FINANCIAL RAMBLINGS FROM THE ROCK
Is the US housing market attractive?
Internal Rate of Return assuming 10-year hold
Annual Residual Current Total Multiple
appreciation return return of equity
1% 3.8% 6.6% 10.4% 2.7x
2% 6.9% 6.8% 13.7% 3.6x
3% 9.5% 7.0% 16.5% 4.6x
4% 11.8% 7.3% 19.1% 5.7x
5% 14% 7.5% 21.5% 7x
6% 15.9% 7.8% 23.7% 8.4x
Source: Pershing Square Capital Management
NB: This is not a form of solicitation and returns are NOT guaranteed. All investments entail risk and the potential for substantial loss.
US housing, in my opinion, offers a great long-term opportunity. I know this probably sounds a bit crazy as most people think the US housing market is getting worse and has not begun to recover from its epic binge. It has taken this asset class a great deal of time to find any semblance of stability. There are many US housing bears who will NEVER change their opinion on this asset, but let me explain why now is probably a once in a lifetime opportunity to think about buying US residential real estate.
First the bear case and negative spin. Five years into the housing collapse, 28 percent of US mortgages are underwater. Another seven percent or so are delinquent and about 10 percent of houses have been foreclosed on. Essentially 45 percent of the US mortgage market is in a state of stress.
Prices have continued to stagnate and are now down 40 percent from their peak of five years ago. New home construction has pretty much vanished. Sales of new homes had a record peak of 1.3 million units in 2005. The US is now on pace to sell just 289,000 units the lowest count since 1963 (which is as far back as I can see on Bloomberg). Building homes does not even make economic sense in some areas as the cost to build actually exceeds the cost of buying an existing model.
Terrible right? In this case I believe all this bad is actually good. Housing in America is cheap and one can assess this in many ways:
l According to real estate firm Zillow, if one looks at price-to-income trends housing looks very favourable in some areas. At the bubble peak, housing was over five times income but now a lot of metro areas are below pre-bubble pricing levels. Las Vegas for example is 25 percent below its historical trend and Detroit is about 35 percent below. Many metro areas are 10 percent below or more. In an April report by Economics Capital, Paul Dales mentioned: “Relative to historical norms, the sharp price falls of the last five years have left the owner-occupied housing market looking around five percent undervalued compared with rents and around 20 percent undervalued compared with both disposable income per capita and disposable income per employee. Against incomes, at no point in the last 35 years has housing looked this undervalued.”
l Who cares, say the gold bugs. Until you look at housing priced in gold. The median priced new home in the US when priced in gold has never been cheaper in some 50 years. You have to go back to 1979 to find housing this cheap on a national basis.
l The rental market is expanding rapidly and it is not uncommon for property managers to get 8-12 percent yields on investment properties now. Reis, an apartment market research firm, reports second-quarter vacancy rates at the lowest level since 2008, while average rents have risen 2.3 percent. In fact, according to Deutsche Bank, we are now seeing for the first time in the last two decades that renting a home costs US households MORE than paying a mortgage.
l Due to an attractive combination of record low rates and slumping prices, housing is more affordable than it has been for over a generation. The National Association of Realtors' National Housing Affordability Index shows record levels of affordability. If one brings up the chart, housing has NEVER been this affordable as far back as the data set goes on Bloomberg.
One great way to snap up bargains is to be a vulture. If there is ever an opportune time to purchase any asset on the cheap it can often be found in times of stress when there are a great deal of forced sellers (think credit in the 2008-2009 financial crisis). US housing is still in this stage. According to RealtyTrac's second quarter 2011 Foreclosure Sales Report, “sales of homes that were in some stage of foreclosure or bank owned accounted for 31 percent of all U.S. residential sales in the second quarter of 2011”.
Foreclosures that sell for 30-40 percent less than non-distressed homes may offer big bargains. “With average prices on distressed real estate trending down and average discounts trending up, this report is clearly good news for well-positioned buyers and investors looking for bargain real estate that will build them wealth in the long term and often give them cash flow as rental real estate in the short term,” said James Saccacio chief executive officer of RealtyTrac. A continued shift of these assets from weak hands to strong hands should help put a floor on the overall market and provide some stability.
Let's look at supply versus demand. Bears will point out the huge level of “shadow inventory” sitting out there houses in the foreclosure process or delinquent homeowners that do not at this stage have houses up for sale. They argue that great waves of these types of houses are yet to hit the market. To some extent this is true but we have now gone through a prolonged period of exceptionally low levels of new construction that somewhat offsets this. Remember that housing starts are now at levels not seen in 50 years!
Let's also consider the longer term demand picture. If we assume the population of the US will grow to about 360 million people by 2030 (US Census Bureau Projection with constant net migration) and ownership rates remain virtually constant, the US will need about one million new single-family homes per year. With new starts at roughly half of this it is only a matter of time before the excess supply is absorbed.
I am also going to show you the mathematical attractiveness of this asset from recent calculations done by Pershing Square Capital Management, LP (see presentation: http://cache.dealbreaker.com/uploads/2010/12/Pershing-Sq.-pres-on-housing-11-3-10.pdf ). Using their assumptions of a 20 percent down-payment with a 30-year fixed rate of 4.4 percent the table shows the economics of even modest appreciation over ten years.
Of course if housing continues to stagnate the reverse of these calculations is possible.
I do not advocate rushing out and aggressively trying to buy houses. The housing market is very illiquid and will not turn on a dime. There are definitely structural issues in housing that will prevent any form of a rapid rebound, in my opinion. However, I do believe it is now time to make that shopping list and with the help of your banker and financial planner begin the process of snooping around for some once in a generation deals. Properly bought units may offer satisfactory returns over the next ten years in an asset class very much out of favour.
Nathan Kowlaski is the chief financial officer of Anchor Investment Management Ltd.
Full disclosure: Views expressed here by the author do not necessarily reflect the opinions of Anchor Investment Management Ltd.