The Housing Market

Posted by   admin on    July 2, 2004

Interest rates are rising. Income growth is uncertain. What's a real estate investor to do?

Did you know that the percentage of U.S. households that now own, rather than rent, is at an all-time high nearing 70%? This is great news for households pursuing the American Dream, but may be not so great if you are a rental real estate investor. And, given that real property values nationally have run up so much, I can only imagine that households that are still renting might be considering kicking themselves right about now. As well, I am willing to bet all you can think about is how much money you would have made if you had stuck your neck out or stuck your neck out further on purchasing some real estate. Well, that sort of thinking sounds dangerously like the investors in 2000 who thought they were losers if they hadn't jumped on the technology stock craze. And we all know how that story ended!

As mentioned in our prior newsletters, we strive to provide articles on various aspects of wealth management to assist your understanding of why planning for the present and for your future has importance. Yes, we also promote our services; yet, you will find that we always seek to present thought provoking topics that are relevant to our wide audience.

With the rumor that interest rates have bottomed out and will be heading higher in the next few months, panic over this phenomenon has begun to make an impact on the minds of people across the nation. It has many investors looking for a safe haven and mistakenly seems to be feeding the housing craze right now.

In this letter we wont try to make any crystal ball predictions about the real estate market, but we will discuss some of the economic and demographic forces that will drive the housing market in coming years, and how you can navigate them to your advantage. And, as always, we will finish with an update on our investment activities.

The Housing Market  Its Been A Great Run!

In the past five years, home prices nationwide have climbed more than 41%, according to the Office of Federal Housing Enterprise Oversight (OFHEO)  and far greater in the District of Columbia (93%), Rhode Island (80%), California (77%) and Massachusetts (76%). For comparison, the Commonwealth of Virginia enjoyed 49% home price appreciation and 51% was the reward in Charlottesville. Homeowners have tapped that equity to take vacations, buy second homes and build up their nest eggs. They have counted on rising home prices to bolster their future and shore up their present.

But now homeowners may have to face a new reality the party can't last forever.

Over the next five or 10 years, economists and analysts say, home prices are likely to yield a less-impressive return, while the market slows to catch its breath.

For homebuyers, that prospect presents a new set of challenges. In the recent past, diving into real estate was a no-brainer. Interest rates were low, and there were precious few other ways to safely invest money. It was hard to go wrong no matter where you bought. Now, some of the forces that made housing so attractive have faded. The stock market has improved, and home-price appreciation has slowed across the country.

This moderation in the growth of house prices is welcome because continued price jumps like those of the fourth quarter last year (3.7% nationally) would raise the potential for declines later on, said Patrick Lawler, Chief Economist at OFHEO.

Interest Rates

Perhaps no other factor has pushed home sales and home prices higher in the past decade than the long-term decline in interest rates. In 1981, the interest rate for a 30-year, fixed-rate loan averaged 16.63%. The monthly payment for a $200,000 mortgage then was $2,800 a month. Today, the average rate is about 6.25%. For the same $200,000 loan, the payments are less than $1,250 a month. It should hardly be a surprise that Americans bought more than one million new homes last year, up from just 436,000 in 1981.

The problem now is that interest rates are more likely to rise than fall. The economy is rebounding, inflationary pressures are beginning to appear, and the federal budget deficit is growing. All of these forces suggest rates will climb over the next few years.

Of course, no one expects rates to return to anything remotely close to the levels seen in the early 1980s. But even a slight rise in interest rates could knock some buyers out of the market. If rates go to 7%, that would add $1,000 or more annually in payments on a $200,000 loan.

Also, as interest rates rise, more Americans will likely choose to rent their homes rather than buy. Yet, real estate agents will tell you that a rise in interest rates will be offset by an improved economy, which should inspire more buyer confidence and more home sales. That may be true, but only to a point. As the recent business cycle proved, housing can rise to new heights during a downturn, and it needn't boom during an economic rebound. Prices were nearly flat during the first several years of the rebound in the 1990s.

For buyers, one way to mitigate the pain of higher rates is to apply for an adjustable-rate loan that starts with an unusually low rate, then adjusts higher later if interest rates keep climbing. But that increases your risk later.

Income Growth

From 1980 to 2001, median incomes in the U.S. rose 138%. Home prices rose almost exactly the same amount 136%. Mere coincidence? Hardly. Over time, home prices move in lockstep with incomes, because incomes help determine how much a consumer can spend on a home. The relationship isn't always so clear in the short term because builders add more supply if demand rises, and hold back if demand falls. But in general, if home prices grow faster than incomes, houses will then become unaffordable, and that will force a slowdown in price appreciation until the market balances out.

That's what homeowners could face in the next several years. From 1996 to 2003, incomes rose 22%, while home prices climbed 47%. In some cities, the gap was even wider. In Boston, for example, incomes rose 40%, while home prices shot up 120%. In San Diego, incomes rose just 31%, compared with a 142% run-up in home values.

Also, low interest rates have helped mask the problem by lowering homebuyers' mortgage payments. But sooner or later, incomes will have to catch up, especially if interest rates rise.

What should homebuyers do in the face of an income gap? If you're a short-term investor with plans to buy a home and sell it again in a year or two, you should steer away from cities where the gap between incomes and prices is widest.

Does this mean you should necessarily target neighborhoods that have high average incomes? Not necessarily. What matters is the rate at which incomes are rising, not the amount of wealth that's already there. After all, income growth can easily stagnate in posh parts of town when an economy goes south. Often, the best investments are made in transitional neighborhoods that were once economically distressed but are now enjoying rapid income gains due to new investments and new jobs in the area.

Are we in a bubble? Should I sell and rent? Will I be able to use the value in my home for retirement?

OFHEO Chief Economist Patrick Lawler notes, "Last year's rise in borrowing rates may have stimulated fears of further rate increases, causing some prospective purchasers to move more quickly to buy than they might have otherwise last Fall. That sense of urgency apparently diminished last quarter after rates stabilized. It will be interesting to see what the effects of more recent interest rate increases are in the future."

Let's see if we can put housing prices in some inflation-adjusted perspective. If you bought a $75,000 home in 1980, if it merely kept up with inflation, the home would sell for about $180,000 today. Whereas, the national average applied to that home bought in 1980 now sells for $232,000. Thus, roughly two-thirds of the average rise in housing values is simply from inflation.

However, if you lived in Massachusetts, your $75,000 home is now $462,000; in Virginia, $243,000; and, in Rhode Island, $346,000. California home values have risen to $311,000, although in such a vast state, there is quite a difference in price increase between a San Diego beachfront property and the desert, to be sure.

But it is not all sweetness and wealth. If you lived in Louisiana, a small bubble might be a thing to be desired. Housing values in Louisiana have not kept pace with inflation. The average $75,000 home from 1980 has only appreciated to $144,000. Yet, if we look further northwest to Oklahoma, the state with the smallest rise in the US, homes have risen to only $130,000. That means their home values rose slightly more than half the rate of inflation. In fact, from the OFHEO study, I count 16 states that have seen home values rise less than inflation over the past 24 years.

Recently, I read a story about the Los Angeles residential real estate market, which is on fire. The story focused on a 30-something couple that was hoping to buy a home for $600,000. They experienced frustration through bidding against another couple that wanted the same home. They lost because their offer of $500,000 had been far from sufficient. The real estate agent commented that houses that were $600,000 last year are selling for $1.2 million this year and anyone who didn't buy last year was locked out today.

If I were there, I would have advised them: 'Run for your lives! Rent! Move to another city! Don't sign that contract!' Of course, I would have cheered to the sellers, 'Way to go! Take the money and run!'

Is a $1.2 million home necessarily a bad investment for that couple? Maybe and maybe not. If they expect to flip it in 2-3 years, they are taking a significant risk. They are buying after a large run-up in home values. Looking through the OFHEO tables suggest that run-ups are followed by softer periods.

But if it is their dream home - the place where they want to live for the next 20 years - and if they have the ability to make the payments in that time, then inflation and the long-term affect of paying down the mortgage should overcome the ups and downs, assuming they do not have to sell during the next recession. If California is where they want to live, if it is where they make their living, then housing is part of the cost of doing business in California.

What have we learned so far? Housing is not simply an investment decision. Parts of the housing equation are the desirability of your local market, local economic conditions, your ability to stay the course, the length of time you intend to live in your home and your own psychology.

ELF Capital Management Investment Performance Update

As we had advised last month, we consider the probability of rising interest rates to be more certain and expect the Fed Funds rate to continue climbing gradually over the next 24 months from the current 1% to a more normal range of 3% to 4%. We consider this a major economic event and have positioned both taxable and non-taxable client portfolios to accommodate this view. For our clients, we continue to focus on minimizing investment risk while in pursuit of seeking reasonable returns. The economic landscape may change, but our philosophy remains the same!

For the month ended June 30, 2004, our one-month performance is up 0.33%, our three-month return is down 5.56% and our one-year return is up 7.87%.

For disclosure purposes, past performance is not necessarily indicative of future results and ELF Capital Management LLC (ELF), formerly Hoffman White & Kaelber Financial Services LLC, cannot guarantee the success of its services. There is a chance that investments managed by ELF may lose a substantial amount of their initial value.

ELF is an independent discretionary investment management firm established in February 2003. ELF manages a strategic allocation of primarily exchange-traded index funds (ETFs), and may invest in other carefully selected securities. ELF may also employ hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for both individual and business clients.

The ELF ETF Strategy returns presented herein represents a composite of actual results from all client portfolios managed by ELF. Currently, it is the only composite presented by ELF and separate client account portfolio positions are substantially similar, except as may be modified for retirement plan accounts and accounts with net equity of $60,000 or less. There is no minimum account size for inclusion into ELFs ETF Strategy composite and accounts with net equity of $60,000 or less have a tendency to downwardly skew the combined results.

The performance data presented herein includes the reinvestment of dividends and capital gains; as well, ELFs ETF Strategy composite returns are presented after deducting actual management fees, transaction costs or other expenses, if any. ELF charges an annual investment management fee as follows: 1.25% on the first $250,000; 1.00% on the next $750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.

Copyright 2004 ELF Capital Management, LLC. All rights reserved.