may take decades and there may be
more productive use of those funds in the mean time. Raw land investment must be evaluated in terms of the potential capital gains on
the future sale of the property versus the opportunity cost of tying up that capital for many years.
As opposed to raw land, rental property is a cash flow asset. All developed property has carrying costs. These include maintenance,
insurance, property taxes, financing, etc. These costs are relatively fixed and unavoidable. Most rental property carries a mortgage. The
mortgage creates leverage that allows the property owner to utilize a relatively small amount of capital to purchase expensive rental
property. The mortgage is usually the largest fixed cost in a property. A good rental property generates cash flow in excess of its carrying
costs. Some owners purchase properties that have carrying costs in excess of rental income. This is negative cash flow and is very
dangerous. These owners are speculators who are expecting the price of the property to rise over the near-term so it can be resold to
another speculator for a profit. If the price does not rise, these owners are in a difficult position. They are stuck with an overpriced
property that is draining capital and is typically either sold at a loss or allowed to foreclose. In rental property, the bulk of profits are
expected to be from cash flow, capital gains are an added bonus.
Owner-occupied real estate incurs all of the costs associated with any other developed property. All of the maintenance, insurance,
taxes, and financing costs incurred by rental property also apply to owner-occupied property. However there is no corresponding income
generated from the property to offset those costs. Owner-occupied real estate is a pure expense. Whether rented or owned, housing
always costs money. If it costs less to own a home than to rent a similar property, then it makes sense to own. Of course, a primary
residence is much more than a cash flow device. For most homeowners, their property has value far in excess of its market price. Many
nonfinancial factors enter into a decision to buy or sell a primary residence. Quality-of-life factors may lead some people to pay premium
prices for homes regardless of the financial considerations. That said, an owner-occupied home has many valuable financial
characteristics. It offers tax shelter due to the deductibility of home mortgage interest. It also represents collateral to a lender which
allows the owner access to low-cost credit that may also be tax-deductible.
Most homeowners expect the market value of their property to rise over time. Higher real estate values give homeowners a sense of
wealth that is often reflected in a greater propensity to consume. This home equity “wealth effect” is credited for keeping consumer
spending healthy during the recent economic downturn. This feeling of enhanced wealth is somewhat misplaced. It is true that higher
real estate values can be easily tapped and spent, but this does not mean that homeowners have greater real wealth. People always
need somewhere to live. If a homeowner attempts to capture the capital gains in a primary residence by selling it, that person must find
another residence at equally inflated prices. To realize net positive cash on the sale of a primary residence, the homeowner must
purchase a less expensive replacement home, rent a residence, or go deeper into debt. All of these cash-out options imply a lower
standard of living.
The economics of home ownership is clear. Although homeowners experience a healthy increase in their nominal net worth over time,
any attempt to use that wealth for other purposes will result in a lower standard of living. At best, a primary residence is an excellent
hedge against inflation. It is not a good source of capital gains. Any gains realized from the sale of a primary residence will
usually be consumed by its replacement. Furthermore, any use of debt to exploit increased home values for consumption will increase
debt load and deteriorate personal balance sheets. The home equity wealth effect certainly exists, but is based on faulty beliefs.
Demographics
Demographic trends have been identified as a primary driver of higher real estate values. These demographic trends include immigration,
millions of Echo Boomers (children of the Baby Boom generation) entering the housing market, transfer of wealth to the Baby Boom
generation from their aging parents, and social trends such as single-occupant households. It is true that demographic trends have
been powerful sources of housing demand in the past, but will they continue to be so in the future?
Immigration has certainly been an important source of housing demand. The huge wave of immigrants into the US from all over the world
during the 1990’s has consumed a large amount of housing. This could be identified as major cause of real estate inflation during that
period of time as more and more people bid for a limited supply of housing. However, it is difficult to believe that this influx of immigration
will continue far into the future. Immigration is likely to become a hot political issue in upcoming election campaigns as nationalism rises
and competition for jobs becomes more intense. Defense against terrorism will also mandate stricter immigration policy and fewer visas
granted. In short, immigration will almost certainly be less potent as a source of housing demand in the future.
The children of the Baby Boom generation are now coming of age. They will leave their parents homes to form new households by the
millions and comprise the bulk of future demand for real estate. This new generation has already been given unprecedented access to
capital for purchasing homes. It is not unusual these days to have young people buying homes right after starting their first jobs out of
college. Many young people, however, relish their freedom and choose to rent for long periods of time until they decide to settle down
and have families. This may delay household formation for as much as a decade for these free spirits. Since a large number of young
adults already own homes, future demand from this generation will be weaker because it is already partially spent. The Echo
Boomers segment will continue to be strong homebuyers but probably less than anticipated.
The Baby Boom generation will be the beneficiaries of the greatest transfer of wealth in history as they inherit the assets of their parents.
These assets will typically include the parent’s home. People who inherit significant wealth typically use some of that wealth to enhance
their standard of living, which may mean upgrading to bigger and better homes. On the surface this would seem like a big boost for
luxury home sales. But on careful examination, inheritance is actually a net negative for housing in general. Take this example of a
typical family of elderly parents and two grown children. The parents will most likely own a home, as do the grown children who probably
have families of their own. When the parents die, they will leave the home to the children along with whatever other assets remain. One
of the children could take over the parent’s home or else it will be sold. Both children may decide to sell all of their homes and take the
money to purchase bigger residences. Any way you look at it, one additional unit of housing will enter the market after the parents die.
This is an increase in supply without a corresponding increase in demand, which is a net negative for the housing market. The transfer
of wealth to the next generation by inheritance always means a net increase in housing supply and will never be a positive force
in the real estate market.
The housing market has benefited from a long-standing social trend of independent living that has resulted in fewer occupants per
household. This is partially due to smaller families but also because of many affluent single men and women who now own homes
independently. Most of these people at one time lived with roommates but became affluent enough to live alone and pay a mortgage.
Fewer occupants per household means more housing is required and this trend is one part of the long-term increase in housing
demand. It is relatively easy to imagine many of these people abandoning solo living for any number of reasons. Difficult economic times
and long-term unemployment may force some into bringing in roommates or borders to help pay the bills. Many people may decide to live
with aging parents to help with home care or just share expenses. Many people may simply decide that it is not pleasant to live alone
and bring spouses, family, or friends into their homes. Social trends can reverse quickly, even long-standing ones. There is anecdotal
evidence that this is already happening as economic recession drags on. A major social trend change that results in more occupants
per household would dramatically reduce demand and be quite negative for real estate prices.
One of the most ballyhooed statistics in real estate is the percentage of homeownership among the eligible population. It currently
stands at a record 68% of adult US population. This same statistic proves that most of the demand for owned housing has now been
satisfied. One cannot assume that all of the remaining 32% will ever purchase a home. Many people prefer the mobility of rental, and
many others will never qualify. This leaves the smallest percentage of the population ever as potential new homebuyers. Economically,
this means little latent (unsatisfied) demand left in the market, another negative for home prices.
Many of the demographic trends that have supported rising real estate prices are in danger of reversing. If even just one or two of them
reverse, prices may decline. Demographic trends are getting weaker as a source of housing demand and will reduce upward
pressure on home prices.
Modern Mortgage Finance
The vast majority of people purchase homes by taking out a mortgage. Few have sufficient liquid capital to purchase a home with cash.
Even for those who do have the money, it is often advantageous to use low-cost, tax-deductible mortgage financing to purchase a
residence and deploy their cash into more productive uses. Mortgage financing has allowed anybody of modest means to become a
homeowner. The availability and cost of credit is the single most important economic factor in the real estate market.
Traditionally, most mortgage financing came from banks or savings&loans. These institutions created pools of money collected from
depositors that were then lent out to homebuyers. Lending institutions carefully evaluated each mortgage applicant to ensure that there
was a high probability that the person would be able to complete his or her mortgage commitment. As with any other loan, a mortgage
application would be evaluated on the basis of the 3 C’s of Credit: Collateral, Capacity, and Character. In a mortgage loan, the collateral
is the home itself. To confirm collateral, lending institutions hire independent appraisers to confirm that a home has sufficient market
value to cover the loan in the event of a foreclosure. Capacity is the applicant’s ability to make payments. Capacity is usually measured
as a percentage of disposable income available for mortgage payments. Character is a measure of the applicant’s payment reliability.
Past payment histories are used to validate the borrower’s character. Lending institutions were always very careful to fully qualify
mortgage borrowers to reduce foreclosure risk. Foreclosure is one of the biggest risks in holding mortgage assets.
Banks and S&Ls typically held mortgages for the life of the loan as a part of their asset base. A solid portfolio of mortgage loans was
considered to be a reliable but slow-growing revenue source for lending institutions. The late 1980s were a very turbulent time in the
banking business. A major crisis developed in the S&L industry after aggressive lending to commercial real estate market went sour.
When the commercial property market became overbuilt, prices collapsed, taking many institutions down with it. The cleanup of the S&L
mess fundamentally changed banking and the residential mortgage business. Most S&Ls were closed and banks shifted to higher
growth revenue sources. Looking for higher returns, banking institutions were less interested in carrying mortgage loans on their books.
So they invented new forms of mortgage finance that allowed existing mortgages to be packaged and resold into financial markets as
fixed income securities. Instead of carrying mortgage loans, most financial institutions now just originate the loans and then resell them
to investors as mortgage-backed securities, reaping huge fees.
There are many forms of mortgage-backed securities. Ginnie Maes, CMOs, REMICS, and dozens of other exotic financial instruments
represent the majority of today’s mortgage finance investments. The largest issuers of mortgage-backed securities are the so-called
GSE’s (Government Sponsored Enterprise) Fannie Mae and Freddie Mac. These are publicly-held corporations with a special
government charter to provide mortgage financing for new and low-income homebuyers in exchange for special privileges. The GSE’s
now control the largest share of the mortgage-backed security market and have total assets in excess of $2 trillion. The GSE’s are
controversial and have extremely complex structures. Credit analyst Doug Noland has written extensively about the GSE’s in his
excellent “Credit Bubble Bulletin” and clearly describes the many risks in the GSE system. (The Credit Bubble Bulletin is published for
free on the Internet, see the link at the end of this article.) Mutual funds, pension funds, insurance companies, and foreign investors are
the largest purchasers of mortgage-backed securities. Most of the mortgage money in the United States comes from these sources.
Mortgage-backed securities are attractive to investors because they provide relatively high interest rates along with the perception of low
risk. This perception of low risk is critical to the functioning of the mortgage-backed security market. Should the GSE system become
shaky, this source of mortgage funding could dry up causing a significant rise in interest rates.
Investors in mortgage securities receive the interest payments from homeowners. Mortgage brokers receive commissions from the loan
origination fees. Mortgage loans are typically originated by third party brokers who perform all of the paperwork required to make
mortgages conform to the requirements of the securities markets. Mortgage brokers receive fat fees for bringing in business. Unlike
traditional bank financing, mortgage brokers have no need to worry about a borrower’s ability to pay; they only receive fees from a
successful mortgage application. This separation of risk between mortgage brokers and mortgage holders creates a conflict of interest. It
is in the interests of the mortgage broker to make the borrower look as good as possible to the finance market in order to make a
successful loan, regardless of the borrower’s real credit status. If the borrower defaults on the mortgage, the broker is not at risk and
gets to keep the commission. It is the holder of the mortgage-backed security that accepts the default risk. Partly as a result of this
conflict of interest, lending standards have gradually deteriorated over the last decade. It is now possible to qualify for no-money-down
financing and payment load of over 40% of income, something unheard-of as little as ten years ago. Many observers link lowered
lending standards to price inflation in entry-level homes because many more marginal borrowers now qualify for mortgages, which
creates additional demand. This may or may not be true but if lending standards were tightened, many people would be instantly
disqualified from the housing market causing a dramatic reduction in demand and corresponding price declines.
Lowered lending standards would normally imply higher risk and a higher interest rates to compensate for that risk. But under the
moniker of “Government Sponsored” the GSEs have been able to sell mortgage securities with the implication of a government
guarantee. There is no language in the GSE charter that specifically grants government guarantee to their lending activities, but the
marketplace has collectively assumed that no government administration would allow the huge GSE system to fail. This assumption is
reasonable considering the past US history of bailouts and the politics of home ownership. GSE’s have a relatively small capital base
relative to liabilities. It would not take a large number of defaults to make the system insolvent. A meltdown in the GSE system would be
highly disruptive, with the US taxpayer ultimately stuck with the bill. To their credit, the GSE’s have been responsible for granting home
ownership to millions of families, but at the cost of greatly increased systemic risk in the financial markets.
Conjoined Twins
The residential real estate market is not just homes, it is a highly co-dependent marketplace that is joined at the hip with global credit
markets. Contrary to popular belief, real estate and its conjoined twin the mortgage-backed security are not risk-free investments.
Like conjoined human twins, illness in one twin will almost certainly affect the other. Risk in the real estate market leaks into the mortgage
market and vice versa. The two markets share a delicate circulatory system of money and credit. This cash lifeblood is entirely dependent
upon the perception of very low risk in the property markets.
The perception of low risk in real estate has been cultivated from decades of almost uninterrupted inflation in home prices. General
declines in home values don’t happen very often, but they have occurred. Many of the long-term demographic trends that have driven
home prices are now starting to flatten out. Therefore, it would be difficult to imagine double-digit price gains continuing into the distant
future. No matter how low interest rates go, home prices cannot outpace income gains forever. The best possible scenario for buyers,
sellers, owners, and lenders alike would be a flattening out of the market and a return to home price inflation that about equals the
general inflation rate. With inflation and interest rates at 40-year lows, this would be a difficult equilibrium to maintain. If the inflation rate
goes negative (deflation), the highly leveraged real estate market could easily shift into reverse. If interest rates tick up, real estate will be
negatively affected. A flat real estate market in this environment would be sitting on a knife-edge.
The greatest risk in the real estate market may be the market itself. High price momentum markets tend to become dependent on
their own price increases. If price increases slow down for any reason, speculators will exit, making the market even weaker. Momentum
markets are inherently unstable. If upward price movement stops, then prices will reverse course because premium pricing only applies if
the price keeps rising. Widespread home price declines would increase risk in the mortgage-backed security market, which in turn would
increase interest rates and further accelerate weaknesses in the property market.
The consequences of even a modest decline in average home prices would be serious. So many industries are dependent on real
estate (construction, landscaping, remodeling, furniture, lumber, appliances, municipal governments, etc.) that a slowdown might become
self-reinforcing and cause a widespread economic decline. A general home price decline will almost certainly lead to higher foreclosure
rates. Most people would work hard to keep their homes, even if the market price declined below the purchase price. But there are many
highly indebted homeowners with little or no equity who could be forced to sell into a weak market. If the home sells for less that they
owe, these people would be liable for thousands of dollars at the closing table. Few people would pay to sell their homes, the only
alternative being foreclosure.
If widespread price declines do occur, different regions would experience markedly different performance. All property markets are local
and each area would respond to these challenges in different ways. The most vulnerable markets would certainly be areas with the most
indebted homeowners. New housing developments, condos and townhomes, or high-turnover neighborhoods with lots of recent buyers
would probably experience the highest rates of foreclosure. Recent buyers typically have the highest debt levels and cost bases. High
foreclosure rates would depress prices even further as these neighborhoods gain a “distressed” reputation. Homeowners with high equity
and manageable payments who live in established low-turnover neighborhoods would fare the best. A small decline in market price
would make little difference to longtime resident homeowners who plan on staying put. Some regions may even benefit from the exodus
of wealthier people out of distressed areas.
Although real estate markets are local, the mortgage-backed security market is global. Foreigners are among the largest holders of
US mortgage-backed securities. Offshore financial institutions receive hundreds of billions of dollars as a result of the massive US current
account deficit. Since the US imports much more than she exports, foreigners receive boatloads of dollars for their goods and those
dollars must be reinvested in dollar-denominated financial assets. US mortgage-backed securities are preferred by foreigners because
they are plentiful and offer high risk-adjusted return. In a supreme global irony, the profits from excessive US material consumption are
recycled right back into low-cost mortgages that allow US consumers to purchase bigger and better homes. Obviously, foreign investors
represent another big risk factor in the real estate market. Widespread international tensions make foreign investment very uncertain.
Should the flow of international dollars into mortgage securities falter, interest rates would rise with deleterious effects on real estate.
The popularity of mortgage-backed securities in international finance means that homeowners are inexorably bound to global financial
institutions. This dependence actually creates a stabilizing influence. With so many powerful interests exploiting the home equity game, it
is difficult to imagine anyone deliberately trying to undermine it. It is likely that corporate and government entities will do just about
anything within their power to maintain home prices. But it is not clear that they have the power to reflate a highly localized real estate
market should prices decline sharply.
The conjoined twins of real estate are a delicate entity that can be injured by any number of internal or external forces. Ordinary
homes play a sophisticated game with the most powerful financial institutions in the world. The complexity of the system makes it very
difficult to make reasonable predictions, but the sheer number of major risk factors makes it likely that a trend change is coming. This is a
worrisome situation in an economy that has become dependent upon unsustainable home equity wealth effects for growth.
© 2002 George J. Paulos |
