Ownership Can Be Ephemeral
Deflation is upon us. There is excess capacity in everything far in excess of demand. Every Central Bank in the world is devaluing its currency. The US alone added over $4 trillion to the Fed’s balance sheet. Abe has been going hog wild in Japan during the last two years. Euroland is finally joining us with a “me too” QE. Under these circumstances, it should be a no-brainer that any asset such as gold, cows, oil and real estate should hold value better than paper money. Real estate has utility value. It provides shelter. Taking out a mortgage is even better, borrowing at today’s dollars only to repay it with future dollars that are likely to be worth a lot less.
Before we run out and buy all the real estate we can, there is a question. Who determines how real real estate is?
The Opus Hong Kong building, designed by the Pritzker Prize-winning architect Frank Gehry. It is home to one of Asia’s priciest condos. According to a Times of India report, the buyer paid $9,773 a sqft for the 6,200 sqft apartment, on the eighth floor of the 12-story building. Total price: HK$470 million (approx. $61 million).
Once upon a time, there were the Navajos, the Cherokees and a number of other tribes occupying the land that became the real estate that we now own. In 1947, the United Nations created a real estate subdivision called Israel even though there were other people living there already, and this involuntary ownership transfer is still ongoing. At the present time, I wonder how real real estate is in Ukraine, Crimea, Iraq, Afghanistan and many other places. I am not trying to condemn anyone for acts of the past, present, and certainly the future, I am just stating that real estate is nothing more than a right to ownership as long as you can hold it.
Geopolitical issues are not the only factors that determine real estate ownership. Each level of government also affects your rights to real estate within their jurisdiction. Domestic policies and economic conditions not only determine value but rights to enjoyment.
For example, what is a condo? Just rights to air space. All those high priced condo co-ops in Manhattan are nothing more than air space. In outrageously expensive cities like Hong Kong, you do not even own a fractional interest in the land under the air space, it is a land lease. Say your air space is on the 26th floor, I would like to see how you get there if the elevator is not working. In other words, you are totally relying on your government to protect not only your right to ownership but to provide the essentials for your right of enjoyment.
Mortgage Delinquencies in the US
Before I digress too far, my point is that current conditions are such that we need to examine how real owning real estate is in the US. Allow me to elaborate.
Who owns your house? If you have a mortgage, it means you have pledged your ownership in exchange for a loan. In other words, you only own the rights of possession until you pay off the loan, pretty much like a car loan. The lender owns your house. This was not an issue before when it was a free market. Today, there is only one lender, the Federal Government, operating under the names of Freddie, Fannie, FHA and VA. These agencies are now competing against each other to provide the easiest low cost financing, just like the sub-prime lenders ten years ago.
So how healthy is the mortgage market? Headlines may mislead the uninformed that delinquencies are in the past and real estate is well on its recovery path. That is not remotely true. Take a look at the following historical delinquency chart from the St Louis Fed. While we may be off the highs after the sub-prime crisis, we are not even midway to the historical ranges prior to sub-prime.
Delinquency rates on single family mortgages, via St. Louis Ferderal Reserve Research – click to enlarge.
With sound underwriting standards, delinquencies should only occur under extenuating circumstances. As was the case prior to the sub-prime loans, the delinquency rate was typically below 2%, and only spiked up a percent or two during recessions. Actual foreclosures were seldom above 1%. We are still far from that today, 8 years after the crash.
Contrary to what you may have heard, the current underwriting standards as dictated by the government agencies are not tight but irresponsibly lenient. Using common sense, how logical is it to lend money to households with >50% debt to income ratios, using only 3% down and probably very little by way of reserves for that rainy day? One missed paycheck would send these borrowers over the edge.
Real Estate Socialism
What is wrong with this picture? As the market has witnessed since 2007, the Government could dictate the conditions of real estate ownership, even when it was not the lender. Today, it is in full control. What would this government do when the defaults return? There will be forbearance, credit counseling, tax credits, tax forgiveness, refinancing, principal reduction, anything but foreclosures. In other words, real estate ownership may become a subsidy, or some form of government housing. Would debt servicing be based on one’s ability to pay? May be the principal will be adjusted based on market conditions? What type of real estate market is that?
At the same time, it is the Federal Reserve that determines what is too high or too low. Three rounds of QEs during the last 7 years have kept prices up, offsetting the free market efforts to correct imbalances of supply exceeding demand. Going forward, if prices are pressured lower, the Fed may be out of ammo. If price pressure is in an upward direction, the Fed may decide to raise rates. What do I really own, when it is the government that determines the value of my asset?
Real estate ownership as an investment is even more challenging. During the last few years, Wall Street has been actively buying up single family houses under REO-to-rental models. Apartment construction has also outpaced single family construction. If economic conditions were to deteriorate, not only would real estate rentals suffer from high vacancy losses, the likelihood is great that local politics could impact rights of ownership. In this scenario, changes to eviction laws may be the most likely outcome. How would you like it if you had tenants who are not paying rent, but whom you cannot evict? If economic conditions improve, before the landlords have time to cheer about raising rents, rent control may come into the picture. It should take very little effort for small time local politicians to drum up anti-Blackstone (or Wall Street 1%ers) sentiments in return for political gains.
In conclusion, I believe the fundamental problem with real estate is cost. The average household, whether renters or homeowners, is allocating too much of its income to housing. As a result, public policies are likely to continue in the direction of more subsidies, such the Federal Reserve’s manipulation of long term rates, and more regulations, such as eviction and foreclosure prevention, and rent controls. Real estate, could become a lot less “real” in the foreseeable future.
A bunch of early 20th century socialist real estate planners
Photo via Wikimedia Commons
