Why housing bears are wrong (Part 4)
OK, let us continue. In the previous post, I addressed affordability concerns from the monetary supply viewpoint. It appears that those semi-intuitive conclusions that I presented in Part 2 are borne out quite well by the M2 supply numbers, and that despite growing much faster than median incomes, housing has not become more expensive in proportion to the total purchasing power created by the inflationary growth of M2.
I'm still receiving comments about housing. Some of these comments are of the "I'm a poor man, and I really need that house" variety, and clearly don't merit an answer. However, there are other, more serious objections having to do with the opportunity cost of buying houses instead of stocks. Thus, player renegade49 agrees that real estate is better than a CD (in his own words, "Stocks and real estate will beat out bank savings and money in the matress"), but he thinks that real estate is just too overvalued at the moment, so I assume he prefers stocks. QualityPicks also believes that stocks will outperform housing (he expects to earn annualized 7% from the stock market). Player fransgeraedts agrees with me that the extra liquidity (he insists that I call it "capital") is being produced in "excessive" quantities, which generates bubbles, but he suggests that capital is mobile and will move from housing to stocks.
There is certainly some truth in this argument. The "stocks or housing?" debate has been going on forever and there was always some competition between these classes of assets. During the 90s housing was relatively cheap as every enterprising young man was putting his spare change into Microsoft and Pets.com. After the stock market's debacle, stock enthusiasts turned into would-be Donald Trumps, and for two years, housing advanced while stocks stagnated. Today's relative strength of the stock market is suggesting that some would-be homebuyers are going Buffett again.
So, should we expect homeowners to sell their houses and buy into S&P? I wouldn't expect that. The main reason this is unlikely to happen is that a house remains a better investment than a stock.
Part 4. Why housing outperforms stocks.
Yes, I know that what I just said is anathema to most readers. We've all heard the Foolish mantra: a house is not an investment, it's an object that appreciates in pace with inflation. Then, when pressed to the wall, the Foolish stock enthusiast confesses: well, it's actually inflation plus 1-2%, not a big deal. Then, when you ask the stock enthusiast how his picks fared in the market, he grows less sanguine. He's learned from his past mistakes, he bought the best stock portfolio in the universe, he is sure about his future 20% annual gains from now on, but the fact is, up to this point, he earned only about 7% a year. Still this is better than housing, which has returned only about 6% a year in the historical perspective. So yes, upon a second thought, he will grant that housing is not that inferior to stocks. But he still believes it's inferior. Especially when you count that onerous real estate tax and the trouble of mowing the loan (you may wonder what other chores he's going to quote when his Rule Breaker pick IRBT introduces a Mowba).
So did the Foolish enthusiast win the argument? Not by a long shot. Now, here comes the next question. How much did he pay in rent while earning his 7% annual returns on stocks? At this point, confident smile disappears from his face, and his tone becomes subdued. "Umm, well, I haven't thought of that" is the standard reply.
OK, let's now do an honest calculation. For starters, a house always generates rental income. Either you're renting it to someone else, or you're renting it to yourself. In either case your revenue equals the average rental rate in your neighborhood. Apply the income tax to that revenue if you're renting to someone else, otherwise don't apply the tax. Subtract the operating expenses - heating, water, repairwork, condo association fees, insurance, and real estate tax. Apply tax deductions where applicable if you were already itemizing deductions on your tax return prior to the purchase; otherwise, if you were using the standard deduction, the incremental benefits may be negligible. Divide the net profit by the price of your house to obtain the annual yield. In most cases, it should be around 2.5%-4%. Think of it as the dividend payed out by your housing stock.
And then, count the capital gains returns via appreciation. Taking the conservative 5.5% estimate for long-term appreciation and the even more conservative 2.5% yield, we get 8% a year, comfortably ahead of the stock market. Compare the taxation of capital gains for stocks and housing, and housing gets still farther ahead.
A 2.5% yield is virtually guaranteed to the investor even in those markets which are considered extremely overpriced. For example, in my area, new 2-bedroom condos start from $500,000. The rental rate for a similar apartment would be no less than $1600, and the maintenance fees would be around $200. Then $16,800 is the cash flow generated by the apartment, and the yield is 2.8%. Furthermore, if you run the numbers for 1997, the yield will be only marginally higher. It is the same "bubble" as it has been 10 years ago.
Or consider QualityPicks's second example (the first was a $450K studio) here. Mind you, QualityPicks is bearish on housing, so I doubt that he went out of his way to find supporting evidence for the bulls. Note also that he is talking about one of the most expensive markets in the country. Still, in his example, a homeowner renting a $600K house to himself pays himself $2300/month, pays $120 in association fees, $200 in insurance, and some $580 in property tax. We'll assume no heating bill (it's Southern California) and a generous $600/month for water, garbage removal, and repairs, leaving the net profit of $800. Suppose QualityPick bought this house for cash, and suppose he's itemizing his deductions. Then he can subtract a) $7000 in property taxes, b) most of the repairwork -should be some $4000, c) amortization - should be about $6000. Applying a 30% income tax, we get $425/month in additional tax savings, and the effective yield is $1225/month or 2.5% per year.
Projecting 5.5% CAGR from here (and if rental rates follow the trend), we beat the stock market hands down. With the CAGR of only 4.5%, we still match the stockmarket's performance, and with much less volatility along the way. As a boon, his $600K capital gain will be essentially tax-free (currently the limit is $250K if you're single and $500K if you're married, but it will surely increase with inflation).
And if that 2.5 yield doesn't impress you, keep in mind that QualityPicks has selected a place where one buys a lifestyle rather than a cash flow. Irvine is one of the most pleasant towns in California (I would place it right after Santa Barbara, Malibu, Huntington Beach, Laguna Beach, Dana Point, Cambria, and Santa Cruz) that will continue to attract all those who are rich enough to afford a premium location but fall a bit short of affording the coastline. As a buyer, you're making the correct bet that people will be moving to California, that Irvine's economy will prosper due to its top-notch University, and that rich people will be willing to pay up for a premium location. Second, you're paying for the proximity to that dairy cow - UC Irvine with its 20000 students. With those 3 bedrooms and 2 bathrooms, it's not hard to rent a room to a student. A room in a private townhome starts from $600 and goes all the way to $900, and this way, many Irvine homeowners are able to squeeze this much additional income from their primary residence. Third, Irvine has excelled in the art of using ecology as a pretext to deny construction permits, so it will always maintain its deficit of housing. And finally, rental rates in Irvine are bound to go up because of the monopolistic position of Irvine Apartment Communities. This future potential helps justify the current price tag.
Finally, for those of you who might say that if the yield is real, then the appreciation potential must surely fictitious, I must repeat a simple fact: most of that appreciation is nothing but the ordinary monetary inflation. When M2 supply grows 4 to 6 percent a year, there is no way to avoid inflation, and in particular, asset inflation that grows faster than consumer prices. Why would someone want to buy that 2.5% yield? For exactly the same reason that people are happy to pay a PE of 40 for GOOG: future cash flows. When the Fed doubles the money supply, and the lion's share of the newly printed dollars winds up in the hands of the top 10%, the money competing for houses in Irvine can easily triple or quadruple. That's why current yields are low. If you look at less fashionable locations (think Detroit!), you will see that their yields are much higher. This is because investors realize that these places will be attracting less than their fair share of the Fed's incremental liquidity, and are asking for higher yields to compensate for that. The market is not stupid and it is baking appreciation into the current price only when this is justified by the location.
One final touch. I don't like the word "hedonics", but this is precisely the case when the hedonic component is very real. So let me also add some hedonics to boot (why, I am certainly not worse at it that the Bureau of Economic Analysis!). After all, living in your own house is definitely worth something! It's clear that people will always be placing a hedonics premium on top of purely commerical considerations (if told that their house will trail the S&P by 1%, I'm confident that most people will still choose the house over the brokerage account). So we may as well make it a part of our valuation. Can I feel justified in augmenting my tangible cash yield by 1% in "intangibles"? It won't make us richer, but it will make us less worried about that "capital mobility" thing.
This combination of yield and appreciation potential with a sprinkle of hedonics is what helps real estate outperform stocks, but the point is lost on bears, because they usually consider either the yield or the historical appreciation, but not both.
Reason # 4. Bears simply use the wrong methodology when comparing the benefits of stocks vs. real estate. When you add the numbers properly, real estate emerges as the winner.
This is one part of my answer to fransgeraedts's concern about capital mobility, and it is that capital will not move away from housing because it has no reason to. The rest to follow latter.