2011-07-28

Building a Contrarian Position on Real Estate

There is no question that we are still feeling the effects of the infamous housing bubble. When things first started going downhill, I attended a speaking engagement of economist Steven Poloz'. This must have been early 2007, before things really started to get recessiony. In that speech, Poloz rightly pointed out that it would be "at least five years" before the market was able to recover from the housing bubble, and potentially much longer than that. To my knowledge, Poloz is not in tune with the Austrian School of economic thought, but I found his analysis of the housing situation at the time to be very accurate, and time has only confirmed his analysis since. 

My sincere belief is that real estate prices have not corrected as much as they should, and that they continue to be propped up by the actions of both private and central banks, who have every reason to keep the value of real estate as high as possible in order to protect their loan collateral.

In a way, you could say that the world's financial system is backed by a de facto "real estate standard" rather than a "gold standard." While certainly not universal, it does appear to me that a sizable number of financial instruments and loans throughout the world are based on real estate. The credit crisis in many ways is a crisis of loan collateral being collateralized more than once, double-counted, and simultaneously viewed as an asset and an account receivable. At any rate, the final cause of all this financial abstraction is real estate value. this is why the "s--t hit the fan" when the real estate bubble popped. This is why so many economists and finance experts believe that the issue can be resolved by tighter regulation of financial derivatives and accounting rules. Finally, this is also why the Austrian school of economic thought believes that these economists and financial experts are missing the point.

If today were a Saturday and I had more time to write a blog post, I would now provide a discussion of credit and banking from the Mises perspective. Mises' analysis is fully applicable here, and provides good insight into where all this crazy housing/credit/monetary trouble came from. Unfortunately I just don't have the time to go into it today, especially since the purpose of this blog post is to actually discuss something else...

The question on the minds of ordinary people today is, "To purchase real-estate, or not to purchase real estate?" Is it a good buy? Are people better off renting?

The answer to this question depends on a few things:
  1. Will real estate hold any future value whatsoever? Is it a good idea to, in the words of Peter Schiff, "Go into debt to pay too much for a house"? At face-value, I think the answer is a resounding no. But the problem with the face-value analysis is that it assumes homogeneity of real estate. As we all know, every plot of land is different. To cite an obvious example, if you know that an over-priced piece of real estate sits above a huge reservoir of oil, it's still worth it to take that deal.
  2. Can you make a return on the money you save by renting? Let's assume you rent an apartment for the next five years. While you do avoid debt and preserve some monthly cash flow, you also do not build any equity whatsoever. In order to build your equity, you need to invest the money you would have spent on a mortgage in something that provides you with equity. Are you capable of finding such an investment? Will mutual funds, GICs, stocks, etc. deliver a better return than you would have made simply by setting aside some money every month as equity. (The portion of your mortgage payment that contributes to loan principal is equity on your balance sheet; I have heard this concept called "forced savings," even though that's not a great term for it. The idea is that by taking on a mortgage, you commit to building equity, whereas if you simply abstain from spending that money, you lose it to inflation.)
Therefore, the issue as I see it is whether the decline in real estate prices will be greater than the equity you build. In other words, if you pay $300K for a house today, will it only be worth $200K when you sell it? Peter Schiff thinks so.

But my position is that it depends entirely on the piece of real estate you're looking at. Certainly, I think Peter Schiff is correct with respect to those mass-produced homes in overnight subdivisions. These houses are on tiny lots in remote corners of cities. If you buy one of these, you'll want to make absolute certain that the neighborhood will still be appealing in 20-30 years. I don't think they will be.

On the other hand, in every city there are older neighborhoods adjacent to valuable commercial areas, where the lots are larger, the green space is a little easier to come by, and the surrounding area is genuinely appealing. If you're considering a real estate purchase and can find one of these lots, I still think it's in your best interest to buy them. The prices are coming down, the sellers will be anxious to sell, and you will end up with more than just a house, you'll end up with a patch of land that has real value. 

Well, that's my thesis, anyway. I will have to spend more time thinking and justifying it. It's worth considering, though.