Mises Daily Articles
The Allure of Real Estate
These days everyone is sitting at the edge of their seats waiting for a real-estate recovery. Indeed, during the past ten years, everyone has become a real-estate addict. It is hard for me to walk down the street without someone telling me that the market has "hit bottom" or that the market is on the "rebound."
Do I know anyone interested in this piece of property, they ask? Is the timing right? Can I put together a deal? These are the questions that I am constantly bombarded with by the real-estate "junkies" that I encounter while making my rounds trying to find the next deal — and my next paycheck.
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. And unlike stocks and bonds, it can actually be touched and admired. You can even live in it. It is part of the American dream.
As a developer, I can tell you from personal experience that completing a project, no matter how small, gives one a great sense of accomplishment. I have colleagues in the business that have transformed entire city skylines. Wow! It gives me a rush just thinking about it.
These attributes, however, are what makes real estate so volatile and, therefore, dangerous. Fortunes have been made and lost — sometimes within the course of the same business cycle. And the fact of the matter is that most of the real-estate-development process is not even under your control. You can be stymied in all of your efforts by some government planner who has never risked a dollar of his own money and who has never even added a single unit to the real-estate inventory. A notable mention should also be given to the roller-coaster ride that most developers are given by the erratic monetary policy of the Federal Reserve.
Because the real-estate market constitutes a large portion of GDP, the government closely watches over real-estate activity. Housing inventory and vacancy rates are studied. Even the number of building permits filed is monitored along with a dozen of other statistics that relate to real-estate activity.
There is no denying that real estate is an important component of the economy. In fact, the world economy is currently in a tailspin caused by the malinvestment that found its way into the real-estate development process.
Therefore, the government is focused on stabilizing the market. Each day that you read the paper, you will find some new government concoction aimed at reversing the real-estate meltdown. In fact, you read about all sorts of ideas aimed at stabilizing the real-estate market so that economic growth can be stimulated.
Nevertheless, all the "support" that the government has given to the real-estate market in the last few years has done very little. Even the S&P/Case-Shiller Index has indicated that the real-estate market has weakened further. According to the recently released numbers, six cities have hit new bottoms. This is not good news for the government whiz kids working on the real-estate recovery.
Therefore, the real question to ask is, can you spur economic activity by getting the real-estate market moving upward again? It seems to me that this is like putting the proverbial cart before the horse. Let me explain:
In order to get the housing market moving again, there must be willing and able buyers. People are usually willing and able to buy when they have jobs. Without economic expansion, there is no job creation. Without jobs, people do not have the confidence or the purchasing power to consider buying or investing in real estate.
Once again, we can turn to Say's law for guidance here. An increase in productive activity, and hence job growth, will create the demand for products in general, including the demand for homes and other real-estate assets.
With an unemployment rate above 9 percent, not to mention the current rate of underemployment, the US economy is not positioned to create significant job growth. The small business man, the main engine of job growth, is still financially strapped and unable to expand and create value. Unless this situation is altered, there will be no significant growth in real-estate assets. This is not rocket science.
So it seems to me that the main focus should be aimed at increasing US productive capacity. As a free-market operative, I may be biased. My prescription is therefore simple — let the free market operate and we will reach a new equilibrium in the shortest amount of time possible. The Depression of 1920–21 proves this conclusively. It was over in one year and has been labeled "our last natural recovery to full employment." This short duration and the minimal amount of government interference are the reasons that this economic downturn is conveniently "forgotten" by the mainstream.
My next suggestion is going to shock many nonbelievers: stop trying to stabilize the market. Let the market deflate. Real-estate prices are still too high in many areas. Therefore, seasoned investors — at least those who still have some money left — are not buying. The risk–return ratio is still not positive, or at least still not acceptable.
Prices must drop to a point where mortgage payments are not consuming an entire paycheck. After all, there is still milk and bread to buy, not to mention little Johnny's tuition payments. And let's not focus simply on the Housing Affordability Index, a statistic that just before the meltdown was telling us how cheap it was to own.
The proper way to look at this is to compare the cost of buying a house to the cost of renting a similar unit. If after you factor in the tax expenditure and any possible appreciation, it still makes more sense to rent than to buy, then the price is too high. When I am marketing a unit, this is the first analysis that I perform to determine value. Obviously, valuation is more complicated with larger investment properties where we must employ discounted-cash-flow analysis and other financial modeling. But the crux of the problems that we are experiencing today is in the primary and secondary home markets.
A deflation in the market will also restore the confidence of prospective buyers. No one is going to buy a home that is underwater on the date of closing. Everyone wants to feel that there is some value in the asset that they buy. We have not reached that point yet.
From a personal perspective — I look at real-estate assets nearly every day — I am still not finding any deals that make sense. Short sales are the only game in town and many of them are still not reasonable given the amount of work necessary to bring the unit to a marketable state. In addition, most short sales wind up not closing. To protect against this, title companies that I deal with want the title-search fee up-front when they realize that they are working on a short sale.
It is only when prices drop to the point where the deal makes sense that housing inventory will drop to normal levels — a sign that the "bottom" has been reached. Even today, inventory in many markets is too high. As of December 2010, the national inventory level is at 10.5 months. It is much higher in specific markets. For example, it will take over 20 months to absorb the roughly several thousand units priced over 500K that are currently for sale in Miami-Dade County. A healthy inventory of homes is somewhere between 4 and 6 months. Therefore, prices are still too high.
I am all for workouts for buyers who put down a substantial down payment and have equity in their homes but simply cannot make the mortgage payment due to a reduction in personal income. This is a free-market approach that many smart bankers are employing. However, those homes that are underwater and cannot be saved should be heading straight to foreclosure. The quicker that this happens, the quicker the market will reach bottom and the quicker that the homeowner will be free of a heavy financial burden. This deflation, a condition that is simply an economic adjustment, is a necessary requirement to subdue an overheated market.
The same scenario is applicable to the commercial real-estate market. Everywhere you look you can see vacant commercial spaces that were occupied for years by the same tenant. If small businessmen experience a loss, they will eventually shut down and vacate the spaces they once occupied. Unless small business begins to grow, the spaces will remain empty. There is, therefore, no way to help the commercial real-estate market unless you can generate a healthy rate of small-business formation.
Finally, I should like to point out that all of the TARP money given to banks did absolutely nothing to help the ordinary consumer. All it did was positively adjust the balance sheets of the "too-big-to-fail" institutions. Most banks are sitting on cash and simply not lending unless they are in an extremely favorable position. This sounds ironic because it was their unhampered lending that created the mess in the first place.
Contrary to the thinking of the government economists, banks are not going to lend money, even if it rightfully belongs to the taxpayer, simply to increase the number of nonperforming loans on their balance sheets. Why aggravate the situation? Anyhow, does anyone really think that the bailouts were aimed at helping the consumer?