Real Estate Is Not Cyclical
Is real estate at a bottom? Why am I having such difficulty answering that question? Why is it that I find the indicators so meaningless? Why is it when I read expert opinions, they seem to make no sense?
Real estate moves through phases as politics, demographics and economies change. From the first day that white settlers laid claim to the good earth here, the changes have been fundamental, structural and definitely not repetitive.
Fast forward to the post war era (WWII, Korea and Vietnam), the US economy enjoyed three decades of steady economic growth as the US established itself as the dominant country in the world. The baby boomers were forming households as they rolled into their most productive years. As children raised by parents who lived through the depression, the boomers were savers.
The country did not have the housing supply to meet this steadily growing demand. Consequently, real estate prices enjoyed a prolonged period of appreciation. That period was over by the late 1990s. The first decade of the 21st century was thrown into chaos by the Greenspan subprime bubble, followed by random government interventions supposedly for the purpose of keeping the bubble inflated.
Now that I have cleared my mind of the old misconceptions, it becomes far easier to navigate the treacherous waters ahead. First, we need to do a baseline assessment to determine where we are today. Then, regardless of one's bullish or bearish sentiments, one can model the shape of the US economy in, say five years. From there, one can work backwards to determine future housing needs using the baselines we have established earlier.
Market Price (MP) = Intrinsic Value (IV)+ Government Accommodation (GA)
In this formula, the intrinsic value (IV) is declining due to numerous factors such as excess supply and a weakening demand pool. Natural economic forces are driving market price (MP) down. Policy makers are determined to hold MP steady by increasing the amount of accommodation to offset the decrease in IV.
Another adjustment that I want to discuss here is government intervention (GI).
Market Price (MP) = Intrinsic Value (IV)+ Government Accommodation (GA)+ Government Intervention (GI)
GI is sometimes positive and sometimes negative. For the purpose of illustration, I am going to use some extreme examples. When the white men first came to this land of plenty, the government decided to kill off the original occupants. Those who were not killed off were moved to reservations located in areas that no one wanted. That was very positive for the new settlers and detrimental to the previous inhabitants. Because of GI, MP went from zero to something that the white men could trade, eventually arriving at the MP of today.
Another example would be when the communists took over China and GI reverted all real estate ownership to the Government. MP went to zero but the intrinsic value remained. When GI was slowly removed, the MP returned and created a multitude of real estate tycoons in what was officially still the land of the communists.
Today, GI once again comes into play. When the government unilaterally decides to alter the terms of contracts retroactively, GI's value in the Market Price equation rises significantly. For example, 50 State Attorney Generals extorted $26 billion from the nation's top five loan servicers.
Before 2001, GA and GI played fairly negligible roles. The system was accustomed to a steady, but low level of tax benefits pertaining to home ownership. The government offered protection of property rights, including those of the mortgage lenders. Therefore, one could almost ignore GA and GI. At equilibrium, market price equaled 'intrinsic value' with very minor adjustments. Astute investors would recognize times of imbalances and buy when IV was higher than MP and vice versa.
1. IV – Intrinsic value will continue to decline as society adjusts to a lower standard of living, compounded by the demographic drag of an aging population.
2. GA – Government Accommodation will continue to go hog wild, even though policy makers have no understanding of its objectives nor are they paying attention to its unintended consequences.
3. GI – Government Intervention will lean in the direction of socialized or nationalized real estate. The transfer of wealth from the rich landlords to the poor peasants will be a popular campaign platform for politicians.
In the next five years, market prices are likely to be strongly influenced by government accommodation and intervention. If market prices go down, we can count on more and more accommodation. If defaults rise, we can count on more and more intervention. On the other hand, if market prices go up, we can count on the removal of accommodations and interventions. What will be the point of analyzing intrinsic value when we know the government will step in and alter the outcome?
In conclusion, I believe this level of government manipulation of the free market is unsustainable. Home buyers and investors alike should pay far more attention to GA and GI instead of IV.
by Pater Tenebrarum
This is a brief comment that will hopefully help to avoid confusion. We briefly discussed the use of the term 'intrinsic value' above with Ramsey. As our readers probably know, we are strongly convinced that all valuation judgments are subjective. In that sense, there can be no objective value – it simply does not exist (i.e., value is not 'intrinsic' to objects, it is assigned by those doing the evaluation).
However, we decided to leave Ramsey's terminology intact. It should be clear that what he describes by the term is simply 'market value without intervention', in short, the value and prices that would be established in an unhampered market economy.
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