Monday, April 9, 2007

Real Estate: NEVER the BEST Investment

I've been mulling the idea for this post over for a long time. It's very much a back-to-basics, fundamental clarification of what I think real estate "really is". I've decided to write about it, because I've seen a few posts by Jesse F, and some comments that have made me want to write about it. At it's heart is this:

Real Estate should NEVER be the "Best Investment" idea in almost any location.

OK, think about it: Commercial property is the consequence, or result of economic activity NOT The Cause. Does Duncans facility exist for it's own purposes, or to house his store? Real estate exists to house economic activity, NOT for some sort of weird existential reason. This applies to homes. It is fairly difficult to construct a home in the absence of commerce. This is why Ghost Towns are so... ghostly.

Real Estate is an Effect of Commerce, NOT the Cause.

Saying that real estate is The Best Investment in a town is an indication that either it is an exceptional situation (a vacation town where money is largely imported), there is a shortage that cannot be satisfied, or that there is something strange going on (a bubble).

This isn't to say There Can't Be Bubbles, there can. Bend is in one, or was. Jackson Hole and Aspen are proof that local economics can totally disconnect from home prices permanently. There is a conveyor belt income effect that supplies the needed levitation in these towns, and they are small enough to make it work. Bend is not. We are too big (even though we're not very big) to sustain a bubble without the help of a healthy commercial base.

A real estate bubble is a relatively long-lasting increase in prices (and usually supply) of commercial or/and residential real estate in excess of the local (or relevant) economies ability to support it. You will find bubbles happen many times in areas of high growth at the tail end of a growth spurt.

Look at Vegas. It's grown by incredible amounts over the past 50 years, and there are periods of overbuilding. But Vegas' rapid growth has always seemed to take care of this problem, and building begins anew. But Vegas has a Real Live Economic Engine: gaming. If it didn't, the Vegas RE market would have died decades ago.

There's another kind of bubble: It's when a town or area is dominated by a single enterprise (or industry) that is suddenly given a negative economic shock. This is happening to SE Michigan right now. It happened to Peoria, IL in the mid 1980's when Catepillar hit hard times and homes went down 17% from 1984 to 1989. Also the Texas oil patch for most of the past 25 years. These aren't really bubbles insofar as they have inflated, as much as they are fundamental business conditions that are deflating and taking everything with them.

It sounds obvious but so many people have forgotten: Real estate exists for commerce, real estate itself IS NOT commerce. In Vegas, the enormous RE market exists as a consequence of the growth of gaming, not in spite of it. The function of commercial RE is to house commerce; without commerce, you've got an empty edifice with almost no usable function. It's why I was slightly amused at reading this on Jesses' blog:

One question we asked people was, "what is your favorite investment idea for 2007?"

I was astounded at the number of people who answered, "real estate," to this question - people young and old from every economic background.

This is a clear indication that people are investing via the rear-view mirror. In any "industrial" city, with a real commercial base, there should be an engine "powering" real estate. If there's not, your in an unsustainable situation. I understand that you can't really "buy" a piece of the hundreds of little companies that populate a city like Bend, so maybe RE is a "good investment" given the limited choices. But people seem to think that Bend RE has "taken on a life of its own", and doesn't really need a successful economic base to power higher. This is a very flawed investment thesis. It has brought me to this analogy, when I think about RE:

If a town is "like" a public company, area homes and commercial property numbers acts much like "shares of stock". Prosperous and growing economic bases in cities will lead to a gradual increase in the number of shares, but fairly steady prices. But contracting economics will not lead to fewer shares, it will lead to lower prices.

Think about it: When a company is doing well, it splits its shares, keeps them "affordable", and the number of shares goes up. But when things are going South, companies are very hesitant to do reverse-splits, so shares go down. In Peoria, when Catepillar fell on hard times, homes were sold, not "destroyed". So you can take as a general rule, that increasing commerce leads to increasing home numbers. Home building CAN do well, but SOMETHING ELSE has to be doing well before this. Towns that increase home counts beyond all economic indicators that it can absorb them, is like a company that issues shares, banks the money and calls it "prosperity". It's not.

Here's an exercise that might help you: Imagine real estate and "everything else" as the 2 wealth creation centers for a town. Try to imagine wiping away the RE component, and think "What's the growth of the "everything else" and how much RE is required to run this place?". If the growth of RE has exceeded the growth of the "Everything Else" for a sustained period, you are almost certainly in a bubble situation that will bust if real growth doesn't catch up and save it.

This is what Bend RE Bulls are saying. Bend RE will be saved by growth. I think they all know full well that Bend RE growth has exceeded the fundamental ability of the local economy to absorb it. But the growth HAS been high. It's just RE growth has been higher. RE has been the highest growth industry in Bend for years now. My question to the Bulls is: What, exactly is this long latent industry that will save RE? Medical? That'll save some commercial stuff on the East side, but not the row upon row of residential that are all over Bend. Leisure? Again, this seems too little too late. California? They're having their own RE problems. I can't think of anything else.

THIS is why I've been on the bear side of things. Building RE in excess of any other industries ability to absorb it, is like a company issuing shares and calling the proceeds "revenue". It's not. Commercial revenue should "build" RE, all else is a phantom. Bend is just like the "concept" companies of the NASDAQ bubble: No real business model, no real revenue, but by God they're issuing shares like there's no tomorrow! And strangely, the shares are going up! Things MUST be going great! Everyone thinks, "Man, this place must be full of geniuses!". Sadly, this sort of situation NEVER lasts, unless the proceeds from the shares issued is actually put into a real, and durable enterprise. Regular readers may recall my occasional comments that we have "squandered this bubble"; this is what I'm talking about. Bend "issued" shares, but instead of investing it, we bought our own BS, and issued MORE shares. It's a Ponzi Scheme mentality: Build some, that seemed to work, build more, which also seems to work, and finally spend everything we have building like crazy. It's a house of cards that has no destiny but to collapse.

I was in Alaska a few years ago, and there are almost as many ghost towns as "real" towns. Would you go to a ghost town and "buy" a house? There seems to exist a certain bias against it, as ghost towns often remain so. All ghost towns share these 2 traits:
1) An extremely depressed economy
2) A fairly depressed RE market

A ghost town is the ultimate illustration that commerce is linked directly and unequivocally to RE. But RE is a LAGGING consequence, not a LEADING cause. This may well explain why Bends RE market was almost the last to bust in the nationwide housing bust. On a very fundamental basis, real estate is the ultimate lagging indicator. The last structure abandoned in a ghost town IS NOT the mill... it's the individual homes. Conversely, we can probably expect Bend to turn up last when the housing cycle turns in this country.

Remember the earlier illustration of the Peoria bust of the mid 1980's? I see Bend in the same situation, except the dominate industry is real estate itself. Real estate has grown faster here than anything else. Its a black hole of sorts, sucking energy and resources from everything else. There's been less to go into the "Everything Else" because plowing money into the RE machine was a FAR better investment. But the good times are over, and we're going to have get back to reality. And I think Bend will experience something akin to the Ghost Town Effect: In time, there won't be low bids for homes, there'll be NO bids. Not saying homes will go to $0, but people will slowly but surely will be put into an intractable financial situation: they will list their homes for $X, they MUST get $X to pay the mortgage, but no one will come close to giving them $X. Ultimately a financial institution will own them, and they are faced with the same problem. And we've all seen them: towns with rows and blocks of empty abandoned homes. No one wants them, even though they are damn near free. There's literally no demand at any price, no matter how low.

Think of a (tiny) town with the economic capacity to support 3 families, but it has 12 homes. What are the 9 empty homes worth? Well, each family might pay a little for one extra home, but not much. By the time each family has 2 homes, the marginal demand for the 3rd is virtually nothing. On the margin (where comp prices are determined) the market price is $0.

It should surprise no one then, that the long-term returns from owning a home are TERRIBLE. Long term home price appreciation hover around 1% over inflation, while stocks are close to 6% over inflation. In buying a house, you are historically JUST BARELY better off than putting your money in a savings account. You are enormously better off investing in stocks. Investing in "Everything Else" beats investing in RE by huge margins. This is common sense when you realize that RE SERVES NO PURPOSE in the absence of commerce.

So finally we come to my dominate Bend investment thesis:


Nope, not "Buy A New Explorer" with the difference. Invest it. THIS is probably the single best investment idea for this town, with the lowest possible risk. I feel like this will beat buying a home with almost 95+% certainty over the long haul. I don't really have a crystal ball w/ respect to stocks, but I do know that the difference between renting and owning is HUGE in Bend, and investing such a large amount each month will almost certainly exceed the returns from home prices here, which I think will return less than inflation for what could be decades.

When to buy? When you can do cash-flow positive rental deals. Period. That's down about 50% from here in some cases, so it'll pay to be very patient. This town has some awful big White Elephants (Franklin Crossing) and closing the gap between buying cost per square foot, and rent per square foot is many years off. We'll even get the Ghost Town Effect in some of these places where obtainable rents are so far below what is required that they just stay empty for years. And as Duncan points out, Empty begets Empty after awhile.

Some might find this type of post a little too "academic", not enough "data and facts". But Jesses' and Duncan's posts and comments recently has reminded me that many, MANY people have really lost sight of what the purpose of real estate is, and where it stands in the "delivery chain" of commerce. Real estate CANNOT exist in a vacuum. Without commerce (or an extraordinary situation) real estate has no purpose. The historical returns on real estate are TERRIBLE. If you ever think RE is a great investment in an area, you should immediately be able to rattle off at least one BIG economic engine that will power RE higher. For many in Bend, they simply think the engine is RE itself. This is at the root of what I think will be a catastrophic implosion here that will last decades.


Anonymous said...

Wow. Epic post, man. Very nice.

adhor said...

>> "This town has some awful big White Elephants (Franklin Crossing)"

Don't forget residential: There are endless subdiv's dotting this town. Plus, there are quite a few "pregnant" white elephants: Yarrow, Iron Horse, Tetherow, and all those planned destination resorts coming online over the next many years. Thousands and thousands of housing units without any real income stream to buy them.

m_barten said...

I'm going to print this out! I'll show it to my co-workers. And everytime I feel like I should stop renting, I'll read it.

I don't know how many times I've felt like I had to buy a house here, even though I can't afford it. Only been here a year, and I'm glad I haven't bought. But I've been tempted a few times, but I think the Rent and Invest idea is sound.

Anonymous said...

Horton Hears a Suck

jt said...

I like the "building homes is like issuing shares" analogy. And it's true. In the absence of weird circumstances, the natural response to rising local economic activity is NOT rising real estate prices, it's MORE real estate and flat prices.
And typically we don't destroy real estate when things slow down (notwithstanding the arson job on Reed Market), we just sell it for less.

Anonymous said...

Some might find this type of post a little too "academic", not enough "data and facts".

To the contrary, I love this sort of post. If you quote "data and facts", you basically embroil yourself in a tit-for-tat argument with the RE bulls. Much better is an educational post than an argumentative one.

Best post Ever!

MIsstrade said...

Clear, Concise, and something every broker should read as if you aren't advising your customers with this type of thought, you just aren't doing your job.

jessefelder said...

Regular readers may recall my occasional comments that we have "squandered this bubble"; this is what I'm talking about. Bend "issued" shares, but instead of investing it, we bought our own BS, and issued MORE shares. It's a Ponzi Scheme mentality: Build some, that seemed to work, build more, which also seems to work, and finally spend everything we have building like crazy. It's a house of cards that has no destiny but to collapse.

This is exactly right. VERY few people caught up in the real estate industry are smart enough to recognize cycles and save money during booms to get them through the busts. This is exactly why bubbles collapse - nobody has the resources to weather a slowdown because they went "all in" at the top.

It's a total cliche but like most it's truthful: the only way people make huge returns in real estate is by buying low when things are really ugly and selling high when they can't get any better. Then they add leverage to juice the returns even more. And right now is not even close to buying low. When you mention real estate to people and they look like they're gonna puke that will be the time to buy em.

Great post; keep it up! And thanks for the links.


Anonymous said...

My brother-in-law got rich from Real Estate. But he's nothing like the people around Bend that love real estate. He lives in a trailer. He buys property when no one wants Real Estate. He buys very few single-family homes. Almost everything he buys is a crappy multi-family unit in some godawful depressed tiny town.

You'd have to threaten to shoot his dog before he's buy in Bend now.

These people who "love" real estate now? They are going to get hurt. Badly hurt. Like their testicles are going to feel like they've been squeezed into CheezWhiz.

jessefelder said...

This town has some awful big White Elephants (Franklin Crossing)

And you can add roughly 100 new condo units to the potential supply of 10 or so right now down there in the Franklin building. Pretty soon we'll be measuring the supply of condos in decades rather than months.

jessefelder said...

One last thing (for now): most people don't understand that Bend is not unique. Similar bubbles have sprung up all over the country in recent years because of an extremely rare combination of super-liquidity pumped by the feds along with the easiest lending standards in recorded history. These are both now in the process of reversing themselves and will probably never return in our children's lifetimes, let alone our own.

Again, great post. Lots to think about.

IHateToBurstYourBubble said...

Like their testicles are going to feel like they've been squeezed into CheezWhiz.

OK, there goes my love of Cheez Whiz.

And you can add roughly 100 new condo units to the potential supply of 10 or so right now down there in the Franklin building.

From that piece:

But, given the high prices for downtown land and the high price of construction, their economic viability may depend on a single factor — the health of the residential condominium market.

The reason: Selling parts of a building to condo dwellers is the only way, in most cases, to offset initial building costs to the point where ground-floor retail and midfloor office leases can generate a profitable income stream.

In other words, as Bend Realtor Norma DuBois puts it, “It’s the only way you can make it pencil.”

So how is the market for urban condos — a relatively new market for Bend and Central Oregon — holding up?

Results, so far, seem to be mixed.

Bends bubble addled developers detected the smallest hint of demand for "urban condos" and basically interpreted it as a demand tsunami. Only in Bend, after a crappy start to a RE concept, would developers say "To Hell With It", and go on a building bender anyway.

I think there is demand for about 5 or 6 million-dollar urban condos in Bend, but we're probably going to get 200. And condos are just death to sell in down markets.

Anonymous said...

Anonymous said...

Great post!

Anonymous said...

What a great post. You have articulated precisely what I've been thinking for about the last two years. I've been enjoying Jesse's posts as well. It is nice to finally feel a little vindication for what I've been saying the last couple of years. I used to get looks of shock when I would mention my thoughts on RE in Bend, and now I'm beginning to see vague looks of you might be right. Of course "things are looking better this spring". I call it a suckers rally and only see it going down from here.