| PERFORMANCE ANNOUNCEMENT |
As Of: January 9, 2003
Remember Depreciation?
Don't confuse investment in financial securities with investment in real estate.
While we have been in a disinflationary environment for the past two decades, the inexorable increase in residential real estate prices has bothered me. There are lots of reasons why real estate prices have gone up. Population increases and immigration and demographic shifts have fueled demand for housing. A strong economy and dropping interest rates have further strengthened demand. Meanwhile constraints on supply ranging from environmental issues, no-growth policies, stricter building codes, shortages of skilled labor, lack of available land in major metropolitan areas, etc. have supported higher prices for single family homes. But while the stock markets, bond markets, and real estate markets were all moving up during the 1980's and 1990's, the latest divergence between the financial markets (going down) and the residential real estate market (continuing up) should cause one to question what is the difference between these markets?
For investors, the biggest difference between the stock market and the real estate market is that the stock market has been going down for three years now, while the residential real estate market has continued to go up. One of the major factors affecting the markets has been the change in interest rates (the dramatic decline in the expected rate of return). Everyone believes that lower interest rates help the real estate market. After all, low mortgage rates make housing much more affordable. I will argue that we have now reached a point of low single digit interest rates where real estate prices should be going down, not up. This is somewhat counterintuitive, and therefore it does not surprise me that it will take a while for the real estate market to adjust to the new reality.
A picture is the quickest way to explain the difference between financial securities and real estate in an environment where interest rates drop. During the initial drop from double digit rates (typical of an inflationary environment) to high single digit rates, prices rise in both markets. But as we approach low single digits interest rates (typical of a non-inflationary or even deflationary environment) a divergence occurs where financial investments (securities) continue to go up in price while real estate investments go down.
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The big difference with real estate (that everyone seems to have forgotten about) is something called depreciation. I am using depreciation as a catchall for a number of specific costs such as physical repair and replacement over time, functional obsolescence, the need for technological improvements and style updating, etc. Regardless of what is placed in the bucket called depreciation, it is an indisputable fact that land can appreciate, but improvements (buildings & equipment) always depreciate over time. Depreciation is a relatively minor issue during times of very high interest rates. Since we haven't seen low interest rates for many decades, people have forgotten that depreciation becomes a major factor during times of low interest rates.
The explanation for a coming decline in residential real estate prices is quite simple. If an investment produces an income of $24,000 per year and the expected rate of return is 15%, then the investment should be worth $24,000 / .15 = $160,000.00. If the same investment is being priced in a 2% environment, it should be worth $24,000 / .02 = $1,200,000.00. This is exactly how stocks and bonds are priced. When interest rates go down, bond prices go up. Also when interest rates go down, the price/earnings ratio for stocks goes up. That means that if corporate earnings remain stable while interest rates drop, the market price of stocks will go up. We can apply the same logic to residential real estate. Although most single family homes are owner occupied, the mechanics of the market can be explained by considering a rental at $2,000 per month or $24,000 per year. In an environment in which 15% is the expected rate of return, one should pay $160,000 for the property. It may be expected that, just like financial securities, home prices will also increase as interest rates go down. Recent history has certainly shown this to be the case. But prices have hit a point where it is necessary to take into account the effect of depreciation. Consider a residential property that costs $160,000 and is depreciated in a straight line over thirty years. To pick an average number, we will assume the land is worth 30% of the value and the house is worth 70% or $112,000. Annual depreciation will be $112,000 / 30 = $3,733.33 per year. The annual income of $24,000 should be reduced by $3,733.33 and therefore we should not be willing to pay quite as much for the property. However, in a very high (15%) interest rate environment, the land ($160,000 * .30 = $48,000) should appreciate at a rate sufficiently high enough to completely offset the depreciation of the building. Thus we might pay $160,000 or slightly more.
Something very interesting happens as interest rates fall and home prices go up. The annual depreciation of $3,733.33 on a $160,000 property jumps to $28,000.00 on the same property valued at $1,200,000 in an environment in which 2% is the expected rate of return. The $28,000 depreciation completely swamps the $24,000 potential rental income. Furthermore, in a low interest rate environment, there is less opportunity for the property to appreciate in value. Without a significant increase in rental income (something that has not occurred in the current market) it would be foolish to pay $1,200,000 for the property in question because the potential rental income plus appreciation of the land will never overcome the depreciation of the building.
Sixty years ago, residential real estate was not thought of as an investment. Homes were bought for the pride of ownership and for security. The concept of residential real estate being an investment grew out of the inflationary period from the 1960's through the end of the century. Now that we are back in a low single digit interest rate environment not seen for 40 years, people need to relearn (and it will be a hard lesson) that buildings depreciate. Real estate is not a good investment if it is purchased for too high a price - something that has recently been quite common.
Why is it so easy for people to overpay for real estate? Depreciation is not something that is obvious. When a new automobile is driven out of the showroom, it isn't visually obvious to the owner that his car is instantly worth less because it is "used". Likewise, in the space of one year or even three years or five years, it may not be obvious that a building has deferred maintenance or functional obsolescence. The owner may not realize until he goes to sell the property that everyone wants granite countertops, and a large price discount will be required due to the inconvenience and cost of having to remodel the kitchen.
The math suggests that somewhere between a two percent and four percent range is where depreciation starts to overcome the economic advantages of owning real estate. We are in that range now, and it is only a matter of time before the market realizes that the current high asking prices are unsustainable. The need for cities and states to raise property taxes to cover budget shortfalls, and declines in family income due to a slow economy and increasing unemployment are other reasons to worry about real estate prices, but the perception that one's home is no longer an "investment" is certainly a significant factor that suggests weaker residential real estate prices ahead.
You might be wondering why the stock market has been going down at the same time that interest rates have continued to decline. There are lots of complicated answers, but two simple answers: 1) The stock market rose too fast early in the cycle in anticipation of lower interest rates and an increase in earnings. 2) Earnings have not increased or even remained stable, they have gone down. In the long run, stocks should be able to do well in a very low interest rate environment as long as there is economic growth. By comparison, in a low interest rate/higher priced environment, depreciation is such a significant factor that residential real estate will no longer experience price support due to any attraction as an "investment". Unless inflation returns, people will purchase owner occupied homes based on current affordability, not in hopes of making a future profit.