One of the greatest blessings of writing publicly is the continual stream of feedback I am offered from folks around the world. They let me know when I am wrong, help shape my worldviews and opinions, and offer dazzling new ideas that are often absolutely brilliant.
Without everyone who graciously writes in to help deepen my own understanding, my own thought processes would rapidly stagnate. I am always grateful for feedback, positive, neutral, or negative. The people who take the time to write really augment the crucial foundational base off which my thoughts articulated in these essays are formed and polished.
One of the most common questions people have, especially those writing from the States, regards real estate. For Americans, real estate, in the form of their primary family home, is often the largest asset they command. The value of real estate, especially the price trend, is very important to countless folks across our great nation. Many Americans I hear from, especially those with a contrarian investor mindset, wonder what will happen to residential real estate prices in the United States.
The question is a very complex and difficult one, for a whole myriad of reasons. I have been pondering this matter since the US equity bubbles burst and am finally ready to commit some tentative thoughts to paper on this vexing issue. A massive caveat is in order however.
I am approaching this question about real estate price trends from the perspective of a speculator. Not having a background in real estate, these ideas may be completely worthless, so please don't act on anything in this essay without at least first discussing these concepts with a real estate professional you personally trust with decades of experience. I hope this essay will simply spur further thoughts and discussions.
The primary issue that I have been wrestling with in my mind regarding residential real estate price trends in the coming years concerns inflation and deflation. Inflation and deflation are simply opposing monetary phenomena, but both seem to be attacking our fragile post-bust economy in the US with great fury from opposite sides. For some background on these two titanic forces, please see my "Inflation or Deflation?" essay published last December.
Inflation is spawned by the hooligans at the Federal Reserve printing too much paper (or electronic) money, which they have been doing in spades in recent years in a vain and fruitless attempt to stop the normal post-bubble bust process from running its full course. In the last 12 months, the various US money supply measures have exploded up with astounding violence. The absolute year-over-year M1 inflation is 5.2%, MZM 12.7%, M2 7.9%, and M3 7.4%. These numbers are downright frightening in light of historical inflationary precedent!
In an inflationary environment, relatively more money chases after relatively fewer goods, services, and real estate. If the amount of money in circulation is rising faster than available real estate in the areas in which people want to live, residential real estate prices should rise. Realtors use this inflation idea to convince their customers that land prices should perpetually rise because land is scarce.
Unfortunately, that's not the whole story. While real estate professionals constantly bombard us with marketing propaganda claiming that land is scarce and no more is being made, that is a myth. One example why is evident in multi-story buildings. A 10-story structure, for example, has about 10x the usable space as a single story structure, but has the same footprint in raw land terms. Land itself is not scarce, just land in locations where people want to live.
For example, the sparsely-populated state of Montana has about 147,000 square miles of area, or roughly 94m acres. Assuming that only 2/3 of Montana's land is useable (the rest might be mountains or lakes, or streets in cities), that leaves 63m acres. If the entire US population is 287m people, they could all move to Montana and each live in modest estates of almost 1/4 acre, or 9,500 square feet. If their houses took up 1/3 of their plots, and each had a basement and two aboveground stories, every American could live in Montana in individual 9,500 square feet mini-mansions!
Land is not scarce in general. I have seen land sell in the North Dakota Badlands for $25 per acre. I have heard of deals involving vast tracts of land in northern Australia going for under $1 per acre. Land is relatively scarce in small areas in which lots of people want or need to live however, such as New York City's Manhattan Island.
Monetary inflation should indeed bode well for real estate prices, but where will it strike? If US monetary inflation bids on barren lands in the Western states for example, residential real estate in the big Eastern cities might not benefit. Just because the general economic environment in the US is highly inflationary thanks to the Fed's obnoxious and practically criminal monetary growth, that doesn't necessarily mean real estate in a given small corner of the US will do well.
And then we must consider deflation! Deflation is caused by relatively less money chasing relatively more goods, services, and real estate. In deflationary environments money supplies shrink and prices drop. As long as the American people allow the private Federal Reserve bank to continue its tyranny of inflationary theft, there will never be less money in the US economy than there is today.
But, muddying the waters even further, the historical line between money and credit is now exceedingly blurry. Because Americans love going into debt, they insist on buying their houses on time, with borrowed money at high interest rates, rather than working hard, saving the funds themselves, and paying cash when they can afford to buy a house outright. While deflation in the US money supplies is probably impossible with the Fed around, deflation in debt, or credit, is already happening.
With Americans not actually buying houses outright but really in effect borrowing them from banks, any contraction in available debt will leave less credit available to chase houses. With less credit chasing residential real estate, prices will be forced to fall. But, just as with inflation, it is difficult or impossible to predict how the contraction in general credit available to buy houses will affect real estate in any given small area of the United States.
Confused yet? Me too. There are both titanic inflationary and monstrous deflationary forces barreling down on the United States. But, residential real estate markets are all local and many will be affected differently. Deflationary forces could win out in New York City for instance, causing home values to plummet while at the same time inflationary forces win out in Wyoming causing house prices to rise.
Real estate is all local. In the stock markets, it is meaningless whether you buy a share of a publicly-traded company in New York or California. In real estate where you buy your house is everything! Location, location, location.
Since all real estate markets are really local, perhaps there are some warning signs that you can watch for in your little corner of America to warn of impending real estate price drops. While national generalizations about monetary inflation or debt/credit deflation regarding real estate are tough to make, zooming in to the local level for analysis has a much higher probability of success.
Stock speculators throughout history have learned to carefully monitor equity markets for danger signs of maturing bubbles. All markets, including real estate, move in great cycles throughout history, marked by rampant euphoria at the tops and popular indifference at the bottoms. Perhaps applying some common bubble warning signs in equity markets to your local real estate market will yield some interesting fruit.
Three common warning signs for equity bubbles are parabolic price rises, excessive valuations, and overwhelming euphoria.
In real estate, parabolic price rises happen when a local market witnesses prices rocketing up by 15%+ per year, for years in a row. If you go to your local library and look at old newspaper classified ads, or else secure local data from your hometown real estate professional, you can easily graph it in Excel. If prices of comparable homes across time are shooting up on a long-term zeroed-chart like a ballistic missile, like the bubbles in the NASDAQ 2000 and DJIA 1929, you are most likely in the belly of the beast, a local unsustainable real estate bubble.
Check out bubble growth graphed, it sticks out like a central banker at a rock concert!
This graph shows values indexed to 100, but you can just as easily think of them in terms of dollars, starting out at $100k. Imagine you bought a house 25 years ago for $100k, a lot of money back then. If your house price appreciated by 5% per year compounded annually, it would now be worth $339k, which is totally plausible and makes sense.
On the other hand, if your house had appreciated by 15% each year, it would now be worth $3,292k, or $3.3m! This is a massive increase in price, and it ought to throw up big red warning flags all across your cranium. Does it make sense for a $100k house to become a $3.3m house in only 25 years? Absolutely not, that is just silly! As the graph above shows, abnormally high growth rates make for parabolic charts, bubbles that look just like the stock market variety.
If your local real estate market is ascending parabolically like the NASDAQ of 1997-2000, you are in a bubble. History unambiguously shows that no financial trend continues in the same direction forever and all bubbles ultimately pop. Unrealistic annual growth rates are a key bubble warning sign. For a deeper discussion of unrealistic growth rates over the long-term, please see my essay "The Elusive Long-Term" from last August.
Another warning sign of equity bubbles is excessive valuations. In the stock markets, valuations are most commonly measured by the formidable yet often scorned price-to-earnings ratio. The historical average P/E ratio for US equity markets is 13.5x earnings. We can also apply this concept to real estate holdings.
While most people buy a house simply to live in, it is also possible to buy a house to use as a rental property. In a residential house used as a single-family rental, there is a price, the cash paid for the house, and an earnings stream, the rent the family pays to the owner. With a real estate P and E, we can compute a rough real estate valuation multiple. If a rental property costs $100k to buy, and rents for $1000 per month, or $12k per year, its P/E ratio is 8.3.
Even though most families don't own a separate rental property, with a little legwork you can check your local newspapers and calculate some rough P/E proxies for your area. Find houses for sale similar to yours to get price data points. Find houses for rent similar to yours to get earnings data points. Divide the P by the E, and you have a rough valuation estimate.
I don't know what a reasonable average long-term residential real-estate P/E is. I suspect it is probably in the 10-20 range though, as that implies a 5% to 10% return on the owner's capital, which is in line with historical returns available across a broad market spectrum. If you find that houses in your area are renting for implied P/Es of under 20 or so, that is a good sign that house prices may be fair. Conversely, if you find houses in your area renting for implied P/Es of over 20, valuations are probably too high and you should be wary of a potential real estate bubble.
Another common warning sign of equity bubbles is rampant and unbridled widespread euphoria. Remember the NASDAQ in 1999 and early 2000? It was unreal! All anyone ever talked about was the NASDAQ, how boring. As a hard-traveling consulting road warrior at the time, I remember even the shoeshine boys at airports were talking about their tech stock investments as they polished shoes. It was just crazy, just as brilliant historians like Charles Mackay of "Extraordinary Popular Delusions and the Madness of Crowds" fame (written in 1841) warned us it would be.
It is difficult to empirically quantify euphoria, but there is no mistaking it if you keep your ears open and pay attention to what folks are talking about in your social circles. If you find yourself in a local situation where the preferred topic of conversation at every social get-together is always residential real estate and the great wealth to be made in home ownership, chances are euphoria is setting in and you should proceed with great caution.
Just as parabolic price rises, excessive valuations, and overwhelming euphoria are danger signs of bubble tops in the stock markets, they are also equally valid danger signs in local real estate markets. It is probably a wise idea to periodically monitor these three fronts.
In addition to stock market-like traits, there are also other factors that affect local real estate prices. These include net local migration patterns, income trends, and interest rates.
One of the most important local factors in house prices is migration. If you live in or near a community that is growing as more people move in each year, that increases the pool of potential bidders competing for local houses. Prices are far more likely to rise in an environment of net in-migration. On the other hand, if your community is shrinking, both the number of people and amount of capital available to throw at residential real estate dwindles. This is a bad omen for future real estate prices in your area.
Typically cities grow and rural areas shrink as people seek the jobs available in cities. This is not always the case though. As the Information Age continues to evolve, a new population of workers is growing, the information worker. Info workers deal purely in information, like a software programmer. It is often not important where they live, as they rely on the Internet to work remotely with their colleagues and clients. Info workers often earn high salaries and have the means to bid up home prices.
Zeal LLC, my company, is an example of an Information Age venture. My partners and I can research, consult, trade, and write from anywhere on Earth. It makes absolutely no difference to you whether I penned this essay in Alaska, Australia, Argentina, or the Azores. Info workers, whose ranks will grow dramatically in the coming decade, are very blessed to be able to live and work from anywhere.
So, if you live in an area of exceptional natural beauty and very high quality of life, prime rural areas, an influx of urban information refugees from the decaying carcasses of the megalopoli will probably help support real estate prices in your location even through tough economic times. It may make sense to buy real estate in elite communities like the Colorado or California mountain resort towns even if the US economy faces very turbulent times ahead. The Information Age will probably totally alter the dynamics of rural real estate in prized areas.
Another factor to consider is income trends in your area. Ultimately, real estate prices in a given location can never increase faster than income over the long-term. Even for the vast majority who choose to go into debt to live in a house, the level of debt service they can afford is totally dependent on their income.
If general income trends in your community are rising, that is a great sign and is bullish for real estate prices. On the other hand, if general income is falling, for any reason, that suggests real estate prices will have to correct downward to adjust for the loss of debt-servicing ability necessary for folks to borrow money and "buy" residential real estate.
Interest rate levels are also intimately tied into this whole debt service capability. As all those burdened with a mortgage know, for many years most of the monthly payments are almost totally interest. It takes a long time and a huge amount of money dumped down the mortgage black hole, into bankers' pockets, before the amortization starts taking good-sized bites out of principal each month. Amazingly, in the first 2/3 of a typical 30-year mortgage's lifespan, the interest portion of each monthly payment exceeds the principal portion.
So, if interest rates are heading higher due to Greenspan's promiscuous inflation as I have discussed in past essays including "Bond Anomalies Abound," it will severely retard debt-financed residential real estate purchases nationwide. Although interest rates haven't turned north yet, history suggests they will be forced higher sooner or later as the bubble excesses are painfully squeezed out of the US economy.
In summary, attempting to divine real estate price trends is very difficult in a macro sense. There are a great deal of diverse variables that affect real estate prices. In addition, unlike the stock market, there is no national real estate market. All real estate is local, so national trends must be examined for your particular situation in light of the local realities in your community.
Nevertheless, if you do your own due diligence and integrate local real estate data you uncover into national post-bubble trends, you should be able to emerge with a fairly good idea of where your local residential real estate prices might be heading.