In the past I have written that there are times when profits can be made by investing in both real estate and homebuilding stocks. My rationale has been simple: The combination of tax laws that encourage people to own their own homes alongside declining interest rates that allow many more home buyers to qualify for mortgages will result in increasing demand for homes, thus pushing up prices. The subsequent record boom in real estate and homebuilders’ profits confirmed my expectations for an unusual investment opportunity.
A boom is anything that is caused by circumstances that are unique to a particular point in time. And when these circumstances change, the forces propelling the boom melt away. For example, technology spending for Y2K in 1998 and 1999 created unsustainable growth in the sales of technology-related products and services, and displaced sales from 2000 and 2001. The rest
is history — a collapse in technology stocks and tech-company earnings. This boom-bust phenomenon is especially true when everyone appears to be getting in on a boom and making some easy money.
In the case of tech stocks, I knew the boom had peaked when my hairdresser told me how easy it was to make money in stocks. Today, stories of average investors “flipping” numerous residential real-estate properties — and making a bundle in the process — are becoming commonplace.
Like our friend Yogi Berra said: “It’s déjà vu all over again.”
Just as the tech bubble eventually burst, the basis for a housing bust is relatively easy to identify. First of all, mortgage costs are on the rise. Year-over-year, the cost of a five-year adjustable-rate mortgage is up by about 20 percent. Compounding this problem is the fact that many real estate investors have utilized “innovative” financing to facilitate their purchases. In other words, they have become highly leveraged. Not unlike investors in 1999 who margined their brokerage accounts to purchase more technology stocks, these real estate “flippers” could get caught in a residential margin call. Add in increased insurance premiums due to Hurricanes Katrina and Rita (my home insurance just went up by 70 percent!), and monthly payments may force these speculators to hand their keys over to the bank.
Many current and would-be homebuyers haven’t factored in these substantial increases in their monthly payments. What happens when the marginal homebuyer, on a highly leveraged mortgage, gets a big increase in a monthly mortgage payment, along with a larger insurance premium, and notices a newspaper article indicating that his home is now worth less than he paid for it?
One shocker was a mailing I recently received from a local broker. Usually you only receive “bullish” mailings about how sales and prices are rising. This one-page summary of real estate sales for the first quarter of 2006 was an eye opener. Since Hilton Head — my hometown — is one of those desirable places to live on the East Coast, one would expect a continuing stream of retiree purchases in the area overcoming any national slowdown in housing. But the postcard I received provided the following data:
| Homes Sold | | Number | | Average Price |
| 2005 | | 285 | | $894,555 |
| 2006 | | 195 | | $1,014,848 |
| Villas Sold | | | | |
| 2005 | | 464 | | $324,286 |
| 2006 | | 244 | | $412,678 |
| Lots Sold | | | | |
| 2005 | | 111 | | $396,530 |
| 2006 | | 46 | | $644,278 |
The decline in year-over-year first-quarter home sales was a whopping 32 percent, even though prices rose 13 percent. My eyes tell me that inventories of unsold homes continue to increase, so I can imagine that prices will follow the path of home sales — i.e., down. Marginal homebuilders who got into the game late with little capital already find themselves unloading unwanted inventories of homes at large discounts from asking-prices just to offset the rising costs of financing these new homes.
The decline in villas (another name for timeshares and condominiums/apartments) was an even-greater 47 percent, with prices rising by 27 percent. The biggest decline was in lots sold (-59 %), but this in part could be attributable to the fact that available lots are limited. The rise in price of these lots (+62%) suggests that there are many optimistic investors out there who see the opportunity to “flip” the raw land for a big profit.
You don’t have to take my word for a gloomy housing outlook. Take a look at the price declines in the stocks of major homebuilders, even though their earnings growth continues to be exceptional:
Lennar Corp. 28% below 52 week high
D.H. Horton: 34% below 52 week high
Hovnanian: 55% below 52 week high
Toll Brothers: 52% below 52 week high
The most recent news on housing is not encouraging either. In April, housing starts fell 7.4 percent, the largest drop in more than a year. This decline surprised Wall Street economists who expected a flat housing-start number from March.
The factors are falling into place for a price decline in residential real estate. The size and depth of this decline will depend on Federal Reserve monetary policy, interest rate levels, and the impact of speculators, or “flippers,” when opportunities for appreciation become less likely.
— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.
