Sunday, May 30, 2010

The US Real Estate Recovery: Prices and Quantities

Market analysts, pondering when the US real estate market will revive, usually conflate two distinct aspects of the market: a recovery in demand (for homes, offices and retail space) and a recovery in the price of buildings from their currently depressed level.

There is no doubt that price and demand are related. A recovery in demand will put upward pressure on price. As existing vacant building space is used up, the price must rise, at a minimum, to a level at which new buildings can be erected and an investment return commensurate with the risk undertaken earned. But to determine how high prices will rise (in relation to its prior peak) we need to examine underlying factors affecting cost and demand.

Two Factors Exerting Upward Price Pressure

There are two factors that will continue to exert upward pressure on price. On the demand side, trend US population is growing at about 1% per year (with a recent dip due to the damping impact of a soft labor market on immigration). That is the highest rate of population growth for a developed country in the world and it ensures ongoing demand for new homes, places of work, recreation and shopping. The quantity of real estate demanded and used will rise significantly over time. On the supply side, the movement towards ever more restrictive land use regulations and environmental constraints on development have broad public support and are likely to continue into the future. This will limit the availability of land on which the new buildings can be built and increase the price of land.

Three Factors Exerting Downward Price Pressure

There are three factors that will exert downward pressure on price. One is the reduction in leverage in real estate lending, which will be instituted by regulatory directive – higher capital provisioning for real estate loans, reduced leverage in the banking sector, lower LTV limits - and by markets in reaction to the massive losses on real estate lending that has occurred during the crisis. As the cost of equity is normally greater than the cost of debt, the increase in required equity will raise the required real estate investment return and, for a given level of rental income, will depress the price of buildings and the land upon which they locate. This reasoning applies to housing, where the rent is an implicit stream of services the home renders to its occupant and where the increased equity must come from households who are less wealthy and more liquidity constrained than they were before the financial crisis.

The second negative price impact comes from the likelihood that real interest rates will eventually rise above the levels of the past two decades. This is a consequence of the simultaneous reduction in private wealth – which reduces the pool of investible funds – and the explosive increase in public sector debt worldwide over the past two years, which will ‘crowd out’ private investment. A higher interest rate increases the rate at which future rental income is discounted, and this will reduce the price of the asset. A monetization of US government debt may damp real interest rates (while increasing nominal rates) but real rental income would decline as wealth is transferred from the private sector to the government, which will reduce the value of the asset. Likewise, a tax increase to pay for a portion of government debt may reduce the government borrowing requirement, but it will increase the required after tax rate of return on investment.

The third negative price impact arises from the requirement that the US eventually reduce its trade deficit. The US cannot indefinitely become more indebted to the rest of the world.; US net exports must increase. For this to occur, the US must eventually reduce consumption (relative to GDP) and shift spending away from the production of non-tradables (like real estate) towards tradable goods for export (and import substitution). The reduction in the proportion of GDP spent on real estate will exert downward pressure on price. As the required adjustment in trade flows is large as a proportion of the US economy –5% or more - the negative impact on price will be large.

My Verdict- Real Estate Price will not Recover to Anywhere near its Previous Peak

I believe that when the adjustment in the US trade balance occurs - and it must happen some time - the resultant reduction in the share of GDP devoted to domestic non-tradables like real estate will be the dominant influence on the price of real estate. A reduction in resources flowing into the sector has to depress the price, I don’t see any way around it.

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