What do you see happening in the next 5 years?

Question

Reading Ray Dalio's book makes me contemplate some more about where real estate is heading. Looking back at the last 15 years everything seems so predictable. New housing starts grew year over year and well exceeded long term averages. Loans became famously available to anyone who could for a mirror. People with no prior interest (or experience) in real estate started flipping brand new homes that were never occupied before. The hogs had gotten too fat, time for a slaughter. In hindsight it's easy too see.

I don't see any unhealthy development, at least not yet. For the last four years we had a stable economy, unemplyment keeps getting lower, continued low interest rates (anything below 8% is low) and a social trend towards renting (although millenials have started buying as of late). And most importantly a huge supply gap.

Market inventory is well below a healthy supply of 6 months, generally as low as in the early 2000's, in many cases at an all time low. Locally speaking, in the Milwaukee suburbs we have about 2 months worth of inventory in the lower priced segements, which translates to almost nothing avaialble. Construction starts have gone up steadily the last years, we are back in the 1.2 million range, with even more permits pulled as a leading indicator for further gains. However, still well below the growth rates of over 2 million in the years leading up to the crash. Shortage of land and labor have been holding the industry back.

Cost of construction has gone up so much, about 40% (depending on who you believe) in the last 15 years. Consequently new inventory is almost exclusive in the higher price ranges. What tightens up the market even further is that more rental grade SFR's than ever are being held by private investors and they are not thinking about selling. In other words, there is no new supply in these lower price segements and demand keeps pushing up prices.

The current trajectory will not last forever; the question is what will initiate a turn and how will that look like? At the moment (short of a national/global black swan type event) I see more of the same in the next years, just even more accelerated. Does anyone have some insights on what the long term trends might look like?

Matt Maurice · Answer

Provided lending practices haven't overly loosened up, which I'm currently purchasing a home with a traditional mortgage and can tell you for certain this bank has not, then I see the majority of the market continuing to rise at a reasonable rate.  Historical median home prices increase 5.4% annually, so while we are currently tracking above that rate I don't think prices will go backwards again like 2007.  The market crash was fueled by poor lending practices; homeowners biting off way more debt than they could afford with adjustable products that increased the debt burden above their income.  In the retail market, I don't see the adjustable products or the increase of rates blowing up like they did 10 years ago.

What becomes interesting to me is when you apply the same trends of the market collapse to commercial investors, specifically the SFR and small MF markets that are selling for 50-100% more than just a short time ago.  Volatile markets like these (houses under $75k) are being over paid for with commercial notes lasting 3-5 years by investors drastically underestimating unit turn costs.  Tenants generally average 3-5 years in most SFR and Duplexes, coincidence?  The writing is on the wall for a market reset in the near future for these types of properties.

If or when this market reset happens, what will be the outcome?  Well, as pointed out in this post, inventory is historically low and construction costs are historically high which creates significant value for existing housing in the middle even low end of a market.  It's entirely possible when these investors find out their cash cow is a cash black hole they will still be able to sell on the retail market to a homeowner willing to do the necessary renovations.  Option B, the market gets saturated with this type of inventory and the locals that have been building cash for 3-5 years will be able to scoop up houses at numbers that makes sense again.

I think either option result has little effect on the retail market as a whole, it will be relatively isolated to the under $100k market (Milwaukee specific).  One thing I haven't been able to figure out is the effect on rent prices for these properties but also MF buildings.  With the quick and massive expansion in Milwaukee of higher end apartments (can't build new to rent for middle prices due to construction costs) how will that affect the small investors rent?  Not sure.  The big players don't discount rent traditionally, they can't afford to.  They can afford to sit on vacancy until their building fills up, but the volume of available high end inventory has to make a dent to the little guys and median prices... right?

Marcus Auerbach · Answer

Thanks for your thoughts on this @Jeffrey Holst. It seem like a given to me that mid and lower price homes will go up in value. My visits in San Francisco and Washington DC last year have definitley opened my eyes to what expensive real estate can look like, even smaller homes that are far from luxurious. How people with blue collar jobs can afford to live there remains a mystery to me. I don't think the midwest will ever get anywhere close to these prices, but puts prices in a different perspective.

I would like to hear someone challenge my thoughts here, what am I not seeing? I can't see cost of construction come down again, even in an economic slow down. And cost of land will not come down either. And demand is not going away. We have not built any substancial quantity of houses in the last 10 years after 2008; more specifically we have not built any amount of starter homes in Milwaukee since the 60s. The Millennials have started buying and they want something that is both nice and small; and priced accordingly. They are not going to buy a $450k single family in the suburbs. The only conclusion I have is that we are going to see more condos. And what will that do to the existing SF housing stock?

I have been looking at interest rate hikes in the past and the last four of them did not lead to a loss in property values. Surprisingly people kept buying and just put up with the higher rates.

Marcus Auerbach · Answer

@Matt Maurice I see the same, lending has slowly returned to normal (and away from paranoid), with rates going up moderately there should be no issue. Affordability is still very good.

I can appreciate your view points on the sub-100k markets, that is an anomaly and by the way not what I would rate a starter home: that's 100-200k depending on where you are in Milwaukee. Sub 100k properties are a different chapter all together; my theory is that a property value (which is comprised from land and improvements) for a total of 100k implies negative land value, because a 1000 sf structure has some intrinsic value that can not go below 100k as long as it is functional. You are buying the house worth i.e. 120k and you are getting a 60k credit for taking the land, so you pay 60k at closing.

I recommend everyone interested in the sub100 markets to spend a day in the shoes of a property manager in that area before pulling the trigger. From what I know some PM companies will not service these properties, rents are so low that even a 15% PM fee will not cover for basically twice the work and all the issues that come with that territory. I know people who are operating successfully in that market, but they are working very hard for their money and I commend them for doing it; the community certainly needs them. But this is certainly not passive income. Once in a while I see a portfolio of 10 or 20 of these offered for sale, and the seller is highly motivated despite incredible looking numbers - on paper.

Could that segment crash when the 5 year notes come due? Possibly, but it would be isolated and other will pick them up for a discount I think.

You raise an interesting point about the 5 star apartment developments, mostly down town. Some of these guys are building for $200 per sf. That's 200k for a 1000 sf unit! Not long ago the going rate for a MF was 60-80k per unit - depending on where you are in town. At rents over $1500 for one bedroom and over $1700 for two bedrooms I wonder where all the tenants are coming from? I would not be surprised if we see further increased vacancies in that segment. Then the question is will they start offering incentives and who can hold his breath the longest. And how will this effect the small MF market? How will a 12 family building from 1960 compete? I think duplexes are somewhat isolated, almost like SFR, because they provide a different lifestyle. But older medium size properties will have a hard time to compete, especially downtown in prime locations. Foxcon better provide some impulses here, otherwise this particular 5 star MF bubble could burst.

Pat Parrillo · Answer

Interesting discussion @Marcus Auerbach, a topic I'm very intrigued by myself. When looking at the macro outlook of the economy and specifically looking at a market correction study the inverted yield curve and it may shed some light on the timing for the next recession.

I don't have any idea how drastic the next correction will be, and I don't foresee it being nearly like 2008, but once we hit an inverted yield curve we have about 6 - 18 months and the correction will be here. The Federal Reserve is keeping a very close eye on this and they are anticipating the correction which means they really need to increase interest rates so that when the correction comes interest rates are high enough that they have room to reduce them to lessen the impacts of the market correction.

This is a delicate game they have to play in increasing the interest rates and I don't think they're being as aggressive as they would like to be. So the short of it is anticipate interest rates to continue to increase potentially up to once a quarter but the Feds will back off and most likely only do it about twice a year.

When studying the inverted yield curve I think we'll be good through 2018 and may get all of the way through 2019 or towards the end of 2019 and come 2020 I anticipate a market correction. This will affect both the economy and the housing market. This is all speculation on my end and no one really has the answer but that's my two cents.

Mike Dymski · Answer

I see myself investing in value add, cash flowing real estate in good locations.  Artificially low rates for a decade, material tax reform, rising interest rates, and black swans make the economy and housing market highly unpredictable and volatile.

Marcus Auerbach · Answer

Hey @Pat Parrillo I think you are right with the stock market; it's been going to well for too long and has a bright future already priced in. There is no question it will correct, the question is only when and how much. If that will have a cooling effect on the housing market remains to be seen.

Experts have been predicting a cool down of the housing market now for 3 years; yet I dont see it comming. I believe we have another 30% to gain before we are back in line with long term average appreciation (we just got caught up to 2007 price levels last year, so basically been flat for a decade).

Eventually the housing market will cycle as well, also this is just a matter of time. Peaks follow troughs.

The question that I can't seem to find a good answer for is what's going to happen to the different price segements; starter homes, middle segment and luxury segment? Here are some numbers from a recent Innman report:

"Over the past year, starter homes gained 8.5 percent in value while luxury homes only gained 3.6 percent in value. Over the past five years, owners of starter homes have experienced a 44.4 percent growth in equity — 17.8 percentage points more than owners of luxury homes (26.6 percent)."

That lines up perfectly with what I see in Milwaukee and Ozaukee County. While the market is hot in the lower and middle segement and inventory is at about two months of supply, we have ample inventory in the luxury segment with up to 24 months worth of supply. Luxury prices $600k and up) have bearley changed, while what used to be a 120k home in Milwaukee sells now for 150k and more, and what used to be a 200k property in Ozaukee is now hard to find for $250k. Starter homes (which are also the best rentals) are becomming harder and harder to find.

Investors who own SFRs are not selling, which contributes to even tighter inventory.  The combination of cash flow and appreciation is just too sweet.

Even the middle segement 300k to 400k is dry. It's a great market for flippers; selling for a premium is easy, the trick is to get your hands on a good project house. The fundamental problem is that it became physically impossible to build a property under 350/400k in southern Ozaukee. Or for less then 250k in Milwaukee. The cost of land, labor and material are too high. So in the lower and middle segments we are stuck with existing inventory, as no more can be created. At least until the cost of existing homes has caught up with new construction. Existing inventory is aging and not getting better. I wonder if we are headed into the same direction both coasts have? At some point it will become more attractive to build a new house for 250k in Milwaukee than to rehab an old one.

Is this just going to be the new normal? Or will there be a turning point?

What do you see happening in the next 5 years?

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