A noted value investor looks at real estate.
In April 2005 a friend, thinking me a fairly reasonable fellow for a real estate agent, forwarded me an investors’ newsletter article on “the pending collapse of the real estate bubble”. At the time, real estate was going from strength to strength, and my friend was interested in my insightful comments on this contrarian assault on conventional wisdom.
Or maybe he just wanted to twist my tail.
He did that, because the "The Canary in the Coal Mine" fried me. It wasn't the idea that the good times would soon end; I'd been saying that in my own newsletter since 2004. It amazes me that our home prices have held steady or even continued to rise in some neighborhoods, although a strong local economy makes this less amazing.
No, my objections to "Canary" had to do with little things like style and substance. Written by "perma-bear" Jeremy Grantham, chairman of money manager Grantham, Mayo, Van Otterloo & Co. in Boston, I thought it affected the ditzy tone we philistines tend to associate with Oxford dons. A savant straight out of Lucky Jim, with 20/20 tunnel vision, unequaled in his narrow realm of thought but incapable of seeing the world at large. Some people get weak in the knees whenever they run across this charming paradox.
So I figured that any guy out of Boston with a name like Jeremy Grantham must be a pretentious Brahmin affecting the language of the Mother Country to impress the hicks. Two years later and after much wading through Huxley, Orwell, Greene et. al., I now recognize Grantham's highly-readable style as that of the literate Englishman. I've also discovered that as a transplanted Brit he comes by this style honestly, although it's been filtered through Harvard Management School, not Oxford.
As the tag "perma-bear" implies, Grantham is a notorious market bear, who at about the time he wrote "Canary" was claiming that the Standard & Poor's 500 would be "fairly valued" at 730, 35 percent below its July 17, 2005 closing and 52 per cent below its closing almost two years later July 2, 2007. In a April 24, 2005 Los Angeles Times interview, Grantham conceded "that he has been predicting a financial unraveling for the last two years and has been dead wrong. 'We were horribly early', he said."
That's one way of putting it. "I was horribly wrong" might be another. Full marks for style, but a big de-duct the size of Texas for omniscience.
My friend is a reasonable guy himself, but he's been known to refer relatives to me, watch me work my butt off because they’re referrals, then pull the plug by telling them that it's a bad time to buy real estate. It was with this quirk in mind that I responded:
“Good to hear from you, and thanks for Grantham's article. I did read it carefully, and I have an article of my own in my next newsletter that could have been written in response. Its theme is that irrational pessimism is just as self-defeating as irrational exuberance—they're opposite sides of the same coin.
I was going to ask how your [young relative's] home-buying is going, but if he's reading Grantham he's probably signed a five-year lease. That’d be a shame because, as we both know, real estate pays off handsomely in the long run, and your [young relative] has lots of "long run".
In fact, I'm convinced that the main reason real estate is such a good investment is due not to any inherent superiority, but to what's often considered its greatest drawback: illiquidity. Real estate's illiquidity encourages homeowners to be the buy-and-hold investors they should be rather than the market timers they're so often tempted to be.
For example, let's say that Joe Markettimer is the typical small investor, darting in and out of financial markets, usually at the wrong time and for the wrong reason, often at the prompting of gut hunches or hot tips from writers, friends or co-workers. If Joe gets a brainstorm that the economy is about to collapse, he can log on to his e-Trade account and sell his stock quickly and cheaply. That's liquidity—and that's how Joe and others like him under-perform the financial markets in the long run.
But if Joe gets the urge to bail out of his house, he's got a big sales commission to pay, plus fix-up costs, and he's looking at weeks if not months on the market. That's illiquidity, and it tends to minimize the impulsiveness to which unsophisticated investors are prone. It's this impulsiveness that leads to speculation, and according to the economist's own definition, it's speculation that leads to bubbles. That's how economists distinguish between a bubble and the upward trend of a normal up-and-down market cycle. It's the difference between day-traders buying pets.com at 13 because they think they can sell tomorrow at 14, and families buying roofs over their heads for five to seven years because interest rates are low and the economic outlook is reasonably favorable.
If Grantham can't make this elementary distinction, or chooses not to, then whatever he says about owner-occupied real estate should be taken with a large grain of salt.
Apparently without realizing it, Grantham mentions another reason real estate resists impulse selling. If, as he claims, Mrs. Grantham is the only thing keeping him from trading the benefits of homeownership for renting, then he's identified another of owner-occupied real estate's built-in, bubble-resistant safety valves: other people in the household may not think that selling is such a good idea, and their opinion often carries weight.
Grantham’s difference of opinion with the Mrs. reminds me that more often than not it's the husband who sees real estate as a chance to prove his financial acumen. He's almost always the one who says things like "I don't want to overpay" or "I'm looking for a good deal" or "I'll never buy anything that can go down in value" or "I'm looking for an area with upside potential" or "I'm waiting for the market to get back to normal". So he looks for things that don't exist in a statistically meaningful sense, or that do exist but bring their own risky baggage. And if he does venture into the ring to make an offer, he often pulls his punches. On the other hand, the wife usually sees the house for what it is: a nest, an asset in which the long-term financial rewards are only part of a bigger picture. If the couple eventually does buy, it's because the wife puts her foot down and informs her husband that his way ain't working.
No home buyer will ever be able to eliminate risk and maximize upside, no matter how long he waits or how hard he tries, because there will never be a perfect market in which to buy. It's ironic that if [an older relative], who was waiting for exactly the right time to buy, had bought in Silicon Valley’s dark days of May 2001, not only would he have achieved his goal, a house in Palo Alto and the many benefits thereof, but that house would now be worth about 20 percent more than he paid for it. So by trying to buy without penalty, he incurred penalty by missing perhaps $250,000 in wealth accumulation.
It's a comment on our veneration for advanced degrees that the people in the front lines of real estate have less credibility than the academics who study it from afar and often through the wrong end of their telescope. Owner-occupied real estate isn't a market they're used to—its measurements and motivations are different. For example, Grantham suggests that houses should be valued only at replacement value, a dubious concept even when applied to corporations because it ignores the value of a strong brand or superior management.
We see examples of this in the local real estate market where, for example, one city, Santa Clara, sells for just 60 percent of what a superficially similar city, Palo Alto sells for. Both are university towns. Both own their own utilities. Both were built about the same time, sometimes by the same builders. In fact, you'll find identical homes in each city. But Palo Alto has long made a larger investment in its infrastructure than any local city of comparable size, creating an environment that has buyers willing to pay a steep premium to live there.
Grantham's reliance on replacement value shows the danger of hanging your hat on one theory, then drawing a line in the sand around it. Wealth-creation may not require the god-like acuity we assume. Markets are too complex and nuanced to fit one theory, and too big and impersonal to care where one man or one group draws their inviolate line. I'm reminded of the buyer who told me, "Everyone we know was saying the market must realize that if interest rates go up, prices must go down. But prices haven't gone down, and now we're back looking at homes." She's looking in an area where an expanding local economy attracts well-paid professionals, and in an area that never depended on 100 percent financing and subprime loans during the boom and isn't facing a wave of foreclosures now. She's jumped a high hurdle—from "the market must" to "the market is what it is"—that not every buyer clears.
Grantham also suggests that sales prices should maintain a relationship with rents, a concept I think is relevant only to buyers of income property, and not to buyers intending to occupy their property. In fact, rents typically go down when sales go up, because the pool of renters shrinks and loses purchasing power as many of the most affluent renters become homeowners. The wide difference between rents and prices in Silicon Valley is an indication that of the three drivers of real estate—credit, confidence and employment—credit is now the leading one, but I don't understand why this makes the current market illegitimate. The relative importance of these three market drivers isn't fixed. Would today's real estate market be more legitimate if we switched the emphasis and had, say, 1999-style irrational confidence and 1 percent unemployment with 20 percent interest rates? Would that market be more "real"?
I'm convinced that economists care little and know less about owner-occupied real estate, but real estate is big news these days, and economists have newsletters to sell and reputations to burnish. But if economists can’t agree on what caused the signal economic event of the 20th century, the Great Depression (or even why mortgage interest rates are still low after nine rate hikes) then the "dismal science" is more art than science, more subjective guesswork than objective truth.
None of what I've said is real estate booster-ism, just elementary economics and common sense. Even the National Association of Realtors® acknowledges that real estate will cool off and that a cooling is good. Prices may level off or even decline in the short run. What about the people who bought just before the market cooled? No one can successfully time the market, and your [older relative] isn't the only example of why it isn't wise to try. Here are two more. Late last year I sold a house to a client who sold his previous house in late 2002 only because he thought the invasion of Iraq would torpedo home prices. Instead, they went up. Two years later he replaced that house with one in the same neighborhood, smaller yet more expensive than the house he'd sold in a panic. Then there's the client who sold her Sacramento home a few years ago at what she was absolutely positively sure was the peak of that city's market, but rented there instead of buying here because she was sure Bay Area prices would go down too. But prices went up, both here and in Sacramento, and now she's priced out of both markets.
Years of watching this behavior show me why investors so often under-perform markets. They know just enough to think they have to outsmart markets to get ahead. Worse, they think they can, as if markets were giant pinball machines that could be lit up with a few nudges. But if they really understood markets, they'd know that you come out ahead just by being in them over the long term. Markets are more random, profound and just plain mysterious than we mortals, or even god-like economists, can ever comprehend.
So when it comes to the real estate market, buy what you can afford, when you can afford it. Don't make it any more complicated than that. Some things are bigger than we are.”
True in early 2005, and equally true today.