From Jason Payne, Market News Analyst …
Are you an investor who enjoys more personal income than the average U.S. citizen?
Or do you have access to a healthy supply of private funding for your investment pursuits?
Well, if you’ve been following our investing advice here at Real Estate Mogul, then hopefully you do enjoy more income and more funding options than the average American.
And fortunately for you, recent market data indicates that you may now be poised to bolster your financial lead even further.
That’s right, folks. I’m talking about the latest trends in housing affordability, and their implications for your competitive advantage as a savvy real estate investor.
You see, if asset prices are so unaffordable that most people cannot make a purchase, then prices will likely fall in the future. And under normal economic circumstances, this “bearish” environment would likely compel a savvy investor to wait for upcoming price reductions before taking the plunge and buying more assets.
Conversely, if asset prices are relatively affordable, then prices will likely rise in the future, as normal market forces restore equilibrium to the balance of supply and demand. Under normal economic circumstances, this “bullish” environment would likely compel a savvy investor to quickly accelerate his asset acquisitions.
Sounds simple, right?
Well, not so fast, mister!
Although these simple scenarios make perfect sense under “normal” circumstances, today’s economic environment is anything but normal. And real estate assets are a bit unusual by nature, to say the least. Accordingly, savvy investors need to consider the real estate industry’s latest affordability data with an open mind (and an open wallet, in my opinion).
But first, let me answer the obvious question…
How Should You Measure the Affordability of Real Estate?
When trying to identify whether property values are “affordable” or “unaffordable”, don’t allow yourself to focus too much on asking prices or recent sales activity, as most investors are prone to do.
Although this unsophisticated approach may help with identifying your own personal ability to afford a certain seller’s asking price, it betrays two incorrect assumptions:
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It assumes that you conduct your business in an economic vacuum (which you definitely don’t).
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And it implies that property prices are non-negotiable (which they definitely aren’t).
Besides, as discussed two weeks ago in Mogul’s inaugural analysis of investment yields, real estate price growth is relatively stable over the long-term anyways, notwithstanding the recent spate of government-sponsored volatility.
So rather than following the media herd and bombarding you with price-centric “investment” news, we here at Mogul recommend a more sophisticated approach for analyzing the relative affordability of real estate assets (and its implications for your business).
Specifically, as part of our ongoing effort to provide you with the industry’s best tools for market research, we are pleased to offer the following analysis of Price-to-Income for U.S. residential properties, which leverages the latest market data to measure real housing affordability:
Sources: Zillow, Multpl & REIology Research
In this analysis, the solid red line reflects real U.S. gross domestic product (GDP per capita) as a multiple of Zillow's median price for all residential properties sold domestically since 1998 (price per square foot). The two dotted lines reflect both long-term and short-term historical averages for this helpful measurement of general real estate affordability.
By standardizing our historical calculations over a 15-year period, we are able to examine today’s economic climate for housing investments against a thorough history of affordability trends. Because, after all, the ability to understand what was affordable yesterday is often vital to understanding what will be affordable tomorrow.
And by using real GDP per capita as our preferred metric for standardization, we are also able to effectively shield our analysis from the distorting effects of historical price inflation, thereby reflecting an accurate measurement of what the average American can truly afford to buy.
Unsurprisingly, our analysis reveals that residential real estate grew increasingly unaffordable throughout the frothy boom times of 1998-2006.
During that heady period of eight years, a prolonged season of “easy money” policies from Alan Greenspan’s Federal Reserve generated a stunning 87.7% increase in the housing market’s median price (from $75 to $141 per square foot), while the average American’s real purchasing power only increased by 18.9%. As a result, the industry’s Price-to-Income Ratio for investment affordability plummeted 2,000 basis points, from a high reading of 54.7% in early 1998 to a low reading of only 34.7% in mid-2006.
More recently, we observe a similar phenomenon as Ben Bernanke’s Federal Reserve has executed a fresh new set of “easy money” policies during the last few years.
Specifically, we note that standardized prices have increased 26.8% (from $98 to $124 per square foot) since the Fed’s latest round of quantitative easing began to gain traction in late 2011...
...whereas the average American’s real purchasing power has only increased by 1.5% during that same time.
As a result, the Great Recession’s robust improvements for average affordability are now being offset by another stark decline in average housing affordability.
To wit, as illustrated in the chart above, today’s current Price-to-Income Ratio sits at 40.1%, which is several percentage points below both its 5-year historical average of 44.9% and its 15-year historical average of 44.3%. And based on the metric's sharp decline during recent months, it would appear to the naked eye that residential housing affordability is now in the early stages of yet another worrisome freefall.
But things are different this time…
Why Is It Different This Time Around?
Whereas Greenspan’s former economic policies were spurred by a couple of crashes in the equity markets, Bernanke’s current economic stimulus measures are a direct result of America’s worst housing crisis in almost 100 years.
In other words, there is no way in Hades the Fed is going to let the housing market get out of hand again – at least not anytime soon. After all, it was residential real estate that initially got us into this mess!
Yes, the authorities in Washington know all too well that skyrocketing home prices are exactly what caused the recent real estate bubble to form in the first place. And they know that the post-crash nosedive in home prices was a primary culprit for catalyzing the subsequent worldwide financial crisis of 2007-2012.
And this is why Washington is currently doing everything in its power to orchestrate a smooth and seamless return to “normal” price growth for U.S. residential real estate (an asset class that is traditionally famous for smooth and steady price growth).
Even if there is a modest “bump” in the road when Janet Yellen begins tapering Bernanke’s economic stimulus measures at the Fed, you can rest assured that her team would sooner eat roadkill than let housing prices do anything crazy for more than a few weeks at a time.
Which brings me back to Real Estate Mogul’s timely analysis of relative housing affordability, and its implications for your portfolio as a real estate investor…
Pricing & Affordability Are Not The Same Thing
Remember that housing prices and housing affordability are not the same thing.
Washington’s artificially engineered return to “normal” price trends will not portend the demise of lucrative real estate investing.
Similarly, the current decline in housing’s relative affordability does not necessarily reflect a “bearish” economic environment – at least not for those investors who can afford to take the plunge with strategic property acquisitions.
For example, if the price of a certain house is $120 per square foot, it may be entirely unaffordable for the average American who currently earns $45,000 per year. However, a savvy real estate investor with access to larger sources of personal and third-party capital (like you?) might consider the same property to be a steal at that same price – and he can afford to purchase the asset as yet another lucrative investment in his well-crafted portfolio.
Moreover, by understanding Mogul’s latest analysis of housing affordability, the savvy real estate investor could use his familiarity with this important economic context to improve his near-term dealmaking tactics. While at the negotiating table, he might confidently negotiate a much lower price for his near-term property acquisitions (which he could already afford to buy), because he would know that the seller’s asking price is relatively unaffordable for the average buyer.
Indeed, while other would-be investors sit idly on the sidelines, smugly waiting for asking prices to commence an “inevitable” decline, the savvy analyst who understands relative housing affordability can use this information to become a near-term dealmaking activist – with long-term economic benefits – rather than playing the passive role in a game of “chicken” with our price-sensitive economic puppet masters at the Fed.
And although Washington will likely refuse to let housing prices make any extreme moves for a while, Yellen & Co. are adamantly committed to increasing the raw purchasing power of average U.S. consumers, as artfully explained in this report by economist Michael Bazdarich.
This means that residential real estate is likely to become relatively more affordable for the average American during the next few years, even as home prices are likely to stay within a more modest range.
To illustrate this concept, we use the following chart to juxtapose Mogul’s new analysis of the housing market’s Price-to-Income Ratio with a historical depiction of its underlying components.
In this perspective, the solid red line continues to reflect average U.S. housing affordability since 1998, but the dotted lines are adjusted to reflect recent trends in the affordability metric’s underlying data for real GDP and median home prices.
Sources: Zillow, Multpl & REIology Research
As shown in the chart above, average housing affordability tends to be inversely proportional to changes in pricing, but the effects of dramatic price increases are muted during times of sustained GDP growth.
It is a variation of this “muting” effect that will likely allow average U.S. housing affordability to increase during the next few years, as artificially stabilized prices are supplemented by Washington’s simultaneous efforts to manufacture a healthier brand of broad-based GDP growth.
Although we here at Mogul do not provide specific estimates of future GDP growth or price levels, it seems reasonable to expect that the recent increase in prices (illustrated above as a blue dashed line) may soon decelerate when the Fed begins to taper its current “easy money” policies. Simultaneously, it seems equally reasonable to expect that real GDP (illustrated above as a green dashed line) can continue its upward march and effectively restore housing affordability to its historical averages – and beyond.
In fact, we note that the U.S. Bureau of Economic Analysis recently published a significant upward revision to its initial reading of real GDP growth for the second quarter of 2013 (up from 1.7% to 2.5%). And the agency’s preliminary estimate of third quarter GDP growth came in last month at a robust rate of 2.8%, despite a multi-billion dollar economic impact from the recent government shutdown.
(Of course, we’ll be keeping our eye on the final “official” reading of third quarter GDP growth when it is released on Thursday, December 5th.)
The Bottom Line
So instead of needlessly fretting over the relative unaffordability of residential real estate in today's market, savvy investors should instead be asking themselves the following question:
“If I am one of the fortunate Americans with an ability to invest in real estate at this time, how can I be taking advantage of the lack of competition in today’s relatively unaffordable housing market, in order to capitalize on future GDP growth?”
In my view, such investors should strive to take advantage of the current uncompetitive environment for as long as it lasts, leveraging their access to personal and third-party capital sources while negotiating their acquisition prices as low as possible amid a relative dearth of other serious bidders.
And don’t worry if your seller is unwilling or unable to reduce his asking price down to the historical U.S. average of $107.50 per square foot. Instead, mentally prepare yourself to spend a little bit more money for a good property (depending on your market), and then console your checkbook by raising rents as real GDP growth continues to increase the raw purchasing power of your new property’s tenants.
Remember that average net rents have increased by a robust 16% since November 2010, as discussed in our recent report about the importance of long-term investment yields – and this encouraging trend appears poised to continue throughout the foreseeable future.
Yes, as the real estate industry continues to regain its basic fundamental health, and as the broader U.S. economy is gradually weaned off its current diet of economic stimulus policies, we here at Mogul look forward to watching numerous property types reestablish themselves as premier vehicles for reliably high-yielding investment returns…
…including, but not limited to, the residential housing sector.
So don’t be discouraged by today’s rising home prices, thinking that you may have somehow “missed the boat” for lucrative investment opportunities. And don’t be fooled by tomorrow’s potentially stable prices, erroneously assuming that real estate’s investment returns have effectively “maxed-out”.
Instead, appreciate the fact that these unusual economic times may be providing you with exactly what you need in order to bolster your competitive advantage as a savvy real estate investor, by securing long-term gains at reasonable prices, which many other people cannot currently afford to pay.
Jason Payne’s next Market News Update is scheduled for Wednesday, Dec. 11th.