DOES VALUE MATTER?

Max Peterson: “As Warren Buffett says (the quote may have originated with Ben Graham; I don't recall), Price is what you pay, value is what you get.  Longer term, there's no question that value matters.”

F Exactly.

UNDER GOD

Brooks Hilliard: “We won WWII before ‘under God’ was added to the pledge and lost Vietnam afterwards.  The Brudnoy column was good ... I believe in God and have no objection to the inclusion (BTW, there is no comma before the phrase in the pledge, it's "one nation under God").  But I do feel left out (and a bit offended) when I hear invocations ending with ‘in Jesus' name we pray’ and the like, so I can understand the objection to this phrase by nonbelievers.  In sum, I'd be no less happy, patriotic or religious if we kept our references to God and country separate.”

IS THERE A REAL ESTATE BUBBLE?

I still don’t want to talk about the real estate bubble, because this is a time to celebrate.  HAPPY BIRTHDAY, AMERICA!  But I’ll write about it anyway, because I promised.

Let me start with Manhattan apartments, reminding you that every market – indeed every neighborhood and sometimes every block – is different. 

Charles and I have friends – very successful but not super-rich – who bought an 1800-square foot two-bedroom apartment on Central Park West, in a great building, for $980,000 in 1997.  The really neat thing about it is a terrific terrace overlooking the Park.  Not one of those little cookie-cutter kind of slabs beneath the identical one above, but, rather, a true terrace with room for plants and furniture and nothing above, because it comes at a floor where the building sets back.

It’s really a lovely apartment, although it was in pretty rough shape when they bought it.  They put about $500,000 into fixing it up.  (I gasp at the thought, clawing for air, but leave that aside.)  Total investment: a shade under $1.5 million.

Here we are five years later and they believe it would fetch about $6.5 million.  That represents a 34% compounded annual return.  Much, much higher, of course, if you base the calculation not on their $1.5 million cost but on the perhaps $750,000 in cash they invested (with the rest, their mortgage).

“Sell!” I advised, knowing that they wouldn’t.  But if they had, and if they had spent $800,000 of the proceeds on something nice in LA (where they also live) – and maybe $7,000 a month to rent a little something in New York (surely you can get a little something in New York for $7,000 a month) – they would have been left with perhaps, very roughly, $3 million after tax and paying off their mortgage.  Even today, $3 million ain’t hay.

Of course, if New York real estate prices keep rising, or even hold their own, it would be nuts to trigger a large tax bill and go to all the trouble of moving, unless they wanted to retire to Maine or something, which they don’t.

But can these prices hold?  My own guess – and I am generally wrong, which is something to take into account in assessing my advice – is that they can’t.  At some point the shock of the stock market collapse and the Wall Street lay-offs and the looming $6 billion New York City deficit have got to begin to reverse the cycle.  Not to mention the possibility of higher interest rates if things like a falling dollar were to rekindle a bit of inflation.  (A falling dollar makes the things we import more expensive.)

Because that’s just it: real estate prices are cyclical.  I agree that “bubble” is too strong a term for what’s going on in American real estate (and I’m speaking here mainly of residential real estate, where I at least have a tiny bit of anecdotal experience).  I don’t see home prices dropping 95% the way hundreds of NASDAQ tech stock prices have.  But “peak of the cycle” might not be too strong.  Might my friends’ apartment ever fetch “just” $3 million – or even the mere $1.5 million they’ve put into it?  I can conceive of circumstances where this would be the case . . . and that would be a huge drop in price in percentage terms, if not a full 95%.

What, rationally, could account for a 34% compounded annual increase in value of prime New York apartments (or this one, anyway)? I would argue: nothing. Which is why some might call it a bubble.

I get The Van Eck-Tillman Real Estate And Bank Letter, billed as “Adrian Van Eck’s Confidential Letter On The One-Half of U.S. Wealth in Real Estate” ($90 a year, call 800-219-1333). From its June 6 letter:

From coast to coast, the American real estate bubble has been puffing up ever more dangerously in the past 30 days.  My gosh, when I think about the several boom-and-bust cycles I have observed and reported on in the past 40 years, I wonder just how high this one can go and how much longer it can last before it begins to come apart.  When it will end is still hidden from us mortals.  But the fact that it will end and end badly cannot be in doubt or dispute.

Let’s say my friends had to move for some reason – job related, or health related – and they had to sell their apartment a year or two from now.  Meanwhile, interest rates had risen (it’s possible they one day will), New York taxes had risen to compensate for the weaker economy (or services had declined to compensate for the lowered tax revenue) and, given the ever increasing ease of telecommutation and such, demand for Manhattan living had become less frenzied.  So you go to buy the apartment for $6.5 million, and the building requires 50% in cash – there’s $3.25 million you could have put into AOL stock (say) at one-fifth what it had been selling for two years earlier, but you decide to put it into this nice apartment instead – the terrace makes it all worthwhile – and you take out a $3.25 million mortgage at 8%, say, to finance the rest.  (Remember, in this scenario, interest rates have come back a bit.)  That’s a $25,000 a month mortgage, and it would sit on top of the building’s own monthly common charges.  Would a nice young couple like the one who had managed to buy it in 1997 for $980,000, be able to buy it for $6.5 million and make a $25,000 monthly mortgage payment?

I just don’t see it.

Our own apartment, similar but no terrace (oh, what I would give for that terrace – though not $5 million) was purchased in 1977 for $41,000.  That was $11,000 in cash plus a $30,000 mortgage.  The city was in big financial trouble (Ford to New York: Drop Dead!) and the economy was rotten.  Today it’s supposedly worth $1.5 million, maybe more.  So basically, my friends have what I have, plus a $5 million terrace and a view.  The extra carrying cost / opportunity cost of that terrace might be $25,000 a month.  Would you pay $25,000 a month for a terrace and a view?

I’m not being rigorous in this analysis, but I think the broad strokes suffice to give a general idea of my concern. 

It’s true that under the current administration even more than the past one, the stratum of society that can even contemplate $6 million apartments is getting special consideration and huge tax breaks.  So that could be reason to expect the gap in pricing between rich-folks’ home prices and most-folks’ home prices to widen sharply.  That could account for some of what’s happened.  Plus, of course, smart money was exiting the stock market, looking for a place to go, as the market began to crash . . . and fearful and disgusted money, that had waited too long to sell, was next in line to exit the market and look for a place to go.  And that place, for a lot of folks, has been real estate.

It's just that when everyone has finally concluded that something is the right thing to do, the right place to be, it's been bid up so high in price it's become the wrong thing, the wrong place.

For much of my career I have been known as ‘The Super-Bull’ [writes Van Eck in his letter].  But reality is a powerful force and for the moment it tells me that the wide-eyed optimists are heading into an ambush.

I remember slightly older colleagues at National Student Marketing Corporation (whose stock had gone from 6 to 140 in under two years) buying Manhattan townhouses in 1969 with money borrowed against the value of their stock options, only to see their loans called as the stock fell back to 6 and their options became worthless . . . and then see the real estate market tank as others caught in the hangover of the Go-Go years (the late 1960s) had to sell, too.

I’m not saying history will repeat itself in exactly the same way – it never does. 

What’s more, New York is a phenomenal city, and America is a phenomenal country.  Never bet against either.

But now that we’re thought of as a terrorist target, will our real estate values be enhanced?  Or will they be, for a while perhaps, on the margin, diminished.

Now let’s switch from rich people’s housing to the real world.  What of “normal people’s” real estate?  The $120,000 homes and the $300,000 homes?

I doubt the damage to “normal” housing prices, if we have any damage at all, will be nearly as severe as at the high end – but it could hurt nonetheless.  What if interest rates went up, both for new buyers and for those with adjustable rate loans?  What if delinquency rates and foreclosures rose, as people were laid off and/or faced higher monthly payments than they could afford?  Foreclosures are a good opportunity for buyers, but depress the market for sellers.  And higher interest rates are good for neither buyer nor seller.

Will the great influx of illegal and legal immigrants add as much demand to the basic housing market as it has in the past?  Or will we be restraining this flow of new potential buyers and renters for a while?

Will rising interest rates price more new buyers out of the market and put more existing homeowners, hanging on by a thread, out on the streets?

Will the banks that were accepting 3% down payments now require more, further crimping the supply of first-time buyers entering the system?

I bought a 3,000-foot condo in a luxury Miami building directly on the Bay in 1993.  Three bedrooms, four baths.  I bought it from a bank that had loaned $250,000 against it, only to see the owner default.  Years had passed.  Did I want to make an offer, my real estate agent asked?  No, I said – I already had a place to live; and as a rental, it couldn’t possibly carry itself.

“Aw, c’mon – make an offer!” she said.  (We had become good friends by this point, as I had bought several investment properties from her.)

“OK -- $79,000,” I said.

She recoiled before getting the joke – obviously I was joking – and reminded me that the bank, on the hook for $250,000 plus years of carrying costs, had just a few weeks earlier rejected a nearly-as-preposterous offer of $105,000.

But I held firm at $79,000 and that’s where the deal was done.  The bank had had enough.  Sure it was worth more – sort of.  But if no one wanted to pay more right then – and no one did – that’s what the bank would have to take if it wanted to sell.

I’ve rented it for most of the last 9 years, barely breaking even, if that, and this past fall was offered $325,000.  It seemed to be worth more like $375,000 (a lot had changed, as Miami had become hot again, interest rates had plunged, the neighborhood had begun to recover a bit), so I said no, expecting them to come back at $340,000 or something.  They did not.

It’s sat empty now since last fall awaiting a better offer.  Might I someday, years from now, just give up and sell it to some kid for $79,000?

Real estate moves in cycles.  For basic, utilitarian housing, as I say – for a lot of reasons – the cycles should not be wildly wide . . . and each successive cycle might reasonably be expected, on average if not in every neighborhood, to form a significantly higher plateau and bottom than the last.  The Fed and the lending institutions and anyone else who has a hand on the rudder of the economy have a huge interest in not seeing the average homeowner foreclosed upon or the housing industry, with all its corollaries, grind to a halt. 

But my guess would be that Van Eck’s instincts are pretty good:

My 40 years in Real Estate tells me that we are now living through a pretty standard final stage of a Housing Boom [he writes in that June 6 letter].

If so, it may not be great for the profits, or possibly the stocks, of homebuilders and mortgage lenders and furniture makers.  And this might not be the time to rush to buy a second home.  Grab a terrific deal if you love it, but maybe not get into a bidding war.  Something equally wonderful, and a lot cheaper, could come along a few months from now.

Don’t buy a place you might have to sell when you move, in a couple of years, and assume that the selling costs – which can easily approach 10% -- will be covered by the price appreciation you will realize over those two years.  Depending on the location and situation, two years from now you might be lucky to get what you paid.  Or you might find it all but impossible to sell at any reasonable price, for a while.

Yes, interest rates are low.  Grabbing a low fixed rate now on a home you plan to keep forever could be wiser than waiting a while to pay less for such a home but at a significantly higher interest rate. 

And, yes, life is not a business, and your primary residence is clearly a different sort of decision from a discretionary second home, let alone a bunch of investment properties.

I just think it’s sensible to consider the risks more seriously than a lot of people seem to be considering them today.  Much the way they were buying stocks a couple of years ago. 

All that said, let’s not miss the big picture:  We are so fortunate to live here, at whatever price next year’s appraiser values our home.  HAPPY BIRTHDAY, AMERICA!