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The Future for Investorsby Jeremy Siegel, Ph.D.
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Is Real Estate a House of Cards?
by Jeremy Siegel, Ph.D.
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Monday, December 19, 2005


Real estate has been the hottest asset class over the past five years. Some locales have seen prices double in two or three years and news of investors flipping condos reminds me of the frenzied days of Internet IPOs in the late 1990s.


But with the latest rise in mortgage rates there's been an unmistakable shift in sentiment. Recent data from the research firm ISI shows that the dollar value of unsold homes in the U.S. has now surpassed $500 billion, up an unprecedented 33 percent from a year ago.


It seems like everyone wants to sell, which could spell big trouble for the housing market. So now is an especially good time to ask: How does real estate fit into my long-term portfolio?


The Rates That Really Matter


It's no secret that housing prices have soared in recent years. The main reason: The remarkable drop in interest rates.


Particularly important for the housing market is the real rate. This is the interest rate minus the rate of inflation. The real rate is important for the housing market because the two move in opposite directions.


The yield on Treasury Inflation-Protected Securities (TIPS) provides a measure of real rates. It's currently just 2 percent -- about half its 2000 level. This drop in real rates over the past five years means that the after-inflation cost of long-term borrowing has plunged by about 50 percent.


These declining rates can justify big increases in home prices. In fact, the average price of U.S. single-family homes has jumped from $160,000 in 1999 to $265,000 today, a whopping 66 percent increase.


Housing Still Has Sturdy Foundation


Does all this mean that the roof will come crashing down on the housing market?


No!


While many fear rising rates will trigger a disaster for the real estate market, I see a housing market with a firm, concrete foundation. I believe interest rates are near their peak and that any further rise in long-term rates will be modest.


And although historically low interest rates largely explain the jump in housing prices, other favorable developments also played a role. Changes in the tax code in 1998, in a best-case scenario, allow up to $500,000 of capital gains to be exempt from federal tax if realized from owner-occupied homes. This exemption gives real estate a tax advantage over other asset classes. Rising household incomes and a competitive mortgage market have also boosted housing prices.



But this doesn't mean that recent gains will continue apace. In fact, prices very well may fall in markets where price speculation has been the most intense, such as parts of California and the Northeast. Such softening has already occurred in countries where the housing market was particularly strong and the central bank raised rates to prevent overheating.


For example, over the past couple of years the Bank of England has raised short-term rates from 3.5 percent to 4.75 percent, and the Reserve Bank of Australia raised rates to 5.5 percent. Both countries succeeded in cooling down their super-hot housing markets, and prices have leveled off. It's logical to expect the same to happen now that the Fed has raised rates from an extraordinarily low 1 percent in early 2003 to over 4 percent today.


What to Do Now?


Given this, investors may wonderif they should buy rental property. In many cases, the answer is "no." The cost of financing, taxes, and upkeep is often greater than the incoming rent, creating what real estate investors call "negative carrying costs."These costs can only be justified if there is enough appreciation to offset these costs.


And that's a problem.


Historically the majority of real estate's return does not come from capital appreciation, but from "implied rent," which is the amount one would otherwise spend on rent for the same home. This surprises most investors, because capital gains have overwhelmed rental income in the past decade. But investors must realize this was a highly unusual period that will not continue in the future.


The Bottom Line


If you're comfortable in the home you're living in, keep it. And, if you have a second one, keep that too -- as long as you're not holding it solely for future capital gains.


Furthermore, much of the real estate held in real estate investment trusts (REITs) that trade on the major stock exchanges still offer good yields. Their average dividend yields are between 4 percent and 5 percent, a rate that matches or exceeds what you can get on government bonds. So even if REITs don't rise in price, you're getting a decent yield on your money.


However, if you're thinking of downsizing or selling your home, now might be a good time to do so, especially if it will generate tax-free capital gains. And if you're waiting to purchase real estate as an investment, I'd wait a little longer. The increase in the number of units for sale means that a buyer's market is close at hand.

Dr. Bernstein's view on the housing market:


Efficient Frontier

William J. Bernstein

[align=center]Why You Can’t Afford a House in San Francisco[/align]
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[align=justify]Is there a housing bubble? Why are homes in some cities outrageously expensive, while those in other cities easily affordable? In attempting to answer these questions, I found that a simple and intuitive model of the housing market does a remarkably accurate job of predicting median prices. This model allows us to think more clearly about the state of today’s residential markets.[/align]
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[align=justify]Imagine for a moment that we live in a world where all information about home prices is censored and both buyers and sellers—everyone, in fact—has not the faintest idea of where fair housing prices stand. In such a world, how do you estimate median prices? [/align]
[align=justify]Begin by assuming that most people mortgage themselves to the hilt. If the median family income in the U.S. is currently $60,000 per year and if lenders allow a mortgage/income ratio of 25%, then $1,250 per month is available for monthly payments. If the current 30-year fixed-rate mortgage is at 5.7%, then a theoretical median U.S. house price of $215,000 pops out of the spreadsheet. The actual value? $187,000. Not too shabby. (I’m ignoring the down payment, which I assume is borrowed from other sources, and thus is factored into the homeowner’s presumably prudent-borrowing decision making. In any case, the down payment seems to be going the way of disco and balanced budgets.) [/align]
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[align=justify]Next, repeat this exercise over the past 35 years. Data sources: Mortgage rates from the Bureau of Economic Affairs, median home prices from Freddie Mac and the National Association of Realtors. Family income was simulated by multiplying the BEA per capita income figures by two, which very closely approximates the census bureau’s family figures. (The BEA approximation was used because it is a much more detailed time series.) As a dash of spice, the initial theoretical median home value in 1970, $21,141, was invested in the S&P 500 and allowed to run:[/align]
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[align=justify]Indeed, the mortgage-to-the-hilt-at-the-30-year-fixed-rate method does a decent job of tracking median home prices.[/align]
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[align=justify]What does this tell us about the state of the present housing market? First, with the actual median home price about 13% below that of the model prediction, there certainly is no bubble at the national level. In fact, the only time the model screamed "bubble" was in the late 1970s and early 1980s as theoretical home prices plummeted because of rapidly increasing mortgage rates. Rates peaked at over 18% in 1981, while actual home prices blithely continued climbing, albeit at a less heated pace than before.[/align]
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[align=justify]Now that we understand what drives home prices—loan size dictated by rates and income—most everything else about the real estate market, even at the local level, falls neatly into place. For example, it might appear at first glance that falling mortgage rates are a good thing for home buyers. But for the most part, they aren’t; all that falling rates accomplish is to increase the PV (present value) number that appears in the financial calculator. The bad news is that purchase prices go up, but the good news is that mortgage payments won’t be much different than before the fall in rates. At the end of the day, new buyers will write the same monthly check to the bank, no matter what has happened to interest rates. The falling rate/rising price scenario isn’t even that good for sellers; yes, they’ll get more for their house, but this will be offset by the lower expected security returns available to the capital raised. Only the real estate agents and tax assessors are happy.[/align]
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[align=justify]What about the "bubble zone"—California, Florida, New York City, and Boston? Simple. These areas attract an undue proportion of high wage earners, so if you move to one of these locales, you’re competing for houses against folks whose mortgage capacities are among the highest on the planet. When will home prices fall in these modern high-rent districts? When at least one of two things happens: mortgage rates rise, or the average income in these locales falls. If and when either happens is anyone’s guess. To be sure, the increasing numbers of amateur speculators in hot markets, real-estate cocktail chatter, and proliferation of books and courses about getting rich in real estate all scream "bubble." But to the extent that these prices are propelled by high-earning boomers with insufficient savings, the bust may not occur for as long as another 15 or 20 years, if at all. And let’s be clear about what we mean by "bust." As suggested by the above plot, home prices are far less volatile than either stocks or long bonds. But even a 10% to 20% fall in prices would wipe out the speculators and not a few first-time buyers who have fallen on hard times or who must relocate.[/align]
[align=justify][/align]
[align=justify]Since everyone in the housing market at a given moment pays more or less the same loan rate, what really determines the affordability of housing is where in a given area’s wage ladder you fit rather than the absolute amount of your salary. Better a teacher in Omaha than an Upper East Side internist.[/align]
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[align=justify]The rise in the median U.S. home price between 1970 and 2004 was only 6.05%, about 1.3% more than inflation. In this period, the return of the S&P 500 was 11.41%. True, stock returns going forward aren’t going to be nearly that high, but given the retirement prospects of the boomers, neither are returns on residential real estate going to be as high as they have been in the past. I suspect that over the next few decades, the return of a prudently invested securities portfolio will outpace that of residential real estate.[/align]
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[align=justify]About the only bit of arbitrage worth considering involves the growing gap in the high-flying markets between renting and buying. It makes no sense, as is the case in many cities, to buy a condominium for $500,000 when a similar flat can be rented for $1,800. Why the gap between rental values and mortgage payments? Thank compassionate conservatism. Rents, just like mortgage payments, are driven by salaries. Consider the widening income disparities of the past few decades, shown in this plot extracted from Pikkety and Saez’s landmark study, which displays the total national income generated by the top 1% of wage earners:[/align]
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[align=justify]Renters tend to be poorer than homeowners. As the income disparity between high- and low-salaried individuals has grown, it’s no surprise that rental and mortgage payments have diverged.[/align]
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[align=justify]Home prices and rents do not exist in a vacuum, and the factors that influence them are blindingly simple: the mortgage rate and the salaries of those in the market. Where these two critical values go, so go rents and home prices eventually.[/align]

[align=center]Why You Can’t Afford a House in San Francisco[/align]

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[align=left]Because you work for the federal government? [/align]

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[align=left]Happy Holidays everyone!:^[/align]

That is a good site and the article shows why. In Key Westit is cheaper to rent than to buy. That is because prices have skyrocketed.However this is not because of high-income wage earners with big mortgage-pockets, but because so many wealthy people relocate here.Few are writing mortgages, even -- they're paying cash.

It is a case of supply and demand, with the supply being strictly limited and demand running high. Wages have not kept up, thus it is cheaper to rent.Recent events have brought a lot more homes onto the local market sothe supply has suddenly increased.It will be interesting to see what happens.

Dave