Contemplating housing as an investment can lead to fascinating dynamics. Ever since the mortgage crisis, there has been an explosion of discussion on this topic, often challenging folks to question their traditional mindsets while in search for explanations as to why it happened. Even at a simple starting point of considering the merits of measuring housing value from either the fundamental affordability of monthly payments or from a more technical contrasting of comparable sale prices, such choices have consequences. When a car salesman focuses their customer’s attention on affordability, common wisdom suggests it is with the intent to convince the buyer to pay more for the car in question. This is not far from the reality in housing, where focusing on monthly payments tends to shroud the implicit assumption of ever rising sale prices. The problem is, as we've all learned, housing prices can go down. So, while affordability certainly facilitates utility, i.e. getting into the home, sale prices are generally relied upon to track investment success.
Consider the actions of the Federal Reserve in response to the recent financial crisis, a crisis which is defined, in part, by drastic drops in housing prices. By reducing borrowing rates, thereby making monthly payments lower, the Fed put a deliberate positive pressure on those same housing prices (all asset prices really). Does this mean the Fed is performing the car salesman “misdirection?” Maybe a little, but to some extent the Fed’s actions were a prudent measure to stall the economy's recessionary spiral, defined by those falling prices, and get us into a temporary state of recovery. However, the fact that rates have zeroed out also implies the end of rising sale prices of homes due to Fed macroeconomic policy which, for those that include themselves as participants in the real estate market, may suggest revisiting housing prices from a more local perspective.
Does the current macroeconomic state of affairs suggest it’s a poor time to buy a house? Not necessarily, however prudence warrants a review of some basic concepts regarding real estate valuation, such that buyers, financiers and even regulators, can make fully informed choices. And yes, financiers and regulators are also “buying” homes since their commitments to the buyers, and each other, represent a forward agreement to own those homes at a slightly lower price than what the buyers paid. Since money is not free, it stands to reason that the Fed will need to raise borrowing rates in the future, notwithstanding the whispers of “negative interest.” As such, while housing prices reflect an infinite number of influencing factors, all real estate values will at some point, or over some timeframe, have to endure as much negative pressure as they enjoyed positive pressure at the hands of the Fed. This can be considered a systemic, or system-wide, risk to prices.
So how can one identify real estate that will exhibit robust value in the face of systemic downward pressure? Commercialization is a common tactic, in that, improving or re-purposing property to generate current income will reduce the impact of a lower future sale price. Though most appropriate for institutions, individuals tend not to rent rooms out of the house they live in. Accordingly, the choice to forego the current income option means the future net liquidation value of any prospective home is going to need some other form of support, some positive pressure specific to that property.
Only land goes up in value. Though first taught this during my real estate appraisal training, it’s not a concept I hear or read, in discussions amongst the general population of homeowners, investors, economists, etc., so let’s recall. When you buy a house, what you are really buying are the legal real property rights associated with the land along with the existing improvements on the land, i.e. house, utilities, etc. If you consider that physical improvements always depreciate over time, requiring constant curing, it’s easy to realize that the house itself, an improvement, is not really an appreciating investment. While commercial real estate investors may set rents high enough to cover depreciation, a homeowner will need to cover such expense out-of-pocket. Imagine the moment you drive off the lot in a brand-new car, not only does the car’s value diminish immediately, not keeping up with its necessary maintenance will also lead to both the function and value of the car diminishing further. The same logic applies to a house. Without a way to monetize a house while living in it, one must focus on the land itself when considering the ability, or likelihood, of the value of the real property rights exceeding the physical depreciation, hence providing a positive return on sale.
Over-improvement, such as making alterations or enhancements to a property that cost more than the market value added to the property, while being a money losing proposition for the owner of a home, will in fact raise the price that a future buyer will pay relative to what the owner originally paid for the home prior to being improved. In other words, if you renovate your completely functional kitchen for $50,000, the next owner may only give you $25,000 more for your house due to that renovation. The price of the home may rise, but the seller still lost money. When many homeowners in the same region or neighborhood, begin over-improving their property, it will actually put positive pressure on local land values and therein lays the key to identifying properties with robust values in today’s market: Find areas where there’s consistent and abundant over-improvement.
This should sound somewhat like momentum trading in the stock market, as investing in non-dividend and non-utilitarian corporate equity is similar in concept to investing in land, which is the non-revenue and non-utilitarian component of residential real property. The fact that a homeowner can enjoy the utility of the improvements, while having a level of control over their land commensurate with their capital’s risk profile, i.e. equity, gives housing its distinct nature as an investment class (a stock market investor typically does not enjoy those same benefits). Yet, this does not take away from the point that land values are inherently pro-forma, speculative, subjective and ultimately reinforced by the local ‘herd.” While never wise to follow a herd as a rule, finding neighborhoods exhibiting real long-term equity capital investment is going to give homebuyers and financiers some measure of confidence they could not claim otherwise.
This logic has interesting ramifications as we circle back to the current macroeconomic state of affairs and the dynamic of housing finance reform. Reform has been another big focal point since the crisis, and amongst the many ideas, goals and policies being discussed is the notion that such reform should target wealth creation. Some questions come to mind. How exactly does the homebuying experience create wealth? Can your home’s value rise above the price you paid after accounting for depreciation? Can a homeowner enjoy the benefits of rising land values without contributing the additional capital required to fund the over-improvements which in turn pressure those land values higher? Is your home simply a reflection of your wealth, as opposed to a means of building that wealth? Consider the answers to these questions not from your personal perspective, rather from that of a financier or macroeconomic regulatory authority. Of course you could buy the small house in a neighborhood which is experiencing a high degree of renovation, and see your land values increase without doing any over-improvements yourself. In a sense, you’d be riding the wave created by your neighbor’s capital investments. Unfortunately, though you may be able to succeed with this passive strategy, not everyone in the neighborhood could, otherwise there would be no wave to ride, so to speak. Not everyone can “beat the market.” It stands to reason then, from a macroeconomic perspective, it might not be prudent to view homebuying as a path to wealth creation for all, notwithstanding the ability of a necessarily small percentage of the population that could “ride the wave.”
Put another way, if wealth is most accurately defined as the result of accumulating net savings through maximizing income and minimizing expenses, and this strategy works for all, while housing is only a measure of wealth for most while creating real wealth for only a few, then policy goals of creating long-term wealth should probably not be focused on increasing homeownership. That is, unless wealth is to be achieved by first increasing the income of those who facilitate homebuying, the advocacy for investment into non-income generating and depreciating assets may actually be working against wealth creation? In this light, the Federal Reserve’s mandate to promote employment takes over from where their rate policy leaves off, as without income growth there can be no real wealth creation, nor the long-term stable housing price appreciation that follows. Whether or not the Fed is successful in facilitating widespread wealth creation, individual homeowners can certainly target the localities exhibiting tell-tale signs of increasing income.
As homebuyers look for over-improvements and regulators tackle wealth creation, financiers find themselves somewhere in the middle. True financiers, as opposed to those who only facilitate transactions, have the unenviable task of trying to manage their exposures to systemic risks without inadvertently adding to such risk. Due to their desire to mitigate individual borrower credit risk, and as an unavoidable byproduct of their size, institutional financiers generally employ a diversification strategy to investing, aka lending. What this diversification leaves in its wake is, by definition, a non-diversifiable, systemic residual risk profile, implying only the risks that affect everyone will affect them. Given the current macroeconomic situation, that puts financiers in a much more risky position than homebuyers, in that while both have to contend with the same future negative pressure of borrowing rates, how can a large-scale financier chase over-improvement? How can they implement any effective local strategies, characterized with idiosyncratic risk profiles, when the act of diversification itself is designed specifically to dampen the impact of this type of risk taking? This is generally where financiers turn to the concepts of risk sharing, i.e. government guarantees, private capital, downpayments, capital reserves, etc., as a means to manage their residual risk, and this is where the most dynamic discussions are happening within the real estate financial reform arena.
Ryan W. Birtel is founder and managing director of Eolith Advisory Ltd., an independent consulting firm that provides economic and financial advisory services related to the real estate and structured finance markets. He may be reached by phone at (646) 707-1502 or e-mail [email protected]