Real Estate Prices Explained

This article from today's New York Times Magazine is one of the most straightforward explanations I've seen for the factors impacting real estate prices.

The long and the short of it - it's not entirely appropriate to think of real estate as a completely different type of asset class, immune to the vagaries of bubbles and speculation.

Shiller’s gloominess has been widely noted. He thinks we are under the spell of that familiar goblin, mass psychology. Lemming-like, people are buying homes merely because they expect that prices will rise. This certainly holds for speculators, like the manager of a rental-car agency at the Tampa airport who confessed to a customer (an economist) that he owned no fewer than 20 condominiums. And it explains some of the impulse to buy second homes, which are closer to being tradable assets than a primary residence is.

But neither is it appropriate to think of it as being the same. Real estate is much stickier. Quoth The Times:

This is the problem I have with the real-estate-equals-dot-com argument. Most homeowners buy to have a place to live. If prices fall, they react precisely unlike stock traders; rather than bail out, they stay put longer. Every share of Cisco may be for sale every day, but every house is not. Case, Shiller’s partner, tracked 628 home listings in the Boston area during 2006, as prices began to fall. After four months, the majority remained unsold, but the sellers lowered their asking prices by only 3 to 4 percent.

But what I liked most about this article was it's treatment about the value of leverage in real estate investing.

Suppose the stock market did rise 10 percent; after a year you would be up $5,000. Whereas the gain on your home would be 5 percent over the entire purchase price — or $11,000. Over 10 years the gap becomes huge — not to mention over 20 or 30 years. This is the little guy’s (and also Donald Trump’s) trick for accumulating equity: leverage.

It then goes on to talk about how leverage is theoretically practicable for investments in other asset classes, but the truth is that the lending rules for real estate are much more forgiving. If stock prices go down and you are leveraged, you're forced to cover immediately. If that held true with real estate, as the author points out, very few of us would be homeowners. Overall, one of the better articles I've read on this subject.

The Bubbleversary

On March 9, 2000, the NASDAQ stock index hit 5048.62. On March 10, 2000, it began a downward slide from which it has never recovered. On Friday, the NASDAQ closed at 2,387.55, which is a great improvement over 1300 where it sat in September of 2002.

The NASDAQ increased over 500% in the five years leading up to 2000. It had pretty consistently returned 60-70% every five years for the several five year periods before that. There was a lot of talk at the time that things were "fundamentally different". Now it really only matters that large institutional investors thought that, because they move the market. Individual investors really don't have a lot of power to nudge it.

But even if they didn't have market moving power, individuals could still get themselves in a lot of trouble. I remember people who had no business investing in stocks, talking crazy. I remember hearing people say that a stock sounded cheap because it was priced at $10 per share, without any regard for the number of shares outstanding or what that implied about the value of the company. Much less did they try to evaluate the profit the company might return in the future, and what share of that profit their $10 got them.

I remember people buying stock because it was about to split, and they were sure people would buy more stock after it split, driving the price up. They didn't consider that a) a split doesn't change the value of the company and b) even if it did, we ALL knew the stock was splitting, and if it was really that simple a lot of people would have beaten them to the punch.

Anyway, happy anniversary. Did we learn anything? I don't think so. The way I've heard people talk about real estate over the last five years, I'm pretty sure we did the same damned thing just a couple of years later -- people who knew nothing about real estate talking about it "knowingly" like they were Conrad Hilton. Many people think the reckoning has come, but it certainly hasn't felt like a reckoning to me. NASDAQ 2000-2002: now that was a reckoning.