Real Estate

I watched Why the Meltdown Should Have Surprised No One on Mises Economic Blog. This video is a bit lengthy and winding, but it got me thinking about real estate again. In the past I was positive on real estate as investment seeing it as the better of many poor options nowadays.

What is the fair value of a real estate, a flat, a house? Two years ago, we bought a flat. It cost us some €300,000. The actual building cost (material and labor) is about €70K. So, more than 75% of the cost is just immaterial, the right to occupy that space. I computed the possible return on investment through rent. Putting all the data together (rent, property taxes, income taxes, insurance, expenses) I computed a 2% annual return. Even if the home prices would stay flat (which they are not) that 2% is most likely below the annual inflation. Conclusion, the flat would not be a profitable investment, it would be a loss.

How did I buy the flat? I looked at 5 flats and picked the one that had a reasonable price tag in comparison with the other 4. This is the price. But what is the value? Value must be determined by some real facts, not just by what people ask for and in comparison to prices of other flats. This is just a herd effect, a bubble. The only factors that occurred to me to determine some base line of a value are: construction cost and rent. How much would it cost you to build one yourself? How much would people pay to live there? Very simplistic, I know. But according to this trivial factors it is clear that the flat was and is overpriced. The real value is (a lot) lower than what I paid. I enjoy the flat anyway and we use it ourselves, so these financial calculations do not mean that much to me, but they do direct my thinking for any future real estate purchase.

Here I found Housing market indicators: price to income ratio, affordability index, median multiple, ownership ratio, price to earning ratio, price rent ratio, rental yield and more. These mathematical formulas are helpful, but since I have no cross reference data for my market, I can compute some of these values but I cannot compare them to other regions or other times (e.g. last decade). Still this is a starting point. All these numbers applied to my case point in the same direction: the real estate market is overpriced where I live. Where does overpricing end and where does a bubble start?

As an example look at the price earning ratio. For our flat I computed a PE of 50. For a different flat in the city where there is more demand I computed 35. Compare that to the PE of the S&P500. It is clear to see there that 35 or 50 is part of a bubble. A PE of 20 seems more in the stable, sustainable range. Sure, I am comparing real estate with stocks, but why should that from an investment perspective be so different for the PE. You pay price P for the investment, you get earnings E out of the investment. Using this figure as a rough guide I reach the conclusion that my real estate was overpriced by 57% (20/35). Sure, it is not as simple as I portray it, but it is a piece in the puzzle and the other indicators point in the same direction.

What impressed me most was how long it took in Japan to deflat the bubble. The home prices in Japan went down for 15 to 16 years! Imagine a turnward turn for 15 years! From roughly 1991 till 2005. I do not have the data for 2008, but with the worldwide problems it would not surprise me if the prices are continuing to go down. Anyway, will the home prices ever reach the 1991 level? Even if prices go up again, after 15 years of downturn, it will take 10+ years for some recuperation to take place. See this diagrams and links: Japan housing market, Japan housing prices, Japan housing prices.

Will the US be any different? Maybe, maybe not. I certainly would not gamble on it, especially if people expect a 15 year depression. Look at the US building cost index, look at the US rent increases of the last decade, and look at how home prices have grown over the last 10 years. If a bubble needs 10 years to inflat, they say as a rule of thumb, it will need same amount of time, i.e. 10 years, to deflat. US home prices went up by a factor of 2.5 (increase of 150%) over the last 10 years. The US real estate bubble just burst, but the price drops in real estate will continue for many years, I'd say for at least another decade before they hit rock bottom.

Is it any different where I live, in Spain? No, it is the same basic picture with some minor changes: little rent and still no acceptance in the mind set of the people that real estate prices can actually go down. Everybody is still holding on to the prices even if the real estate does not sell for 2 years. There are 2-3 million unsold pieces of real estate in Spain with 80% of all families already owning their home. There are hence few buyers, i.e. very little demand, a gigantic supply, but the prices do not drop because people still think "if I just wait one more year I will be able to sell at break-even". Is there a real estate bubble in Spain? Yes. From 1997 till 2005 prices have risen 247%! That is a continuous 11% growth per year. Salaries have not gone up like this, neither has rent. So, eventually prices will have come down again, but people have not yet accepted the fact. I was looking for property recently and with the three real estate pieces I looked at, it was all the same: they were on the market for 2 years without having been sold, and prices in general have come down a very marginal 4%.

What is the conclusion for me? In Japan prices on average (not peak) went down 50% for homes and 80% for commercial real estate. Having looked more carefully at the situation now I expect the same for the US to happen. There was a big drop already but prices will come down even more, slowly over the next years, maybe the next decade.

In Spain, I would like to buy some real estate, but with the data I recently learned I have to consider waiting because eventually when people accept the fact that real estate prices can actually go down or when they cannot wait any longer to find a buyer the prices will come down. It might take a couple of years though for the Spanish mentality to change.