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Real Estate and Debt Insanity


Land has no intrinsic value outside of the last price that a buyer subjectively decides to pay.


Let me say that I'm a big fan of the site. That said, the prophecies on the demise of real estate as an asset class by individuals that make their way in the equities markets doesn't sound like it's based on a whole lot of experience investing in real estate markets.
There is more to investing in RE than housing or one's home. There is the commercial end, whether it's adding value to a piece of land, building a office building, hotel, condo's, storage units, service stations, warehouses etc., or there is buying and holding land. We do all of the above. My family has done it with great success for over 70 years.
I'm no crazy bull suggesting that there isn't a disconnect in real estate markets. There clearly is in some "situations" just as there is in every other asset class. This is where a downturn will hurt people. There is also what you have mentioned about the growing gap between "haves" and "have nots." There is opportunity to invest in the "haves" vs. the "have nots" as well, even in housing.
And I say this: real estate isn't a monolithic market. The debate is very one sided on the site. Furthermore, one of the big drivers of price in new construction is how much it costs to build, not just houses - EVERYTHING. The costs have increased dramatically.

Minyan AI
Dear Minyan AI,

Toddo shared your email with me, as I often buzz about real estate, and there is no doubt that I contribute my fair share to the "one sided" (negative) commentary on the current real estate market. It's fair to say that much of the discussion in the 'Ville has been centered on residential and, to a lesser degree, commercial real estate, so that's what I'll address in the next few paragraphs.
We, as a family, have been involved in real estate for three generations as well, and still are; I mention this because it actually brings up a very important macro point. Over the last ten years, on the development and ownership side of the business, the players have changed dramatically. On the commercial side, real estate used to be dominated by buy-on-hold private investors who viewed their properties as sources of cash flow; the occasional refi or sales would provide a nice bonus. Today office buildings are more and more the domain of public or private institutions, whose funds are allocated to real estate primarily for short term (3-5 years) speculative purposes; as the institutions comprise more and more of the total players, more and more of the real estate inventory is being flipped. Even those who initially invested for cash flow find themselves in need to enter the "flipping" fray if they want to remain competitive. Such, in my view, is the nature of bubbles, i.e. the railroading of an asset class away from its intended "business" purpose and toward speculation in the asset itself. Nothing wrong with speculation of course, as long as one can find a chair when the music stops.
So, while I agree that commercial real estate is not a monolithic market, at least not nationwide, I would suggest that the ways in which institutions with nationwide reach are playing this market has injected pure speculation in this asset class.
There are some silver linings to the current commercial real estate environment: First, the players have very deep pockets and can absorb the occasional bath. Second, relative to their corporate resources, overall leverage still seems reasonable, with Loan-To-Value (LTV) ratios on specific properties that allow for the fact that part of the "V" may not actually be there. And third, valuations are very high, but if one, as you suggest, considers the increased construction costs, there is still some rhyme or reason to the prices at which buildings are changing hands.
As long as an investor in commercial real estate recognizes that the game has changed (from cash flow to speculation) and controls his/her risk accordingly, there may well be some play-time left before the industry runs into widespread accidents.
Unfortunately, none of the above, IMHO, applies to the current state of the residential real estate market.
At its core, the purpose of buying a house is to put a roof over one's head. The business of homebuilding was to provide an inventory of homes for people to live in, earning a mark-up in the process. Government subsidies, in the form of mortgage deductions, occasionally afforded the opportunity to buy a rental property, earn a nominal cash flow, and, at the end of the day, hopefully realize an appreciation a bit in excess of the rate of inflation. In fact, I would argue that investing in real estate was much more a vehicle for forced "savings" than a true investment.
In fact, I'll push this further and submit to you that returns from residential real estate in excess of marginal cash flow and perhaps 4%/year in appreciation, have historically been totally illusory, as the "excess profits" of one investor would ultimately result in equal losses by another. A similar illusion is the concept that if land is scarce it will always increase in value. Land has no intrinsic value outside of the last price that a buyer subjectively decides to pay.
Let me give you a couple of examples: we own the last piece of land in what is currently one of the hottest real estate markets in the country. There has been no other parcel available in this particular business district for years. Five years ago – when the economy was on the ropes - we were having trouble convincing a bank that the land was worth $20 per buildable square foot. Fast forward to last summer, and we were getting feelers from speculators north of $70 per buildable square foot. If we wanted to sell it today, it'd probably bring no more than $60. Nothing changed from five years ago to last summer, to now: the land is the same piece of dirt it has been since the beginning of time. What changed was the potential buyers' perception of "value." If you view the above as too anecdotal, ask a resident of Tokyo how much land was worth in 1980, in December 1988, and again in 1998. I am pretty confident the differences had nothing to do with the availability of land.
I believe that one can obtain more cogent reasons for the current perceived "value" of land by consulting a behavioral psychologist than by polling an army of real estate professionals. What we are seeing is nothing more than the same old cyclical burst of speculative juices that have afflicted this asset class since the beginning of time; often, incidentally, after the bursting of other bubbles in more ephemeral asset classes (if you are interested in the history of bubbles I urge you to read "Devil Take The Hindmost").
Moving away from the land value and to more concrete costs, there is still a total disconnect between "costs" and "values." In the "hot markets" (which are more than just an anecdotal few) the prices of today's homes bear no relation to construction costs, obtainable rents, or anything else remotely concrete.
For example, the total of hard and soft costs for town homes or single family homes in the Washington D.C. market ("the market that never goes down") run about $175-225 sq./ft. For condos requiring underground parking you are up to $300/sq.ft. Given today's rental rates, if one bought a property for $400/sq.ft, putting down 20%, and getting "investor financing" (as opposed to lying that he/she will live in the house), after real estate taxes and condo fees that person would have a meaningfully negative cash flow. Hence, if anyone knows of something better than the "greater fool theory" to explain why homes and condos are selling for $500-600-700 and, in a few cases, more than $800/sq.ft., I am all ears.
I recognize that owning a home has an intangible value that cannot be quantified. But the desire for homeownership does not explain the buying binge we have seen over the last three years, as more than 83.3% of the population with income above the median already owned a home three years ago, vs. 84.3 at Q4 '05. Alas, I am back to the "greater fool theory" of buying homes for speculation, at unjustifiable prices.
Unfortunately, the above does not even paint the really scary part of the picture. The twist in the current mania is that it has been fueled by an unprecedented level of debt. "Paper flipping" of condos is not a novelty; nor is people leaving their jobs to become "real estate investors." What is different this time is the degree to which risk taking has been leveraged; such risk not only has the potential to crush the "investor" (as has always been the case), but the "securitization" market, which has served as the source for the debt, has "hidden" the underlying risk within the entire financial system. IMHO, it is because of the pervasive leverage attributes of this residential bubble that the damage will show up in places that never accounted for real estate risks, let alone a real estate bubble. To this extent, the current real estate mania is not only widespread to the point of being monolithic; it actually engulfs parts of the economy that presumptively would not be correlated to the real estate market.
To wrap up this tome, I do agree that even outside of one's home, real estate per se constitutes a great asset class to own, but at certain times and certain prices. I do not know whether today presents opportunities in the warehouse, industrial, or other "non-popularized" real estate assets. I am also firmly convinced and worried that we are witnessing a convergence of real estate and debt insanity such as modern times has never seen, and the aftermath will inflict a degree of pain that no amount of helicopter passes by Boom Boom will be able to soothe. And of course . . . I could be wrong.
-Prof. Zucchi
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