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EScroogeJr (< 20)

Why housing bears are wrong (Part 6)



October 08, 2007 – Comments (6)

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%.

6 Comments – Post Your Own

#1) On October 08, 2007 at 3:38 PM, floridabuilder2 (99.34) wrote:

this is all theory dreamed up on some liberal campus with no basis in reality...  first you make no arguement for living in Wyoming vs New York city...  If 2 individuals live in these different RE investment areas are they better off in stocks or real estate....  next, as a theorist you do not take into account timing...  If the start date were 2000 for both then real estate wins... if the start date were black monday 1987, then stocks win... the ability of "mobile capital" allows one to go into real estate when it is cold and into stocks when they are cold then exit when recovery occurs... you make the assumption that one only invests in one vehicle and is either too stupid, or slothful to move his money.... finally, I would be interested to see if your thesis of returns takes into consideration cost... the transaction cost of stocks is minimal and you can switch from one investment to another.... the transaction costs in real estate are not... of course you like to pooh pooh things such as watering the lawn, property taxes, etc... but as a renter you can avoid a significant amount of costs...  early on in my series you laughed that the cost of carrying spec homes (utilities, taxes, interest, etc...) were insignificant... if so then why would a builder fire sale something if their wasn't a cost of capital... you cannot honestly expect anyone to consider you knowledable when it comes to "investment vehicles, opportunities, macro-economics" etc.... when your score is so poor in CAPS....  every person on CAPS has the exact same ability to test their theories of investing and you can mimic real world hard investments buy going long oil, gold, housing, etc....  Don't give me the i have a 5 year time frame, because why would anyone in their right mind ride down and lose millions (in your case CAPS points) when they don't have to?  Its because your timing is off and your theory is off most of the time... you are unwilling to cut losses when proven wrong... this is a typical liberal mistake...  they always think they are right even in the face of overwhelming evidence to the contrary....

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#2) On October 08, 2007 at 5:22 PM, EScroogeJr (< 20) wrote:


taking your argument down to the personal level is not the best way to feign confidence. Yes, I'm reading your blog with interest, and I think you do a really good job of muck-raking, but at this point your hypothesis is still only that - a hypothesis. And quite frankly, when I'm reading your posts, I can clearly see that you're very emotional about your thesis, like a man who is constantly raising the lid in his impatience to see if the water has boiled. For the fact is that what you hoped would be a blitzkrieg is turning into a positional quagmire. Prices have not come down by 10% or anything close, morgtage rates dropped 0.5% in anticipation of the Fed move and stayed there, public builders have not gone bankrupt, at least so why not have some little patience? If your thesis plays out as you expect, nobody is going to deny you your well-desrved  reputation regardless of whether my score is plus or minus 2000. And in case something goes wrong, we may as well refrain from comments that we may come to regret later

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#3) On October 08, 2007 at 8:25 PM, floridabuilder2 (99.34) wrote:

Escrooge, since Aug 1 when i joined CAPS you are the only person to discuss your political/social/economic policy core belief - liberal....  As if I care... which I don't...  I don't let my political views leak into my investment strategies...  when I look at Iraq, I don't see good or bad policy, dead bodies, disfigured civilians, tribalism, etc....  what I see is a war that is going nowhere, that probably won't escalate, and most of the war profits have been made... so my top down view is not to buy war related stocks...  i don't believe in calling tops or bottoms, just watching trends and waiting for a cycle to begin for several months before I go long... since i don't go short...  there is no trend today that justifies going long builder stocks... period...  it is foolish advice to tell people to go long to call the bottom like the Citibank analyst when the fundamental trend is still down...

as for my emotional views..... you hit it on the head... that is my writing style and personality....  I never said this would be a blitzkreig... in fact, if you actually read my blogs I stated that I didn't even think 1 builder would go bankrupt earlier this year, but then the liquidity squeeze radically changed my views...  I have recently went on to state that it would be a domino effect, but until that first domino falls you are at a standstill...

As for prices not coming down, you are looking at national data... i could care less about national data... what i care about is what submarkets are new homebuilding occurring and what is the year over year price change in these new communities... the core holdings of public homebuilders are in newer communities and not infill or rural populated areas... in these new communities prices are down 10% to 20%...  to deny this, i would have to start calling you Tokyo Rose

I am not a patient person, especially when it comes to making money...  the writing is on the wall, it is inevitable that this thing will implode.. the faster it happens the faster i will make a lot of money... 

Although you may feel that I am making personal attacks, i would suggest not to bring political beliefs into an investment arena... additionally, you cannot deny that you hold losers far too long and you should reconsider your strategy... eventually you may be right, but again why ride your caps score down when you can make adjustments in your investment strategy... i will give you credit for a nice accuracy score... which means you are right more than wrong, but again cut your losses

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#4) On October 08, 2007 at 10:12 PM, EScroogeJr (< 20) wrote:


First, let me assure you that I still enjoy reading your series, and find lots of interesting information there. I would enjoy it still more if you spared us from that talk about trading software and TA gobbledygook. 

I can agree with you that my score would benefit from a change of strategy, but this has no bearing on the discussion. The truth is, Caps situation is very dynamic, and all these comparisons and quarrels over who has a higher score are pretty meaningless at this point. In a couple of years we'll know better.

I cannot agree, however, that I'm discussing politics here. For the most part, I was covering things like the historical returns, advantages of leveraged long-term investments, etc. This is zero percent politics and hundred percent economics. The only time I expressed what could be construed as a political view is in the beginning, when I mentioned the economic policy of the government - any government, mind you, regardless of its political affiliation. Excuse me, but I have seen your scorecard the next day after the rate cut, and it wasn't a pretty sight either. Should I now say "OK, it was political, so let's pretend it never happened"?

The one interesting comment you made is that the liquidity crisis has caused to to change your views radically. This is indicative becuase it suggests to me that you may be lacking a long-term conviction. You see, in the past, I have often had a similar change of heart about some stock after some nasty event. In nearly all cases, my newly-acquired pessimism has turned out to be overdone, and after some point it only prevented me from seing the positive side.

Also, and you can correct me if I'm wrong, but I have a distinct impression that you simply cannot forget some unpleasant experience like an emotional altercation with your boss or company executives that happened when you were auditing the books. Now, don't get me wrong, I am not saying that builders are angels. But I am not so sure that if you happened to audit some other bunch of companies, you would have found executive compensation schemes very different from the schemes employed by builders.

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#5) On October 08, 2007 at 11:30 PM, floridabuilder2 (99.34) wrote:

see your comment #2, to the first in your series why bears are wrong....

that is the comment i am referring too... liberal intellectual... this was the first post in your series and although not in your blog, but in the comment section... intellectual philosophy may work on the long term strategy that you are married to, but I prefer a strategy of constant re-evaluation of macro-economic conditions...  i loath the investment firms that talk about their "bottom up philosophy of investing".... i am a pure top-down investor...

So I apologize you are not discussing politics here, but my point was that if your using your political views as a basis for investing, it doesn't work...

Although my score dropped like a rock with the rate cut, it was still in the black and the fundamentals of housing did not change and i felt would not change based upon this rate cut

my long term conviction on homebuilder implosion would change if there was government intervention, but I would have to see that policy become law first... otherwise we are still submerging...

as far as my hatred for homebuilders.... it is not based on auditing, because i wasn't an auditor in homebuilding... it was based on the stupidity of the policies that were being rolled out at the top of the organization and the fact that these guys were paid millions of dollars and didn't see this coming?  are you kidding me...  That is why I decided I am done with corporate america.... i am confident my team will eventually land the right deal in 2008 and I will make as much money as the clowns who knew nothing but ran their respective organizations into the ground....  We will see... I've decided that rolling the dice and taking my destiny into my own hands will lead to far more success than working my way up a public ladder

i have no ill will toward you, i mean c'mon this is just a blog series and investment tool...  I just do not agree with you at all because i am closer to the situation than you... now if you and i are talking shippers, china, russia, gold, oil.... we probably would have some similar thoughts... but when it comes to residential homebuilding, I have always been the biggest bear vs. my peers and have always been the first to identify a new trend or direction... so for this subject matter, I really am not open to other opinions

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#6) On October 09, 2007 at 9:25 AM, EScroogeJr (< 20) wrote:

My respect. I mean, how often does someone enter into a discussion with the statement, "I really am not open to other opinions"? :-)

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