February 14, 2011

US Real Estate Will Never "Recover"

These days, most people believe that the current real estate downturn is due to rampant speculation.  At some point it will recover from this excess of speculation, and will resume its upward trend.   How realistic is this expectation?

Well, consider the following:
  • Real estate hasn't always appreciated. Indeed, from 1890 to 1970, while being equally volatile, real estate appreciated at almost exactly the rate of inflation -- making it a paltry investment, indeed.
  • Baby Boomers went into hock, too. Ask any Baby Boomer about their home-buying experience in the 1970s, and it sounds just like what Generation X'ers are going through today:  Both groups bought as much as they could afford, and fretted over making the payments.
  • Economics 101:  For an asset's value to appreciate, someone else has to be both willing and able to pay more for that asset.
So, given that every generation spends as much as it can on home prices:

How does the 2010 home buyer afford so much more than the 1970 home buyer?

When we can answer this question, we can assess whether the 2050 home buyer will afford proportionately more than the 2010 home buyer.

It turns out that are four reasons why real estate has appreciated so much since 1970.  All have abruptly ended.

1. Family income greatly increased.
This is likely the largest reason why real estate has appreciated.  Women entered the workforce in the 1970s in great numbers -- first in lower-paying jobs, but over the past 30 years their salaries have been steadily increasing.  
Can family income continue to increase?  Barring selling our children into slavery, the US family will not experience any additional income earners.   Moreover, any residual increases in second-earner income (as the gender salary gap further declines) are more than offset by increasing childcare and education costs.

2. The cost of borrowing declined.
In 1982, the 30 year mortgage rate hit 21.50%.  Over the past 30 years, it has coasted down to the mid-4%s.  This allowed people to borrow more money while leaving their monthly payments unchanged, and implicitly increased the amount they could spend on their homes.
Can the cost of borrowing substantially decline further?  Highly unlikely, interest rates are already at 60 year lows.  All indications is that the US is flirting with losing its triple-A debt rating over the next few years, which would cause interest rates to skyrocket.
3. People borrowed more money.
In the 1950s and 60s, mortgage debt was seen as a temporary evil.   You could not purchase a house with less than a 20% down payment -- and the goal was to pay it off quickly.  Since then, people have progressively financed larger percentages of the home price, and are far more comfortable holding long-term debt.   This has allowed people to spend more money on their homes.
Can people borrow even greater sums of money?   People already often put 0% down, and routinely upgrade their homes once they get enough equity in their current homes (i.e., keep themselves constantly leveraged to the hilt).  I don't see how people could borrow more than they do today.

4. People borrowed on more risky terms.
In 1982, Congress deregulated savings and loan associations and allowed banks to provide adjustable-rate mortgage loans (via the Garn St. Germain Depository Act).  This act was cited as a major factor in the savings and loan crisis of the late 1980s.  Nevertheless, it stuck around, and even more risky terms have appeared: No Disclosure Loans, Option Arms, Interest Only Loans, to name a few.
Can people borrow on even riskier terms?  The market has already dabbled with insanely risky loans, and only backed off because they're wholly impractical.  There is no room to lower payments (and consequently increase home prices) by incurring more risk.

Appreciation between 1970 and 2010 didn't happen by magic.  Speculation played a role, but most appreciation was due to long-term trends of increased household income, cheaper borrowing, more leverage and more risk.

If these trends have halted, we can expect a reversion to the longer term trend:  real estate appreciation equal to the rate of inflation.  However, if these trends have reversed, we can expect appreciation even lower than that.

It this pleasant news?  No.  Is it realistic?  Probably.

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