Housing is usually more stable because the motivations of the buyers are for long-term occupancy rather than exclusively for profit. But by rigging the market toward speculators, the Fed may have queered the pitch. Sadly, once the money has fuelled a boom, you can’t just take it back
One of the brightest parts of the American economy is the housing market. It is considered the strongest proof of a recovery. Recent numbers appear to create a very optimistic story. The S&P/Case-Shiller Index, the best measure of housing prices, showed a 9% increase since last year. The construction trade, which lost 1.92 million jobs in the recession, has recovered 370 thousand jobs. Sales of new homes have increased 18% since last year. Sales of previously occupied homes are up 10.3% over the same period. Inventory of homes for sale is at levels not seen since the height of the bubble in 2006. With this type of shortage new construction is booming. Even the size of new houses is getting bigger. The median size of newly constructed houses hit 2,259 square feet (210 sq m) in 2006, before dropping 6% to 2,132 sq ft (197 sq m). They have now reached a new high of 2,309 sq ft (214 sq m). The best news is that a major cause of this revival, low interest rates, will continue into the foreseeable future.
But the beneficial effects of the low interest rates are only part of story. The reason why the US Federal Reserve is manipulating interest rates is to encourage investors to put money into riskier assets. This helps explain record stock markets in a lacklustre economic environment. With yields at record lows many other investments appear attractive including risky junk bonds. For the past 30 years the Barclays US High Yield Index (junk bonds) had never been lower than 6%, but last week it dropped under 5%. The average yield on CCC-rated bonds is now 6.77% down from 10.13% a year ago. The triple C rating for a bonds means that the bond has a 50% or higher chance of defaulting.
With yields this low, purchasing housing that can be used for rental income looks very attractive. With cheap financing from the Fed, large investment companies expect to get a 14% to 27% return on a $100,000 home. The rental market in the US is strong because of the housing crisis. The housing crisis not only threw millions of home owners into the streets as their homes were foreclosed, the foreclosures also destroyed their credit histories. Without the ability to qualify for the cheap credit, most of these people had only one option—rent.
Besides excellent rents, investors might also expect the houses to appreciate. The US housing market peaked in 2006. It had its largest decline in 2007 to 2008, but continued to decline until 2012. By buying at the bottom often at 30% to 40% discounts to pre-crash prices, investors can expect appreciation of at least 10%.
As you would expect, investors have flooded the real estate market. The combination of low prices and money at practically no cost has been irresistible. Investors have been especially interested in multi-family homes. The optimistic data from house construction is almost entirely due to multi-family dwellings. The 7% rise in new constructions last month was a combination of a 31% rise in multi-family housing. Single family housing, the ones most likely to be purchased by a home owner, fell 4.8%. Multi-family housing starts are running at an annualized pace of 392,000 which dwarfs the ten year historical average of 238,000. Investors bought close to 20% of all homes available in both February and March. Although many of the homes purchased by investors are purchased for cash, last December 13.6% of the mortgages taken out were for second homes or investments topping the 13.4% reached at the peak of the market in January of 2006.
The low interest rates have distorted the market. Normally housing recoveries are driven by first time buyers. In healthy recoveries they make up 40% of the market. There are years of pent up demand. But with the high unemployment, many of these first time buyers cannot enter the market. So despite the demand and the low prices, first time buyers made up only 30% of the market.
While the Federal Reserve’s cheap money has been available to speculators and hedge funds, it has not found its way to the ordinary borrower. This situation is due to a number of factors. Borrowers with recent defaults or periods without a job will have trouble qualifying for loans. The concentration of banking has eliminated many of the smaller institutions which might have been more sympathetic. The almost total domination of the mortgage guarantee industry by the federal housing agencies of Fannie Mae and Freddie Mac have standardized all of the requirements, so if you don’t fit the mould, you don’t get the loan. This shows up partly in the headline price rise, because only the wealthy can qualify. The prices of larger homes, $500,000 to $750,000, have risen by 25% since last year. Homes between $100,000 and $250,000 have risen only 7%.
A good example of what is happening is Las Vegas. Las Vegas—the gambling capital of the United States—is a city of 2 million people. The housing market had one of the biggest run ups of any market in the US. The average price of a house increased from about $120,000 to $240,00 almost 100% from 2003 to 2006 before falling to $100,000 in 2010. There are 20,000 homes in Las Vegas in some state of foreclosure and the jobless rate is two percentage points above the national average. Yet, Las Vegas is experiencing a housing boom.
Home prices have risen 30% in a year. Investment firm, Blackstone, has purchased 400 houses in Las Vegas. Blackstone and other investors have accounted for at least 10% of homes sold last year and 60% of sales are for cash. The investors’ objective is to invest an amount sufficient to fix the house up for rental. The demand from investors for this type of property has increased the median price up to $161,000, much of that since last June.
This model seems like a one-way bet. Borrow at record low interest rates, buy houses at heavily discounted prices often at foreclose auctions, fix them up a bit, rent them out and finally sell them at a profit. The problem is that the real economy can mess up the best spread-sheet projections. Unemployment is Las Vegas is still high. The main industry is gambling, tourism and conventions which are all discretionary spending. With so much supply, rents on single family homes are declining. Normal house buyers are priced out of the market and often investment firms are the only bidders.
Las Vegas is an extreme example of what has been occurring across the country. Other depressed markets in Arizona and Florida are seeing similar booms. The problem is that any distortion within a market is inherently unstable. Today’s boom could easily turn into tomorrow’s bust. Housing is usually more stable because the motivations of the buyers are for long-term occupancy rather that exclusively for profit. But by rigging the market toward speculators, the Federal Reserve may have queered the pitch. The central bank may be belatedly recognizing this with its just-announced strategy for winding down the QE program. Sadly once the money has fuelled a boom, you can’t just take it back.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)