Friday, June 23, 2006

On the Perceived Affordability of Buying, Rents, and the CPI

I thought this was an interesting and concise summary of the situation at hand:
As real estate prices spiraled upwards over the last ten years, artificially low interest rates and lax lending standards were not the only factors helping to maintain housing affordability. Just as important were the expectations of future price appreciation and the suppression of the rental market. With these two factors largely reversed, the housing market is much more vulnerable than most people understand.

Given that many people expected to extract money from future appreciation, which could help pay mortgages, taxes, maintenance, and insurance, houses actually seemed cheaper to buy, despite soaring sticker prices. On the other side of the coin, without offering the bounty of free cash, the rental market suffered a multi-year torpor. Flat rents anchored a rock-bottom core CPI, which allowed the Fed to keep rates low and the cheap mortgages flowing.

As the slowing housing market increases the perceived cost of buying, renting becomes a far more compelling option.

Rents make up 40% of the core CPI, and are by far the index' largest component. For the reasons outlined above, a softening housing market eliminates the financial advantages of buying and increases demand for rental properties. Recent data shows that national rents are increasing at a rate not seen in more than five years. This has begun to show up in the core CPI, which will continue to grow with the surging rental market. Just as rising home prices paradoxically suppressed the core CPI, falling real estate prices will now do the reverse. A more rapidly rising core CPI will force the Fed to continue raising rates, putting even more pressure on home prices, and initiating a particularly nasty spiral.

The Fed of course now has a real conundrum on its hands. It either plays down the significance of the core, possibly excluding rents entirely as they now do food and energy, or continue to raise rates even as housing prices collapse. The former, which amounts to a version of "heads I win, tails you loose", risks exposing the Fed as hypocrites. The loss of any remaining faith in the Fed will cause a run on the dollar and even more inflation. On the other hand, to continue raising rates will surely tip the economy into a recession.

My guess is that the Fed is already preparing the markets for a pause even as core consumer prices continue to rise. The spin will be that peaks in core consumer prices historically occur with a lag relative to the end of a tightening cycle. This will likely buy the Fed a little extra time until the markets finally notice that rather than peaking, core prices just keep on rising. Therefore, the greatly anticipated, highly illusive pause will not be the least bit refreshing.

7 Comments:

Blogger rejunkie said...

Recent data shows that national rents are increasing at a rate not seen in more than five years.

Music to my ears. It's about time, too. I need to close the negative cash flow on my rentals. I have one place that has not seen a rent increase in 5 years.

This is nothing new, BTW. Rents and prices seldom move up at the same time -- the late 90s were an anomaly.

Jun 23, 2006, 2:53:00 PM  
Blogger John Doe said...

My guess is that the Fed is already preparing the markets for a pause even as core consumer prices continue to rise. The spin will be that peaks in core consumer prices historically occur with a lag relative to the end of a tightening cycle. This will likely buy the Fed a little extra time until the markets finally notice that rather than peaking, core prices just keep on rising. Therefore, the greatly anticipated, highly illusive pause will not be the least bit refreshing.

Sounds more like wishful thinking or crack smoking. Bernanke has put his hoof down on inflation and thrown down the gauntlet. For him to back down now would brand him for the remainder of his very, very short time in the FED. At least with hawkish talk and action economists will give him respect. If he pauses, economists will hate him, and politicians will hate him anyway because of the ongoing meltdown that is inevitable with the giant sucking sound of liquidity around the world.

Ever wonder what a "credit event" sounds like? you're in the middle of it right now.

Jun 23, 2006, 3:53:00 PM  
Blogger John Doe said...

I have one place that has not seen a rent increase in 5 years.

5 years, huh? And it's still negative cash flow? Or, are you just speaking in general?

BTW, I would love to see how you come to the conclusion that rents and prices rarely move up at the same time. By my OFHEO and HUD data, I'm seeing it pretty much for all recorded history. Live links will be sufficient and I will do the sleuthing.

Jun 23, 2006, 3:57:00 PM  
Blogger Twist said...

Bernanke really has no choice- he will appear weak and indecisive if he does not raise rates this next go around.

I believe that as we near the end of the summer selling season in real estate, and continue to have tremendous levels of inventory, real estate will be a growing concern, and Bernanke may throw a pause in their somewhere. However, with inflation continuing to be a concern, I doubt he will believe that he can stop soon.

I am wondering if the upward pressure on rents will be as great as some are suggesting. As more "Repartments" - uncondo conversions become available, and as more upside down investors rent out homes, I think this may serve to dampen the upward trend in rents.

Jun 23, 2006, 11:11:00 PM  
Blogger rejunkie said...

John Doe-

Marin price information is easy to come by, local rents are harder. Rents did rise during the early to mid 90s during the last slump, but that is my own personal experience, not something to draw charts on. I will see what I can do to back up that assertion.

Regarding the rent increases and negative cash flow: the first one was very firmly positive (bought in 1997) until I took out money in 2002 to buy another, hence they are both negative now (although the 170% capital gain on the first and the 45% gain make me feel better about the cashflow somewhat).

Jun 26, 2006, 4:21:00 PM  
Blogger John Doe said...

Regarding the rent increases and negative cash flow: the first one was very firmly positive (bought in 1997) until I took out money in 2002 to buy another, hence they are both negative now (although the 170% capital gain on the first and the 45% gain make me feel better about the cashflow somewhat).

Excellent, Smithers (tenting fingers) Excellent.

It's an enviable position to be in with so much in cap gains waiting for you. On the other hand, it's not fun to be cashflow negative. Over the long run, it will beat many investments, but it's notoriously cycle-prone and terribly illiquid and indivisible as assets go. As long as you don't go down in a blaze of glory if demand weakens, they'll for sure be good ones.

RE investing would not be my way of going, but some really enjoy it. No thanks, I did enough repair work when I owned my own house, a rental would be the death of me. Of course, if it got really cheap, I might change my mind.

I think what some investors fail to realize is that it doesn't always go up... on the appreciation or rent side. I did some consulting out in Endicott, NY where rents have been stagnant or falling since nearly 1987 (almost 20 years going). To be negative cash flow that long would be a real bummer. You can also pick up a rental house in the area for about $40k, down about 60% over that same amount of time.

I would argue that economic theory would suggest that falling demand for all types of housing in a locale would drive both prices AND rents. Will that happen in SoCal? It's a gamble to see what inflation will do when mixed in with regional cost of living.

Jun 26, 2006, 11:58:00 PM  
Blogger Marinite said...

I think what some investors fail to realize is that it doesn't always go up... on the appreciation or rent side.

I guess you didn't get the memo...Marin is special.

Jun 28, 2006, 7:43:00 PM  

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