Thursday, September 28, 2006

Real Estate and the Tipping Point

I have traveled to many of the hot real estate areas of the country over the last two years. I am not an avid real estate investor, but it is such an important part of the economy that where ever I go for business or pleasure, I check out, as best I can, what' s going on in the local market. One reason for my keen interest in real estate is that I have been convinced that the employment statistics, as measured by official government measures, have been undercounting self-employed real estate contractors. I described this phenomenon in 2004 when the naysayers were castigating the "jobless" recovery. I said then there was no such thing as a jobless recovery, and I believe the events of the last two years have born me out. Unfortunately, I now believe that real estate in many parts of the country is much weaker than official statistics show. If I am right, this has big implications for the economy and employment. The danger I see in real estate is in what I will call the "cool" areas of the US: Mountains, water, skylines, golf scapes, and the "in spots," in general, in many parts of the country just cannot sustain the prices at which properties have recently sold. The surest indication of this is the prices at which these same properties can command as rental units. Whether one acknowleges it or not, in the recreational areas, the prices are, ultimately, set by the rental market. It was the rental market that drove prices higher in Florida, Arizona, California, Colorado, the Northwest, the upper Midwest, and New England. Property values shot up because the prices that long and short-term leases could command went up. But, now rental prices are softening even faster than housing prices in many of these areas. I have a place in Central Oregon. My family I are great fans of Oregon and the great people of the eastern slopes of the Cascade Mountains. Unfortunately, I see things going on in one of my favorite places on earth that portend a contraction in real estate prices. Long-term rental prices in central Oregon are a fraction of the underlying values of the properties. In my recent visits, I have seen condos valued at $400,000 advertised for lease at $1500 per month for a a 24 month term. That level of monthly lease represents less than half the underlying value of the property. This phenomenon is not isolated to Oregon. The speculators day of reckoning is near. A person can keep lots of real estate afloat as long as prices are rising, but if prices start to fall, the banks get grouchy quickly. I believe that time is very near, and for that reason, I believe lots of real estate in the recreational areas of the country will soon be coming on the market. In my judgment, when that happens, there will be few buyers because speculators have been selling to speculators for quite a while now. Banks never handle these secular slow downs very well because they have been speculating in real estate along with everyone else. Bonuses, profit sharing, stock prices, and promotions have all become dependent upon rising real estate prices. Some banks will figure out quickly that the true economic value of properties in their portfolios are dramatically lower than the price of the last sale, and they will call in their loans quickly. They will loose a lot of public relations points, but they will escape serious trouble. Other banks will try to ride it out. It won't work. They have loaned up to 95% of the property value, but even as I write this, these properties are only worth 75%-80% of their selling prices if a lot of properties hit the market. Banks who try to ride it out are in for a lot of headaches, losses, and bad press. I want to close by repeating that I am not a real estate expert, so don't follow what I am saying here blindly. However, I am a student of human nature and of the economy. In 1999, our money management firm stopped taking new clients because we believed that speculation in tech stocks had reached the tipping point. That was one of the best decisions of my life. One of the worst decisions of my life was in my not having had the courage to put my foot down and say that the tech bubble was about to burst and sell not only the tech stocks but everything that was trading for more than 30 times earnings. I cannot see the future and there are those who know the forces of real estate much better than I. I am sharing my thoughts because my views of the future are colored by the past and there is a shape and form to bubbles that has become very familiar to me. In my mind, there is a bubble in residential real estate in many parts of the country and the bubble is not sustainable. I will stop here. This is a complex subject and there are hundreds if not thousands who will read what I am saying. I have one suggestion. If you are holding more real estate than you can live in, please talk to someone you trust in the real estate business other than the person who sold you the property. You may think that you can catch the falling knife, but let me remind you that Procter and Gamble sold at 60x earnings in 1999. Today it sells for 20 times earnings. .