298 comments on Peak Oil and the Financial Markets: A Forecast for 2008
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Home Prices Must Fall Far to Be In Sync With Rents
The original article (as well as the data) can be found here:
http://morris.marginalq.com/
According to this model, it could take us up to 5 years to come back from this housing indigestion!
The rent-buy spread is out of whack for sure. Around here (close-in to transit and walkable community) they are building apartments in anticipation of rents remaining strong or increasing.
For a list of projects under construction/just approved see
http://www.arlingtonvirginiausa.com/index.cfm/5231
This is in a pretty small area (Arlington is the smallest county in the US I think)
I am interested in this because lots of people with money are making long term investments here and banks are lending here - right now. So, either everybody is making foolish decisions or it tells a different story at least in this local area.
The assumption is probably that the US government will continue BAU, and therefore even if the price of oil stays where it is (as unlikely as we can see that assumption may be), the local economy will continue running.
Conventional wisdom.
House prices are twice what they should be, given rents.
Therefor house prices will fall by half.
Unconventional wisdom.
What if rents fall? We could be forced by a falling dollar to go into import substitution mode and essentially require people to move to primary and secondary production areas like Michigan and Wyoming to have well paying jobs, the way we required them to leave Michigan and Wyoming and move to the metrocoastal areas during the service economy.
So rents could fall in the metrocoastal areas, leading house prices to adjuct not just down to the current rent, but to the future, lower rent.
House prices after inflation could go all the way back to the early sixties, when short order cooks in diners could afford to buy a starter house for a small family with a ten percent down payment and a twenty year term.
Happy Days Are Here Again, at least for short order cook type people. If you've got money that is invested in housing, or offices, or retail, or whatever in a metrocoastal environment, you could be in for a world of hurt. Some short order cook's family could be living in your house while you are living in his family's apartment.
Ahh but your assuming wages will remain high. They probably will fall as well. Given this you probably will see more housing broken up into apartments as happened to the large homes built in the 1800-1920 boom period. And yes we had a 70 year boom once before. During the first boom expansion into the west and land wealth where the primary driving force. The fairly low density of the suburban housing could probably be rectified with additional infill housing and extensions. Many homes could be converted to small businesses. I don't think you will see happy days but a demographic reversal the wealthy will move closer to work/downtown instead of paying high gas prices. The poor will be relegated to slums outside the cities. This is the demographics of basically all major metropolitan areas in the third world.
The problem is the McMansions are simply not worth maintaining and rents will be following real wages down.
Yes. Those ratios in the graph are so low they must be comparing dissimilar properties. You have to compare apples vs apples. For example the rent on a 3/2 1500 sq ft SFR in a good neighborhood versus the price of same. For prospective landlords, normal property pricing gives you a gross annual ROI of 10% to 12%. You need this much cash flow to pay for the property manager, taxes, insurance, and maintenance and still have a return better than bonds to compensate for the risk and worry of managing property. I find the misleading suggestion that landlords have never earned over 6% annual gross ROI in the last 48 years absurd in the extreme.
The problem since 2002 has been that rental property purchases became a Ponzi scheme driven by speculative greed. Stupid people bought properties that were "negatively geared". By this I mean that the rental income didn't even cover the costs of holding the property. In extreme cases, the rental income didn't even pay the taxes and insurance, much less provide any return on capital (if purchased with cash) or pay the mortgage (if purchased with debt, which is much more common). The whole business plan devolved into hoping to quickly flip the properties for a capital gain. Well, now the music has stopped.
So when should a renter stop renting and buy? Buying makes sense if one has adequate assets or a secure stable income AND the neighborhood is not deteriorating, AND one plans to live there for several years AND the cost of purchase is less than 120 months rent. These conditions are not met in most parts of the western world at the moment. I am currently renting a 2000 sq ft 4/2 new brick SFR in a good walkable neighborhood of New Zealand for USD 1300/month. If I wanted to buy the house, the price would be 320 months rent. The price needs to fall over 60% before buying makes any economic sense. Of note, this is the exact inverse of the 150% house price appreciation over the last 4 years. The entire easy credit driven property price bubble will be reversed.
The same logic applies to prospective landlords. In New Zealand, risk free six month government bonds pay 7.5%. Bank CDs pay over 9% (although banks can fail). There will be absolutely no reason for investors to purchase rental properties until the annual gross rental income is well over 10% ROI. The nimrod investors sitting on negatively geared properties with sub 4% yields will be unable to unload these albatrosses for what they paid for them. Couldn't happen to nicer people.
My only worry is having to move if the bank forecloses on my Donald Trump wannabe landlord. Then I would get a new rental house from another insolvent fracked borrower/failed flipper landlord, another possible foreclosure, rinse and repeat. Well that is still better than buying and taking a capital loss of USD 75,000 every year for the next four years.
Hey Micro,
Thanks for this clear headed strategy.
A young colleague of mine is now in the unenviable position of deciding whether to risk his entire savings in the purchase of his first house. However his pre approved credit standing of last year no longer qualifies him since this year Michigan real estate is now considered a declining market by lending institutions.
After only a year on the job, producing 20% of the down payment, on top of student loans, is quite a tall order.
I never give financial advice since I can barely manage my own but I can show him your excellent analysis guilt free!
Thanks too to Gail for her incisive forecast.
It takes more than a bit of courage to offer, in uncertain times, specific views of the future.
Nicely put, Microhydro.
However, you are comparing rental yields of less than 4% with NZ bond rates of 7.5%. Let's say you can get 8% at a decent NZ bank. That's today's rate. What's it likely to be in 2012?
Gail is suggesting that banks will become more and more risk adverse, and thus presumablly will also being offering higher interest rates in order to attract cash to shore up reserves.
I recall that in Australia in the early 90s you could get 12% on a term deposit. Suppose those days come around again? If your choice is between 12% interest from a bank or buying a house and then trying to find good tennants in the middle of a depression, you are probably going to want a 12%-15% gross rental yield. Which would suggest house prices at a quarter of today's level.
To those who say it can't happen - look at Japan. A country giving a good impersonation of a market that will stay dead for a generation.
I think you also have the issue of the empty or abandoned homes. I think we are already seeing stories of people taking up residence in them. Poor folks who cannot afford the rent may be able to drop out of the rent-paying system.
Well, I hate to burst *your* bubble, while the housing bubble fails to bust, meaning it's only fissling out a little air..
The above chart, in and of itself shows NOTHING. Sorry - instead, it has to be compared to interest rates. Just like stock valuation is a function of what one can get in interest on the market...
1st, interest rates:
Does the curve seem familiar??
2nd, let's superimpose interest with rent returns:
In order to try to figure out what "normal" is, let's say that interest rates and rents were "normal" during the middle of the 1990s and superimpose the two graphs again:
Conclusion: Housing in America is NOT that much overpriced. Falling rent rates (and rising house prices) are much a result of the semi price deflationary environment we are in.
Cheers, Dom
ps. The scenario which Gale is presenting WILL NOT happen in 2008. Bubbles will only burst, once liquidity dries up. Does that look like it has happened recently?
Guys, please read Clif
And weep at how wrong you are.
Dom, please read Mish,
Money Supply Trends Are Deflationary
and see how wrong you are.
had read it, wasn't convinced.
Oddly enough, Clif failed to bring tears to my eyes. Oh well, you can lead a horse to water, and all that.
:-)
I've been following the argumentation of the bears since long before the height of the dot.com boom. Since 2003 I've been following the real estate bubble. Told my brother to sell his apt. in DC after doubling price in just two years WAY too early. But that's no problem, cause you can hardly ever catch the peak of any bubble.
Wondered with Thurow SIX YEARS AGO, when the American house of cards (deficite spending, zero savings, etc..) is going
to crash and burn. Now I know why America's deficite spending, etc.. will continue to work for a good while !!!
Found McKillop 4 years ago - he said price rises in oil are GOOD for the overall economy (where there are most certainly losers). And what has happen in the last 4 years???
Peak Oil will be a real problem for America and the world. But not until production fall more than 1-2% per year. My analysis goes deap and can hardly be explained on the quick.
But my conclusion is: America's problems *probably* won't really start for another couple of years. Comparing now to the 1970s, we haven't even reached 1973, let alone the recesion of 1980..
Cheers from Munich,
Dom
McKillop said that within limits higher oil prices are GOOD for the overall economy. I don't have specific links, but as I recall his analysis led him to posit that around $100/bbl we would see the breaking point at which the benefits of higher price began to give away to the overall pressure that peak oil would exert on worldwide economy. Guess what???
I have never been impressed with Cliff Droke.
and if *I* recall correctly, his "within limits" had nothing to do with an absolute price, but with a shock or no shock. There has been no shock. Just price movement within a rising channel (left and came back in).
For me its obvious. High or rising resource prices make money flow - first to those who have the resources, but then to all the countries in the way of the flowing money. The end of the river is the US once again. The Euro-pond is not big enough to soak it all up yet, and that's why the Euro has been rising.
It is a ponzi game and will crash. But I think we're still a couple of years away. Unless, of course, there is some sort of shock. And I don't think this "housing bust" in slow motion is going to do the job - especially if the idea of bad valuation (see graphs above) doesn't stick. Rents are absolutely lower - but not relatively!!
No one said you have to like Clif.
But here's the point of Contrarian thinking: If the whole world is wining about the stock markets about to crash, and only a correction of 10% is in the game, then obvious the market does not agree with the "fear in the air". If everyone is saying it will fall, and it doesn't, then it will rise!
But this is only one very small part of the puzzle. After this decade, for instance, demographics are going to hit America like a sledge hammer! And like I'll say again and again, falling oil production of 1-2% will take a long time to do its damage. 4% (what I think will be after about 2015) will be another sledge hammer!
FWIW..
Greetings from Munich,
Dom
The problem arises when the cost of "investing" in a property is way beyond the income available. It appears that many of the creative mortgages involved fraud, and there is simply no way of paying back the borrowed money or intent to do so. Hence, the destruction of credit- deflation.
The rent/price ratio is fairly reliable as it adjusts for both price and wage inflation- of which there has been remarkably little.
...According to this model, it could take us up to 5 years to come back from this housing indigestion!
I would offer that since we are past peak, all Models of what it "Historically" (via charts, cycles, etc) are nearly completely worthless. I view peak oil as basically "The End of Growth" period.
There won't be a "Coming Back From" in this. Not for a long long while. Ever since the Financial Graphs with their various business cycles, ran into the Graphs of Post Peak Oil, ALL Traditional Financial graphs are suspect of a basic flaw of paradigms.
Post Peak, Finances will not work like Pre-peak finances.
Supply/demand paradigm for example.