WASHINGTON, May 24 (UPI) -- "In my Father's house are many mansions" says the Bible's King James Version (John, 14:2). I always thought that description made Heaven sound like an American suburb, rather overdeveloped in a building boom. This time around, though, many of those mansions are going to be empty.
CNN/Money Tuesday featured as "Tycoon in the making" the blithe young Robert Cromer family, who have, based on a main salary of $50,000 per annum, accumulated $3.2 million in housing assets in six years, in three different states. Naturally, readers scanned their story eagerly to learn their secret. Well below the lead paragraph, it was revealed that to buy the properties the Cromers have accumulated debt of $2 million, predominantly in the form of 5 year interest only adjustable rate mortgages. The rents receivable after expenses on the family's properties are $3,100 per month less than the interest payments, even at spring 2004's record low interest rates, and their payment outflows will increase by $20,000 per annum for each percentage point rise in interest rates.
The Cromers have alleviated their cash flow problems so far by going into the residential real estate sales business, thus increasing their earnings to $175,000 per annum in this buoyant market. Of course, that doesn't actually reduce their exposure to a real estate downturn!
The Cromer family's mistakes are elementary. You don't finance a long term asset, like a house, with 5 year money. You don't finance an asset with a fixed money yield with floating rate debt. You don't enter into commitments that leave you substantially under water on an operating basis month by month, with the expectation that an ever rising real estate market will bail you out. Investors who make these mistakes on a single property, or on a portfolio of properties that is modest in terms of their overall assets, may survive the downturn by investing more cash, derived from other areas. Investors like the Cromers, who make these mistakes on such a large scale in relation to their finances are bound eventually to find out the hard way what sound financing means.
The surprise is not that retail real estate investors are financing themselves this way -- in every real estate boom, optimists appear who do the same thing. The surprises are, first that after the savings and loan crisis of only a decade ago, mortgage lenders are prepared to lend them such relatively huge amounts of money on such inappropriate terms. Second, more serious, it is surprising that a reputable media outlet would hold up this family as an example to follow to its often unsophisticated readers. Just as in 1999 brokers could be blamed for hyping to ridiculous prices stocks that had few underlying activities or possibility thereof, and in 2001 Enron executives could be criticized for allowing their derivatives operations to grow to the point where they bankrupted the company, so too in 2004 it is fair to criticize those who ought to know better and don't, and thereby lure unsuspecting Americans into a trap of excessive debt and eventual impoverishment. By making the housing bubble extend itself further, they are intensifying the downturn to follow, damaging the U.S. economy, and forcing into difficulties in the subsequent downturn millions of Americans who had nothing to do with the initial speculation.
The principal threat to the U.S. housing market comes from rising interest rates. Short term interest rates have now been negative in real terms (i.e., net of inflation) since the middle of 2001, which has enabled the United States to stage a pretty-looking economic recovery, but has also driven huge amounts of investment into the housing sector, investment that is likely to prove unprofitable once short and long term interest rates return to their natural levels.
Economically, house prices are determined on the demand side by population flows, interest rates and the economy, and on the supply side by construction costs and local land prices. This is why a bubble can appear in one location and not another. If population pressure in a location is low, then land in that area will remain plentiful, and hence house prices will be constrained from rising at more than a modest rate. Any greater rise will bring in new construction companies to take advantage of the arbitrage between prices and construction costs -- barriers to entry in the home-building sector are in the United States very low indeed, so new local construction activity quickly springs up when this opportunity emerges.
The more dangerous situation arises when land is scarce, either because of a physical lack thereof, (as in downtown London or Tokyo in the 1980s) because of rapidly rising population in a confined area, because of legal restrictions, or all of the above. In such a case, land becomes scarce, its price rises uncontrollably, and real estate prices escalate far beyond the level of construction costs, let alone local incomes.
In Tokyo in the 1980s, the principal constraint was sheer space; the area within a reasonable commuting distance on Tokyo's suburban rail system was bounded on one side by the sea and was restricted by small agricultural holdings whose use could not be converted. Hence there occurred a rise in real estate prices that left the Imperial Palace gardens in 1989 worth more than the state of California. Going forward, the aging of Japan's society, the country's immigration restrictions and the beginnings of a gradual decline in population will together ensure that the bubble of the late 1980s will never be repeated, and that Tokyo real estate costs will if anything continue to decline.
In London, too, the arcane and Byzantine restrictions on new home-building, which produce huge delays and leave large areas of "green belt" around London unavailable for development, and the union-ridden and inefficient public transport system, led house prices to be extremely high in terms of the local earning capacity, even though the city's population before 1980 was gently declining. Add EU yuppies attracted by low income taxes at the top end and an uncontrollable inflow of asylum seekers at the bottom end, and you have a recipe for the London real estate market to head towards Jupiter.
The U.S. real estate market was traditionally immune to these effects, except for small enclaves in Manhattan and Silicon Valley (housing in which became a "positional good" -- unnecessary, but attractive for social snobbery reasons) because of the sheer size of the country in relation to its population. However, rapid immigration since 1980, lack of investment in road transport infrastructure (which has thrown the burden of extra population on overstretched suburban rail systems) and a decade of excessive monetary creation have had the inevitable effect of causing land prices in several other cities beyond Manhattan and Silicon Valley to join in a rapid price appreciation. In Cleveland, Omaha or Dallas, where population has not grown greatly and suburban transport remains adequate, house price appreciation remains modest, but in the major cities of the bi-coastal "blue states" a scarcity-fueled price appreciation has taken hold.
The future of house prices in those cities where rapid appreciation has taken place is undoubtedly bearish, but it is not clear how bearish. One sign that much of the appreciation has been caused by very low interest rates is the rental market, where rental yields are at record low levels in a number of cities and the economic recovery of 2003-04 has not affected the depressed occupancy levels of rental property. In addition, a sharp decline in loan underwriting standards, fueled by uncontrollable growth at Fannie Mae and Freddie Mac, has raised the level of home ownership in the U.S. population to record levels. Of course, in cities where this has combined with rapid price appreciation, the potential for a market collapse, fueled by mortgage delinquency, is thereby enhanced.
Nevertheless, a return in the bi-coastal cities to the historic pattern of U.S. house prices governed primarily by construction costs appears unlikely. Political will is lacking to rein in the activities of Fannie Mae and Freddie Mac, so mortgage money will continue to be readily available, and second mortgages and refinancings will be used to cover up mortgage delinquencies. As in much of Europe, the flow of immigration appears out of control, so the population pressure in the cities where immigrants congregate will remain great. Environmentalist opposition to new projects and tight state budgets are likely to ensure that the transportation network around big cities remains inadequate. Thus one of the United States' major advantages over its competitors, the availability of chap residential real estate, is likely to have disappeared forever, at least on the coasts.
Which is not to say that as interest rates rise we won't have a pretty nasty housing recession. According to the National Association of Homebuilders Wednesday, optimism among homebuilders remains very high, in spite of rising interest rates, so a housing glut, at least in relative terms, seems unavoidable.
The Cromers are likely to find themselves hit by a multiple whammy, of poor rental occupancy rates, declining house prices, an illiquid home sale market and rising interest rates on their adjustable rate mortgages. Their financial survival seems unlikely.
But at least they got featured in CNN/Money.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) -- details can be found on the Web site greatconservatives.com.