The Case For A Bull Market In Homes
Few issues these days are more dividing than the future of of the housing market. Most of the noise seems to come from the bearish folk, who believe we ain’t seen nothing yet. While the bearish outlook on inventory, defaults and pricing may seem plausible, it is also worth noting that money isn’t made by following the crowd.
Consider the investment strategies of John Paulson, a hedge fund manager who bet against the housing market in 2006/2007 – at a time when everybody was yelling buy, buy, buy. When it was all said and done Paulson had pulled off the greatest trade in financial history, earning more than $15 billion for his firm, a figure that dwarfed George Soros’s billion-dollar currency trade in 1992. That same John Paulson is now taking the other side of the bet, and is convinced we are on the cusp of a bull market is housing.
Bill Ackman, CEO of Pershing Square Capital, is another highly successful hedge fund guy who recently turned bullish on housing. Needless to say, both Ackman and Paulson are acutely aware of the housing market’s woes, but they are also capable of seeing opportunities where others fear to tread.
Here are some of their thoughts:
Home Values Have Declined Meaningfully: Nation-wide home values are down 28% off their peak (based on Case Shiller Home Price Index). Falling homes prices and lower interest rates have dramatically improved affordability.
As a result of these low valuations, Ackman calculates that the break-even appreciation rate for rental equivalent value is now the best since the 1970s. Yes, prices may have not hit bottom, but the valuation aspect is only part of Ackman’s argument. Here’s the next fact to consider:
The Power Of Low Cost, High LTV Financing
Mortgage rates have fallen to historically low levels. Fixed 30-year rates recently dipped below 4.5% – for the first time in the history of the Freddie Mac lender survey. You can now get a 30-year loan at more than 95% LTV for four and a half per cent. Think about it; no other business or investor can get financing on such favorable terms! Given that you can deduct your mortgage interest as well as property taxes, the after-tax cost of ownership is frequently below the cost of renting. This has a huge impact on the economics of owning a home as this example illustrates:
Click here to see calculation details.
Favorable Long-Term Demand Dynamics
Household formation is a key driver for home-ownership. Since the 1970s household formation growth has trended positively in a cyclical manner i.e. periods of high growth have alternated with periods of contracted household formation growth. In recent years household formation has slowed down. If history is any guide, household formation should soon pick up again. In theory, accelerated household formation and a stabilization of the homeownership rate, should lead to greater demand for owner households.
Housing Starts Are Now Below Long-Term Demand Growth
In the wake of the credit crisis, builders have sharply reduced their construction capacity. Housing starts are now lower than at any time in at least the past 50 years. Starts today are less than half of the average long-term demand. This is creating a significant supply/demand imbalance – the essential ingredient for investment opportunities.
Adding new housing inventory (supply) is not as easy as you might imagine. It can take three to seven years to get land permitted in some of the more desirable markets.
Why Buy Now?
So, why buy now? After all the market may have further to fall. Prices may indeed change over the short term, but so too can other critical factors which would eliminate any gains achieved through lower price points:
- Interest rates won’t stay this low forever
- New monetary lending (QE2) increases the risk of inflation (real estate acts as an inflation hedge)
- Forced selling (REOs) may abate as lenders balance sheets improve (as has been the case in several commercial real estate markets). This would create upward pressure on pricing.
Ultimately, the current circumstances are creating an opportunity to buy a long-term investment at an attractive valuation in a market facing short term distress. That opportunity is here now. It may not be around a year from now.
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