Winter is Coming: Part III, the Housing Market

My argument so far has been:

1. The economy is poised to crash into recession.

2. A precipitating global event is needed for that to happen.

I thought #2 would be China’s invasion of Taiwan — a maneuver that China is being manipulated into, just as Putin was manipulated into invading Ukraine. It turns out that I might be wrong about that event being the one. It seems that Hamas, with explicit assistance, direction and funding from Iran, invaded Israel this week at very high cost of life, in a conflict that will have wide-ranging implications for the region and the world. Whether it’s this or something else, something will cause the dominos to fall and it will happen this quarter.

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I was scolded by a reader for being too negative in the prognosis. It flummoxed me. Do you go to the oncologist and complain about his diagnosis of cancer? He’s just telling the news, and so am I. I don’t flatter myself that my readership is large enough, or my arguments persuasive enough to MOVE events, only guess at them in advance.

The good news is that Walmart sells big girl panties and you can buy them by the gross. Stock up, baby!

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However, there is a valid question to be answered by me, and frankly, for me because of my own investing needs: Where do I put my money if the flying monkeys take over the economy? The answer is real estate.

I know, I know, rates are high. As a matter of fact, they are both really high and not really that high. They are high now because our sensibilities have been formed by the easy credit, low cost of capital environment we’ve lived through for the past 40+ years — AND WILL NEVER SEE AGAIN IN OUR LIFETIMES. Things will be more expensive to purchase, maintain and finance for the rest of your life. Make your mental adjustments to this now, but factor in a key distinction, please.

There is a difference between absolute and relative pricing. The next house you buy will sell at a higher price than it sold for the first time it changed hands in 1968, or whenever it was built. Prices, because of inflation and the demand/supply curve dynamic, increase over time in absolute dollars. Your parents bought the house they live in now for $168k in 1991. The Tax Assessor tells me it’s worth $558k now, and very little has been done to it in the intervening years to increase its value. The purchasing price of the dollar has degraded, and there are more people chasing fewer houses now. That’s it.

The relative price of real estate is quite a different thing, though. In comparing things on a relative basis, you take into account what it costs to own something relative to other factors. For example, let’s say that when your parents bought that house in 1991, the prime rate was 7.58% and their mortgage was roughly that for a monthly payment of $1,183, or $14,196 per year. Assuming their joint income was $125k that year, they spent 11% of every dollar on house financing.

In 2020, the prime rate was higher at 3.5% and the house is worth more so the payment would be $2,505, or $30,060 per year. Oh my god, that’s 2x higher, the world is coming to and end, what will your parents do? Well the good news is that just as inflation increased the cost of goods, they also increased the wages associated with producing those goods, and so your modest parents are proud to report that their incomes also increased along normal lines of about 4% per year, so they are now earning $387,000 per year. On a relative basis then, if they bought the more expensive home, with the cheaper financing, their relative cost of housing would be 7.7%.

It turns out that buying more expensive things with inflated dollars is a good deal. My friend and mentor, Jason Hartman (you’ll want to check out his stuff) loves to call this “Inflation Induced Debt Destruction,” by which he means that buying something on a fixed cost and letting inflation give you more dollars over time means you’re getting fake money to pay real debts off. It’s a good strategy.

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But wait, aren’t rates higher now? Doesn’t this make real estate a terrible investment right now?!?!

Well, rates are higher now because it turns out when you dumb $6T in the world economy, things get more expensive because of the inflation that creates. We are still digesting through that Feast of Benjamins, and the only way to hurry that along is to raise interest rates to drain the number of dollars being allocated for consumer spending off to fixed assets. This is why the Fed waited so long to pull rates up and then had to catch up and raise them faster than they ever had before.

It’s a funny thing, though. Do you know what happens when you put people in cheap mortgages and then raise interest rates so high that new buyers can’t afford those same properties on a relative basis? It turns out that sellers aren’t eager to trade cheap mortgages for expensive mortgages just to change zip codes, so they’re staying put. There are less listings on the market by a factor of 2x than we need to offer genuine replacement rates. Supply is constrained and will be for at least 10 years, probably 20.

At the same time, you have the young boomers coming into the market for vacation homes, GenX buying vacation homes, and the massive Gen Y buying their first and second homes. Gen Y is also not selling their first homes because they can rent them out at advantageous numbers, or Airbnb them for even better numbers. More demographic induced demand is stifled by financial demand pressures but not eliminated. People are still buying.

All of this adds up to making real estate the safest place to invest money over the long term. As I say often on these pages, this isn’t paid financial advice and I don’t owe you a thing until you pay me, but take a look at the data and try to convince me of a different long term scenario or playbook?

There isn’t a housing crash coming. In 2008, we had too much demand fueled by fake, stated income loans that weren’t sufficient to maintain payments on adjustable rate mortgages in the 8-9% range. That isn’t the case today.