Why housing bears are wrong (Part 6)
October 08, 2007
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In Parts 4 and 5, I addressed the issue of capital mobility, showing that capital doesn't need to and doesn't want to leave housing. The final reason, and that concludes my answer to fransgeraedts, is that it cannot leave.
Part 6. Capital? What capital?
Where does capital come from? I mean, that part of capital that goes into housing?
One possibility is from savings. You work for N years, stash X dollars under the mattress, then come to the open house with a suitcase of cash and close the deal at once. If you don't like that house, you can bring these savings to your brokerage and invest in the Motley Fool selections, thus diverting capital away from housing.
You will agree with me that this scenario is unrealistic. Discounting for a pair of dirty socks and a few occasional bedbugs, your mattress can buy you 5-10% of a house at most.
Another possibility is from your stock investments. Now, this is much better. By investing for years, you've kept your head above water, so that house has remained affordable to you. Still, unless your name is Warren Buffett, your brokerage amount won't buy you more 30%-40% of the house. And anyway, this is not how most people finance their purchase.
How about your old residence? Yes, this is even better. This is, in fact, what has kept housing affordable to the majority. It is clear that sellers who trade down are taking their capital out of the housing market. However, every transaction involves a seller and a buyer. Whatever money sellers trading down will remove from the system, must be brought back by the buyers trading up. And these buyers can't count entirely on their houses. They must bring money from the outside.
But if savings and investments are insufficient, what is left?
Correct, mortgage loans. This is how people actually finance this purchase.
Now, let's see what happens when you take that loan. Yes, you guessed it. The Fed prints a stack of green paper (well, actually, we know it's just a string of ones and zeros) and gives it to your bank; the bank writes on a sheet of paper, "I promise to pay you back" and gives the sheet to the Fed; then you write on your sheet of paper, "I promise to pay you back" and hand it over to the bank; and then the bank gives you that stack of green paper. Capital has been created that had never existed before. Now, this money could be inflationary because the only thing that was produced was a change of ownership, and this thing is not edible. But that's beyond the point. Let those who believe the official CPI numbers worry about it. Our point is that most of the capital created in this transaction (anywhere from 80% to 100%) comes from the Fed's printing press. The buyer obtains this capital by contributing his share (0% to 20%) and promising to pay the rest later. And in theory, he should pay the rest later. But in reality, there is no "later". The intelligent buyer will be repaying the loan in installments while refinancing and/or withdrawing equity at the same rate, thus keeping his debt level constant.
Now comes the crux of my argument. The purchase of a house was the condition for obtaining that much capital. The buyer could not have obtained it otherwise!
Let's say, his research has convinced him that stock investment is more attractive than real estate investment. He decides it would be a good idea to put $100,000 into a brokerage account rather than into a house. Unfortunately, with his $20,000 saved for the down payment, he will be able to buy $50,000 worth of stocks at most. (The exact leverage requirements will depend on the broker, but typically you won't be allowed to use leverage higher than 2.5, and you would be insane to use higher leverage even if you could). Even if your stocks outperform your house by 2% year after year after year, 30 years from now your investment will still lag behind because you started from a lower asset base. It will take you a full 35 years to catch up with that stodgy, bulky but highly leveraged asset - a pile of bricks on your private lot.
And if you think a little more, you would realize that even the above scenario is totally unrealistic, the reason being that while a constant leverage of 5 can be applied to real estate with relative ease and safety, a margin account with a leverage of 2.5 is an invitation for disaster. I have used a leverage of 2.0 on a couple of occasions, and while it worked for me all right, I could see very clearly that I would most certainly have been wiped out during one of these market swoons had I been using that kind of leverage on a permanent basis. Practically speaking, 1.5 is the maximum leverage that one can successfully apply to his brokerage account for any extended period of time, otherwise margin calls will force you to sell exactly at the moment when you should be buying. In contrast, the leverage of 5 (i.e. 20% down) is a standard safe lending practice for real estate that practically guarantees that you'll never get a margin call from your bank. Notice that I'm not even considering leverages above 5 even though houses are often acquired with leverage of 10, corresponding to a 10% down payment, 20 (5% down payment), or infinity (0% down payment).
This difference in leveraging makes it extremely hard to beat housing returns with stocks. The stock market must outperform real estate by approximately 4% a year in order for you to beat a $100,000 real estate investment (leverage=5) with a $30,000 stock investment (leverage=1.5) over a 30-year period. However, this condition is unlikely to be met. Historical data suggests that housing performs roughly as well as stocks or underperforms by 1%-1.5% at most. For example, this study for the 34-year period ending in 2002 (this time frame effectively cancels out the effect of the dot-com bubble and ends right before the housing bubble begins) shows that the S&P index returned annualized 11% (in nominal terms) while single-family houses returned 6.3% before you account for the rental yield. Assuming a modest 3.7% rental yield over that period, we see that real estate has trailed stocks by merely 1%. A leveraged purchase of real estate would have worked much better than an underleveraged investment in stocks.
This is why professional real estate investors like their little game and will not abandon it for the sake of stocks. One must have a very unconventional mindset indeed to withdraw a $100,000 capital from housing in order to play with a $30,000 capital on the stock exchange.
Reason #6. Bears treat capital as mobile, but in reality, capital cannot abandon housing easily because in doing so, it will immediately shrink by 70%.
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