Jones Lang LaSalle
WHAT PRICE VALUE?
Jeffrey Lacilla
Jeffrey Lacilla teaches real estate finance at New York University.
For the last five years the U.S. real estate market has had a substantial run-up in value, despite less than stellar fundamentals, including vacancy rates that were increasing and rents that were flat or declining, which did not justify such value increases. Even though fundamentals have been improving in office rents and vacancy rates, real estate price increases are still outperforming gains in these areas. Why is this happening and what danger does this scenario present to investors?
There is a confluence of economic and capital markets variables, which many in the industry point to as reasons for a paradigm shift in pricing. Although much has been written about these, including an expanding economy, low interest rates and the poor performance of stocks and bonds, it would be more profitable here to broadly examine the economic environment that has contributed to the favored asset status of real estate and whether current conditions validate the paradigm shift philosophy or suggest that the shift is temporary.
During the past year or so, the U.S. economy has improved in large measure because of consumer spending, which has been fueled by tax cuts and even more so by home owners refinancing their mortgages and monetizing the substantial appreciation in their homes. The Federal Reserve estimates that $600 billion has been pumped into the economy as a result of home mortgage refinancing. Stocks and bonds for the past five years have fallen out of favor and are less desirable investments than real estate assets. Capital is always searching for a home, and lately real estate seems to have the most attractive prospects. There has been a huge inflow of capital into real estate that has not been seen since the tax shelter days that predated 1986 tax reform. At the time, that reform cut the legs out from under the apparatus that had fueled the flow of capital into real estate during the S&L tax shelter years. Will there be a corresponding event that proves the undoing of this boom?
Optimists abound. Norman Berger of Menlo Park, Calif., writes to The Slatin Report with this question:
"What housing bubble? The San Francisco Chronicle today (02-19-06) posted some Bay Area housing stats. From December 1987 to December 2005 the median house price grew at 7.7% per year; its resultant mortgage payments grew by 5.6% per year (mortgage rates down); Nominal GDP grew at 5.5% per year. Looks like housing in this the most desirable of areas is cheap!"
Nice point, Norman. So from 1987 to 2005, housing values went up an aggregate of 280%. Did income for people buying housing grow at the same annual rate of 7.7% per year? Probably not, but the crazy mortgage products coupled with the low interest rates makes them feel as if that has happened and thus to buy anyway.
Are the paradigm-shift believers correct or will their nescience be their undoing? I believe that the disconnect between pricing and fundamentals is unsustainable, and that the flow of capital into real estate will subside as interest rates rise and stocks and bonds once again become the investment choice of investors.
Despite sustained economic growth over the last 13 quarters, we have been running huge federal budget and trade deficits that will ultimately impact our economy. According to Anthony Downs, a senior fellow at the Brookings Institution, our GDP grew by almost 4% in 2004 to $11 trillion, but our trade deficit was more than 6% of GDP. Our growing trade deficit is also increasing faster than national income. It is expected that in 2005 the government's expenditures will have exceeded receipts by some $500 billion, or 3.5% of GDP. Our total federal debt will approach $8 trillion, or 72% of our GDP, up from 55% in 1990. Interpretation: this country on a domestic and international basis is living beyond its current means while our savings rate continues to be nil. Nonetheless, despite these deficits, our balance of payments is still in the black. That's because countries that export their goods to us are sending that capital right back to the U.S. to invest in our Treasuries, offsetting the effects of the accumulated deficits. This is a perilous fulcrum on which to continue to balance future prosperity; growth likely cannot last with a federal government that cannot control spending, and it seems as though neither political party has the will to force a course correction.. Certainly we can expect increases in entitlement programs like Social Security and Medicare as our population continues to age and we can also expect discretionary spending (i.e. defense) to increase as we fight the war on terrorism. This means that our expenditures will continue to outpace our receipts unless we raise taxes or cut spending. No other options here.
How much longer will our balance of payments be in the black? How much longer will countries send us their goods in exchange for our paper with low interest rates when the dollar value of the Treasuries they are buying is subject to value erosion because of higher interest rates?
Mr. Downs expects a further decline in the dollar, which will raise the cost of imports and lower the price of U.S. goods exported abroad. If that hypothesis proves true, the Fed will likely have to raise interest rates to protect and stabilize the dollar from declining too much even if inflation is in check. That could in turn cause the economy to slow down or possibly enter a recession. A further decline in the dollar may also cause buyers of Treasuries to shy away from such investments because their dollar denominated Treasury purchases would decline in value. Translation: our federal budget deficits will cost more because of higher interest rates, and it will slow the economy. Congress will be forced to act through tax hikes and budget cuts, neither of which they excel at, and both of which they have shown a lack of political will to undertake.
Slower growth, higher interest rates, higher taxes and spending cuts do not sound like underlying fundamentals that can sustain a real estate boom. More importantly, these fundamentals certainly do not sound like the stuff paradigm shifts are made of. This does not mean sell and stay away from real estate. Rather, it means the unbelievably low cap rates at which properties have been trading cannot be sustained.
Real estate prognosticators have become fond of calling the current market, especially for condo converters and TIC investors, a game of musical chairs. Well, whatever song is playing "Up, Up and Away My Beautiful, Beautiful Balloon" or "Oops! I Did It Again," expect a serious chair shortage.
WHAT PRICE VALUE?
Jeffrey Lacilla
Jeffrey Lacilla teaches real estate finance at New York University.
For the last five years the U.S. real estate market has had a substantial run-up in value, despite less than stellar fundamentals, including vacancy rates that were increasing and rents that were flat or declining, which did not justify such value increases. Even though fundamentals have been improving in office rents and vacancy rates, real estate price increases are still outperforming gains in these areas. Why is this happening and what danger does this scenario present to investors?
There is a confluence of economic and capital markets variables, which many in the industry point to as reasons for a paradigm shift in pricing. Although much has been written about these, including an expanding economy, low interest rates and the poor performance of stocks and bonds, it would be more profitable here to broadly examine the economic environment that has contributed to the favored asset status of real estate and whether current conditions validate the paradigm shift philosophy or suggest that the shift is temporary.
During the past year or so, the U.S. economy has improved in large measure because of consumer spending, which has been fueled by tax cuts and even more so by home owners refinancing their mortgages and monetizing the substantial appreciation in their homes. The Federal Reserve estimates that $600 billion has been pumped into the economy as a result of home mortgage refinancing. Stocks and bonds for the past five years have fallen out of favor and are less desirable investments than real estate assets. Capital is always searching for a home, and lately real estate seems to have the most attractive prospects. There has been a huge inflow of capital into real estate that has not been seen since the tax shelter days that predated 1986 tax reform. At the time, that reform cut the legs out from under the apparatus that had fueled the flow of capital into real estate during the S&L tax shelter years. Will there be a corresponding event that proves the undoing of this boom?
Optimists abound. Norman Berger of Menlo Park, Calif., writes to The Slatin Report with this question:
"What housing bubble? The San Francisco Chronicle today (02-19-06) posted some Bay Area housing stats. From December 1987 to December 2005 the median house price grew at 7.7% per year; its resultant mortgage payments grew by 5.6% per year (mortgage rates down); Nominal GDP grew at 5.5% per year. Looks like housing in this the most desirable of areas is cheap!"
Nice point, Norman. So from 1987 to 2005, housing values went up an aggregate of 280%. Did income for people buying housing grow at the same annual rate of 7.7% per year? Probably not, but the crazy mortgage products coupled with the low interest rates makes them feel as if that has happened and thus to buy anyway.
Are the paradigm-shift believers correct or will their nescience be their undoing? I believe that the disconnect between pricing and fundamentals is unsustainable, and that the flow of capital into real estate will subside as interest rates rise and stocks and bonds once again become the investment choice of investors.
Despite sustained economic growth over the last 13 quarters, we have been running huge federal budget and trade deficits that will ultimately impact our economy. According to Anthony Downs, a senior fellow at the Brookings Institution, our GDP grew by almost 4% in 2004 to $11 trillion, but our trade deficit was more than 6% of GDP. Our growing trade deficit is also increasing faster than national income. It is expected that in 2005 the government's expenditures will have exceeded receipts by some $500 billion, or 3.5% of GDP. Our total federal debt will approach $8 trillion, or 72% of our GDP, up from 55% in 1990. Interpretation: this country on a domestic and international basis is living beyond its current means while our savings rate continues to be nil. Nonetheless, despite these deficits, our balance of payments is still in the black. That's because countries that export their goods to us are sending that capital right back to the U.S. to invest in our Treasuries, offsetting the effects of the accumulated deficits. This is a perilous fulcrum on which to continue to balance future prosperity; growth likely cannot last with a federal government that cannot control spending, and it seems as though neither political party has the will to force a course correction.. Certainly we can expect increases in entitlement programs like Social Security and Medicare as our population continues to age and we can also expect discretionary spending (i.e. defense) to increase as we fight the war on terrorism. This means that our expenditures will continue to outpace our receipts unless we raise taxes or cut spending. No other options here.
How much longer will our balance of payments be in the black? How much longer will countries send us their goods in exchange for our paper with low interest rates when the dollar value of the Treasuries they are buying is subject to value erosion because of higher interest rates?
Mr. Downs expects a further decline in the dollar, which will raise the cost of imports and lower the price of U.S. goods exported abroad. If that hypothesis proves true, the Fed will likely have to raise interest rates to protect and stabilize the dollar from declining too much even if inflation is in check. That could in turn cause the economy to slow down or possibly enter a recession. A further decline in the dollar may also cause buyers of Treasuries to shy away from such investments because their dollar denominated Treasury purchases would decline in value. Translation: our federal budget deficits will cost more because of higher interest rates, and it will slow the economy. Congress will be forced to act through tax hikes and budget cuts, neither of which they excel at, and both of which they have shown a lack of political will to undertake.
Slower growth, higher interest rates, higher taxes and spending cuts do not sound like underlying fundamentals that can sustain a real estate boom. More importantly, these fundamentals certainly do not sound like the stuff paradigm shifts are made of. This does not mean sell and stay away from real estate. Rather, it means the unbelievably low cap rates at which properties have been trading cannot be sustained.
Real estate prognosticators have become fond of calling the current market, especially for condo converters and TIC investors, a game of musical chairs. Well, whatever song is playing "Up, Up and Away My Beautiful, Beautiful Balloon" or "Oops! I Did It Again," expect a serious chair shortage.
posted by Jones Lang LaSalle NJ News Blog at 1:33 PM
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