“Well, real estate is always good, as far as I'm concerned.”
— Donald Trump
“If we all worked on the assumption that what is accepted as true is really true, there would be little hope of advance.”
— Orville Wright
Just five or six years ago, there was near universal agreement with the Donald Trump quote above. The significant equity market swoon, from 2000 through 2002, left investors questioning whether equity markets could produce returns commensurate with the high volatility. Housing prices, on the other hand, bucked the trend and showed remarkable strength in “all environments.” Of course, we know what happened next.
Financial markets have a unique knack for inflicting the most pain on the most people. Bubbles form when improving sentiment leads to investor herd mentality, resulting in overcrowding and frothy valuations. Then, on no day in particular, the tide turns, undermining the argument that brought the masses in the first place. Orville Wright likely knew nothing of the financial markets, but he definitely understood the problems with herd mentality. If only the same could be said of investors...
In contrast, I doubt Mr. Trump's quote is a deep reflection on crowd psychology, group think or any attempt to stand apart. Rather, it reflects his predisposition to real estate and self-promotion, and I would doubt that he has changed his tune, despite the recent experience.
For the rest of the investing population, however, real estate is not seen as such a constant investment opportunity. In fact, many have become quite disconcerted and assume prices will not recover for some time. The question now is, "Has the crowd gone too far?"
Housing Stress Remains…
Currently, there are roughly 2 million mortgages already in foreclosure, and another 1.5 million are more than 90 days delinquent. This avalanche of non-performing loans and the litigation surrounding them has stymied bank lending, despite claims otherwise. In turn, transaction volume is light and mostly comprised of distressed sellers. These distressed sales both indirectly and directly place pressure on housing prices: directly, as sellers accept steep discounts and indirectly, as these discounts influence appraisal valuations across the board. It is not uncommon to hear of a failed home purchase where the appraisal fell short of the value needed for the loan application.
For numerous reasons, including American idealism, the early years of this century ushered unqualified buyers into home ownership. However, as recently demonstrated, reality imposes certain limitations on this notion, and home ownership is now reverting back to historical norms.
…But Current Valuations Provide an Opportunity
While the stress has not been completely removed from the system, today's housing prices provide a meaningful opportunity for the patient investor. Median home prices have historically exhibited a strong relationship with median household income. Although this relationship became quite stretched during the real estate bubble, it has since reverted to fairer, even attractive, levels.
Historically, there has also been a strong relationship between the costs of renting and owning a home. Logically, one should be the alternative to the other. Again, this relationship faltered during the housing bubble. Appreciating home values drove an ebullience that led many to purchase rather than rent based on the expectation of future home price gains. Recent calculations show the cost of renting now exceeds the cost of ownership by 14 percent, the widest it has been in two decades.
Improvement at the Margin: The Supply Side
The housing market and the mortgage market, in particular, remain under pressure. Yet, under the hood, this stress appears to be lessening. Mortgages that were previously 30 to 60 days delinquent are trending away from further indebtedness, and obligations are being repaid. The level of 90-plus day delinquencies remains elevated, but the direction is materially more positive. While many homes remain either seriously delinquent or in foreclosure, 2012 may mark the peak of distressed housing sales. Based on the number of 90-plus day delinquent loans, current foreclosed properties and a projection of the path of shorter-term delinquencies, Moody's Analytics recently issued an outlook that calls for a steep drop-off in distressed sales over the next few years.
This more constructive housing outlook is further supported by the ratio of home inventories (including existing, new and foreclosed homes) relative to total home sales. The excess inventory built up during the real estate bubble has been gradually worked off, both through home purchases and a lack of new construction.
Investment Strategy: Broad Implications and Some Narrow Opportunities
If these positive trends continue, housing could gradually transition from a headwind to a tailwind. Residential fixed investment, the component of GDP that represents housing-related spending, accounts for approximately 2.5 percent of our nation's GDP. In more normal economic recoveries, as seen in 1977, 1985, 1993 and 2004, this segment would experience a strong snap-back, typically 10 percent growth per year or better. Since mid-2009 however, residential fixed investment has been essentially flat, a reflection of the difficult environment for home construction and an overall economic drag. A return to even 5 percent growth would add approximately 0.1 percent to GDP growth.
Perhaps more importantly, housing-related jobs, which had been in a freefall since the beginning of 2006, finally appear to be inching in the right direction. It has been a long slog, but perhaps the tail end is in sight. This transition from headwind to tailwind should provide some support to ongoing economic and perhaps more importantly, employment growth, thus re-enforcing recent positive developments.
Jason Pride is the director of investment strategy for Glenmede.
