Real Estate's Top Looms
By David Merkel
RealMoney.com Contributor
5/20/2005 8:08 AM EDT
thestreet.com
Real Estate BEARISH
# The residential real estate market today reminds the writer of a milder form of the Nasdaq in early 2000.
# There are 'bubblettes' developing in the hot coastal markets.
# These factors are bearish implications for mortgage insurers and homebuilders.
The residential real estate market today reminds me of a milder form of the Nasdaq in early 2000.
About a year and a half ago, I wrote a piece called, "The Fundamentals of Market Tops". I encourage you to reread that piece before reading this one, because it will give you a framework for how I evaluate bubbles, and I will apply that framework to the residential real estate market. As opposed to my earlier article, I will try to show why there is reason for pessimism and why we are close to a market top in residential real estate.
This analysis, which does not represent the views of the firm that I work for (even though my views of macroeconomics largely represent the firm's views, I don't directly control all of our investment actions), primarily applies to the hot coastal markets, where I believe there are a bunch of bubblettes developing. It does not apply to the nation as a whole, although I do believe that the bubblettes will not pop individually, but as a group, because excess liquidity is the common factor that will eventually be removed. Furthermore, when the bubblettes pop, residential real estate prices in the U.S. will fall for at least one year in aggregate, which would be a new phenomenon (at least since the Great Depression) and have large repercussions for the financial sector.
As a result, I am bearish on all of the homebuilders and the mortgage insurers. The mortgage insurers carry all of the worst credit risks in mortgages. The relevant companies are MGIC Investment (MTG:NYSE - commentary - research), Radian Group (RDN:NYSE - commentary - research), Triad Guaranty (TGIC:Nasdaq - commentary - research) and The PMI Group (PMI:NYSE - commentary - research). (For what it's worth, MGIC is the most conservative of these.)
As for the homebuilders, I don't have a strong opinion on which companies will do the worst. A basket trade on the biggest should do adequately, though smaller firms should be hurt disproportionately. The five largest are D.R. Horton (DHI:NYSE - commentary - research), Pulte Homes (PHM:NYSE - commentary - research), Lennar (LEN:NYSE - commentary - research), Centex (CTX:NYSE - commentary - research) and Toll Brothers (TOL:NYSE - commentary - research).
Treat this trade with care, because I don't believe that now is the time to put it on. Shorting should not be confused with heroism, as heroics erode capital. I will likely short the mortgage insurers at some point, but the homebuilders are trickier because they are consolidating their industry. That said, they own a lot of real estate, and would be hurt if land prices fall. They can be viewed as a bunch of land banks with development arms.
The Investor Base Becomes Momentum-Driven
If you remember one thing from this article, remember these summary comments on bubbles:
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow's growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
This is what I see in many residential real estate markets now: panicked buyers are saying "this is my last chance," and are buying houses using risky forms of financing. At the same time, I read stories of despair as some potential buyers give up and say that a house is out of their reach for now; they waited too long. Occasionally, I see a few articles or e-mails regarding people (who seem to be bright) selling their homes and renting, but this is a minority behavior.
In the face of this, residential real estate prices continue to rise, particularly in the hot coastal markets, which tells me that the price momentum can continue for a little while longer until it fails. And it will fail because there is no incremental liquidity available to expand the local market bubblettes.
Houses Aren't Stocks, but They're Analagous
It's important to remember, though, that houses aren't like stocks for several reasons:
# Unlike stocks, houses are used by their owners every day.
# Also, it is difficult to partially own a home. Home ownership is largely a discrete phenomenon.
# We can short stocks, but we can't short houses. (Personally, I hope no one comes up with a clever way to do so. We have enough volatility already.)
# In principle, there can be an infinite supply of stock, but there is only a finite supply of land.
But given those differences, there are still some analogies to stocks:
# If a home owner gets bearish on residential housing prices, the most he can do is sell his home and rent. Those doing that are missing out on the current price appreciation. Even if they are right, and prices fall, will they fall below the price at which they sold? This to me is the equivalent of going totally flat in equities, or other risky assets.
Not that one faces negative carry, because the ratio of rent to housing prices in the hot markets is pretty low. In many markets, you can earn more off the proceeds than you pay in rent (leaving tax consequences aside). This leaves aside the issue of appreciation/depreciation of housing values, but when one can rent more cheaply than buying, it is a negative for the housing market.
# Perhaps the equivalent in residential real estate of a long-only manager in stocks is someone who owns his property debt-free, like me, and doesn't see the need to lever up by moving up to a larger home. Measured against the standard of "what might have been" is a terrifying taskmaster from an investment standpoint. I avoid it in equity investing, and in home ownership
# My point about momentum strategies is definitely pertinent here. With the existence of contract-flipping, a high level of amateur investment (seemingly under the guise of "buy what you know") and a high level of investor interest (10%+), there is a lot of momentum in real estate investment. People buy because prices are going up.
Some buy because it is "the last train out," and they have to jump rather than be stranded. Nonetheless, momentum tends to maintain in the short run, and the slowdown posited last fall definitely has not occurred.
# The distinction between "value" and "growth" used with stocks does not exactly apply here, but in the housing market, people are paying up for future prospects more than they used to, which is akin to growth investing.
# This is just an opinion, but many of those who are making money in residential real estate today are less experienced and less rigorous than most good businessmen. They see the potential for profit, but not the possibility of loss.
# Using a concept from value investing, we can look at the earnings yield that residential real estate is throwing off. Compare the rents one could receive from a property vs. the cost that it would take to finance the property on a floating-rate basis. What I am seeing is that more and more hot coastal markets earn less from rents than they require in mortgage payments.
Property price appreciation is no longer a nice thing, but is required to bail out inverted investors. Contrast this with those who invested in tech stocks on a levered basis in early 2000; they paid cash out to hold appreciating positions, before they paid cash to hold depreciating positions, before they blew the positions out in panic.
# With respect to land being constrained in hot coastal markets, this is true, but not relevant. A piece of land is not priceless, but is only worth the subjective present value of future services that can be derived from the land to the marginal buyer. When that marginal buyer is highly leveraged, the value of that land can fluctuate significantly, even in supply-constrained markets.
For a parallel, consider pricing in the art market. Many pieces of art are priceless, but the market as a whole tends to follow the liquidity of the rich marginal art buyer. When liquidity is scarce, prices tend to fall, though it is often masked by a lack of trading in an illiquid market.
Pseudo-Corporate Behavior
Discussing corporate behavior in my prior article, I wrote: In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.
Real estate is the same as other businesses; cash generation and disposition govern the economic outcomes of every real estate investment. As a result, the size and likelihood of cash flows to finance residential real estate investment are critical to the valuation of real estate.
# Every time a new home is sold, a privately placed IPO is held, with one buyer.
# With housing, making the earnings estimate means being able to pay the mortgage payment each month. The degree of slack here is less than in the past.
# When rates are low, it is no surprise that the homebuilders try to take advantage of the situation and provide supply to meet the demand. But if it is only rate-driven, rather than from growth in real incomes in the economy, the quality of the new buyers will be low, because now they can just barely finance the house they could not previously. If their income level falters, they will not have any safety margin allowing them to hold onto the house.
# Private investors in residential real estate have multiplied at present. This is akin to an increase in venture capital. They tend to appear in size toward the end of price moves; they help put in the top.
# Leverage for new buyers has never been higher. This occurs through second and third mortgages, as well as subprime mortgages. Interest-only mortgages are commonplace among new mortgages. Beyond this, investor-buyers often hide themselves so that they can get the cheap rates associated with owner-occupied housing.
# Lending crises tend to appear in the areas that have experienced the most dramatic growth over the recent past. That asset class is residential real estate lending. In order to underwrite all of these new mortgage loans, lending standards have been compromised. The Federal Reserve and the Office of the Comptroller of the Currency have noticed this, and they are starting to tighten the regulatory standards.
# When financing expands dramatically in any sector, there is a tendency for the assets being financed to appreciate in value in the short run. This was true of the Nasdaq in the late '90s, commercial real estate in the mid-to-late 1980s, lesser-developed-country lending in the late '70s, etc. Financing injects liquidity, and liquidity creates confidence in the short run, which can become self-reinforcing, as I believe it has in residential real estate today.
# Because of the reliance on hybrid ARMs and interest-only loans, current housing finance is cheap, but not sustainably so. Eventually, principal will have to be paid back, and interest rates may not be so low when the hybrid ARMs reach the end of their fixed periods. Present prices rely on low financing rates and current levels of disposable income. If people had to finance using fixed rates while amortizing principal, over 40% of current borrowers would have debt-service-to-income levels in excess of 50%. Low financing rates and non-repayment of principal are virtually required in order to keep housing prices well-bid.
# Once we get to the hybrid ARM reset dates, which will be coming on fast and furious over the next five years, the payments faced by the 15% or so of homeowners with such financing will increase by over 30%, as rates rise, and principal starts to amortize. Short rates would have to rally significantly to bail these borrowers out. We would need the fed funds target at around 2%.
The Top Is Coming Soon
The Federal Reserve is still a major influence in the housing market. When the Fed is withdrawing liquidity from the system, the price of housing tends to slow down. Like the real economy and the equity market, this is not immediate but follows a six-to-18-month lag. This is another case of "Don't fight the Fed."
The reasons that I gave to be worried in my previous column on equities remain in place in real estate today:
* Valuations are getting stretched in some parts of the market.
* Debt capital is cheap today.
* There is an increasing number of momentum investors in the market.
* Making the earnings estimate is once again of high importance. (Gotta pay my mortgage!)
But there is more that makes me even more bearish:
* The Fed is on the warpath, and liquidity is scarce. And getting scarcer. The only thing maintaining the current level of liquidity is the willingness of banks and specialty finance companies to lever up their own balance sheets in order to lend. Further, the banks and finance companies have lowered their underwriting standards significantly to do so.
* In response to that, banking regulators are beginning to lean on banks to tighten up standards on home equity lending.
* Appraisals overstate the value of property that financial institutions lend against.
* Homeowners have a smaller margin of safety than they have had in the past.
* Leverage has increased for the average homebuyer.
* People are paying more than they ought to for new and existing homes.
I am decidedly a bear on housing prices (at least in the hot coastal markets) at present, but I recognize that momentum can carry prices far beyond sustainable levels. That's the way markets work.
And that makes me bearish on those who build homes, and those who finance them, or retain the risk of financing, like the mortgage insurers.
We are at an unsustainable place in the ability to finance the residential housing market. Either an increase in interest rates or a decrease in ability to pay for housing can derail the market. This is the inflection point that we will come to over the next year or two. It is probably premature to be short now, but the time is coming when it will no longer be so. As for the momentum now, we are simply building a batch of bigger, badder bubblettes. Honor the momentum, and be careful. |
