Comstock Partners, Inc.September 22, 2003
Potential Catalyst For Deflationary Bear Market - Real Estate
Written 9/22/03--Charts Updated 7/16/2008
Our regular readers know that we have concluded that real estate is the most logical catalyst for the deflationary environment we expect to unfold within the next 6 months to a year. We have also mentioned a collapse in the dollar or a major bankruptcy as potential catalysts, but real estate stands out in our minds as the prime candidate. This real estate comment is longer than normal and will serve to replace the usual Tuesday and Thursday's comments this week.
In the Special Report-"The Bubble" on our home page we go into the macro-economic reasons as to why real estate is just about the only asset which continues to attract loans from lending institutions at an alarming rate. We went into the historical precedents of past inflations and deflations and determined the best way to pinpoint which areas are the most vulnerable--you just have to determine which areas are attracting the most capital. Usually this capital takes the form of a loan, and lending (especially by banks) when concentrated in any one-area drives the sector to levels of extreme overvaluation and eventually collapses. It happened in the 1970s in lesser-developed countries and the oil belt, followed by the oil sector in the early 1980s and real estate in the late 1980s. The lending came close to destroying the junk bond market while sending Mike Milken to jail in the early 1990s. The lesson the bankers never learned is that the reason the collateral behind the loan was rising was due mostly to the fact that too many of the lending institutions' capital was concentrated in the same specific area.
You have to keep in mind that housing price increases fueled the refinancing mania that has been going on until very recently. According to the Richebacher Letter, since 1997, total housing values have soared from 8.8 trillion to about 14 trillion presently. According to the Center for Economic & Policy Research (CEPR), the national rate of home price growth surpassed the overall inflation rate by more than 30% since 1995. They concluded that there was as a high probability that "the existence of a housing bubble now is similar to the stock market bubble of the late 1990s".
Moreover, U.S existing home prices as a percentage of median family income just hit a new post-war high. Year over year, new home prices have accelerated 17.5% and existing home prices were up 13.8%. This relationship shows clearly that existing homes are less affordable now to U.S. households than they have been for the past 50 years. International Strategy & Investment's (ISI) data shows that every time existing home prices exceed 3 times the median income, housing prices shortly decline. The median existing home price is presently $182,000 and the median income nationwide is $60,000-according to this ISI formula, housing prices are due to decline.
Despite recent evidence of an improving economy, mortgage delinquencies rose to a seasonally adjusted 4.62% in the second quarter from 4.52% the previous quarter. The delinquency rate for loans insured by the FHA also rose sharply to a record 12.59% from 11.65% in the first quarter. According to the office of Federal Housing Enterprise Oversight, a federal housing agency, home prices rose 0.78% during the three months ended in June, the slowest quarterly rate of appreciation since 1996. Mark Zandi, the chief economist of economy.com, points out the fact that since home price appreciation is slowing, it could make it harder for families that are falling behind on their loans to sell their houses and get out of trouble.
Another concern that Comstock has with real estate is that mortgage debt rose at a 14% rate during the second quarter, the fastest pace since the second quarter of 1987. This acceleration in mortgage financings has been facilitated by the government-sponsored agencies of Fannie Mae and Freddie Mac. This is the same quarter that home prices rose at the slowest rate since 1996, so while mortgage debt rose the fastest in 16 years, housing prices rose less than in any quarter in seven years. And because home values rose less quickly than mortgage debt, homeowner's equity fell to a record low of 54.3% of home values during the second quarter from 55.3% during the first period.
The rush to refinance over the past few years is without precedent. According to ISI, the cash outs of the refi's last year were in excess of $200 billion. One of the amazing aspects of the massive refinancing of homes, which is effectively piling on consumer debt at record levels, is the fact that this is being done with the blessings of our esteemed Federal Reserve Chairman, Alan Greenspan. In various testimonies he has stated that borrowing the equity in consumers homes is helping the economy and he supports it. Imagine the head of the Central Bank of the world's largest economy becoming a cheerleader for individuals to continue borrowing on the equity of their homes while they have already incurred a record amount of debt and the homeowners' equity is falling to record lows. Could the Fed Chairman actually think it is appropriate to use ones' home as an ATM cash machine?
Real estate bubbles bursting are different than stock markets bubbles bursting because bubbles in the stock market only effect the owners of stock and maybe a few brokerage firms that don't adhere to strict margin requirements. A collapse in real estate, not only affects the borrower, but it also the lender. Over the past few years poor macro economic fundamentals have diminished the demand for commercial and industrial loans, causing commercial banks to seek other avenues of profit. In particular, the banking sector has increased its exposure to consumer, residential mortgage and commercial real estate (CRE) loans.
The irony of banks currently fighting "tooth and nail" over generating loans to real estate is amazing since the spread between home prices and incomes are the widest ever, and the spread between the cost of owning a home to the cost of renting a home is the largest ever. The price versus rent in real estate is similar to the price-earnings ratio of common stocks and presently in RE this ratio is the highest level in history. This is where we were with stock market P/Es at the beginning of the century.
Combine the home rental record spreads with problems in the commercial side of real estate where office vacancy rates, a key indicator of the sector's health, are at decade highs. The national vacancy rates according to Cushman and Wakefield are 15.5% in Central Business Districts (CBD) and 21.3% in non-CBD. These vacancy rate peaks are not confined to areas that you would think would be in trouble like the rust belt, but include some of the most desirable and expensive markets such as Silicon Valley, Atlanta, and San Francisco. This confirms the fact that the recent economic malaise was not just confined to manufacturing, but has also impacted the service and technology sectors.
The price to rent situation is just as bad commercially as it is with homes. According to the New York Times last week ever since the stock market bubble burst at the beginning of 2000, all areas of New York City are showing increases in availability rates (space available to sublease). Also, decreases in asking rent prices, and the actual deals (final agreed price) are being struck at larger and larger discounts.
In every bubble there is a certain amount of corruption. This has been clear in the stock market and real estate is no exception. There were recent articles posted in the L.A. Times and Washington Post about the pressure put on appraisers to raise their estimates of property values to "hit the number" needed for a sale or refinancing to go through. Both papers quoted from a study conducted by the October Research Corp. Joe Casa, founder of October Research stated, "The reality is that pressure on appraisers is a serious problem. Everyone knew it existed, but nobody thought it was this bad. The pressure typically involves a direct or veiled threat to withhold future business from an uncooperative appraiser or to withhold payment for any appraisal that did not "hit the number."
In summary, we believe that real estate will be the main catalyst for the deflationary environment we expect is inevitable. This is the result of the tremendous demand for RE since the mid 1990s driving valuations through the roof. The prime driver of the appreciation was the liberal lending policies of banks and mortgage institutions. The combination of the lax lending and the demand from homeowners to continue to borrow against the equity in their homes, have placed RE in a vulnerable position. The rising prices have moderated substantially, while until just recently the borrowing and lending continued at record levels. This dropped homeowners' equity to record lows. Since every valuation ratio of real estate is presently at record highs, if the slowdown in appreciation turns into an actual decline in values, the present economic recovery and stock market recovery could reverse and be potentially devastating to the financial environment.