Make no mistake home prices are headed down - part 2

Residential real estate has no doubt at times been a very good investment and has at times produced exceptional returns on capital invested. The important keys to producing these returns have been leverage and inflation. Putting 20% down (and borrowing 80% of the purchase price) leveraged the capital invested 5 times. Because of inflation those borrowings were paid back in cheaper dollars. The... [more]

Residential real estate has no doubt at times been a very good investment and has at times produced exceptional returns on capital invested. The important keys to producing these returns have been leverage and inflation. Putting 20% down (and borrowing 80% of the purchase price) leveraged the capital invested 5 times. Because of inflation those borrowings were paid back in cheaper dollars. The real estate asset price rose and we saw some spectacular gains in residential real estate. Generally, for most of the last 50 years incomes were rising and inflation was positive. This was to the benefit of debtors and at the expense of creditors. Creditors were returned nominal principal in an inflated world. At times a very inflated world. And in fact, because the absolute return was positive, the returns on capital were greater if you employed more leverage. Because of inflation, the terms of trade favored debtors over creditors. But today, the world and the U.S. economy is facing a serious deflationary threat. US Government TIPS (Inflation protected securities) are pricing in negative inflation (deflation) for the next several years and 10-year break even inflation rates 10 years forward are still very close to 0%. This means that the terms of trade advantage has shifted from debtors to creditors. Paying back a nominal debt in the future will be more expensive to the debtor in real terms. In a sense, a dollar today is worth less in the future in real terms. Creditors will be able to buy more goods and services with the money repaid in the future because things will cost less. Unlike the past, creditors are gaining at the expense of debtors. This is devasting to returns on the capital invested in real estate were leverage is high. And of course on top of the goods and services deflation there is the very real deflation in home prices. From Barclay's Research yesterday: "The decline in US home prices accelerated during Q3 08 as the credit crunch worsened. OFHEO’s quarterly house price index (HPI) fell 4% from the same time last year, compared with a 1.8% drop in Q2. The seasonally adjusted purchase-only data showed a decline of 6.0% over the previous year and 1.8% over the previous quarter. According to OFHEO, the y/y drop in home prices was the sharpest in the index’s 17-year history." In New York City, on top of goods and services deflation and the asset deflation, we have the added feature of rapidly falling incomes. Make no mistake. Home prices are headed down and will be for several more years. If you buy now it will be many years before you see prices return to what you are paying today. [less]