Apparently I'm the Last Man Standing Against This Sector

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I might just be the last pessimist in the housing sector.

Our president, Federal Reserve Chairman Ben Bernanke, nearly every analyst you talk to, the Fool's own Morgan Housel, and the most recent building permit data would indicate that the worst is behind us and housing is on the upswing. Building permit data released Tuesday indicated a 3.5-year high to a seasonally adjusted rate of 717,000 homes. This is not even one-third of the 2.27 million peak reached by new housing permits in January 2006, but it's been trending higher for a few months now and homebuilders' sentiment is also at a five-year high.

Individual homebuilders have also shown moderate new order growth and have rallied on the prospects that things are, simply, not as bad as once thought. In January, Lennar (NYSE: LEN  ) reported a 20% pop in home orders while D.R. Horton (NYSE: DHI  ) profiled a 13% rise in net sales orders and an 18% jump in backlog.

You might be wondering how someone could possibly be bearish in light of these figures. It's actually pretty easy if you consider the very unpopular possibility that the homebuilders don't have the slightest clue what they're doing.

Think about it. These same homebuilders were calling a bottom in 2008, then in 2009, then 2010, and so on. That strategy ensures they'll eventually be right, but who's to say that this is the year we hit bottom? The data so far would suggest the descent of building permits has stopped, but it hasn't done a thing to address the glut of vacant housing already on the market.

According to RealtyTrac, there are 1.35 million foreclosed properties waiting to be sold with LPS Mortgage Monitor predicting another 4 million foreclosures will hit the market over the next two years as banks begin to take possession of foreclosed properties. It's not a coincidence that housing prices have been steadily dropping ever since foreclosures flooded the market, and I think it would be a misconception to assume that's going to change anytime soon.

I also wonder just what homebuilders are thinking by ramping up new orders when, based on data by mortgage-data research firm CoreLogic, 11.1 million homeowners (22.8% of all homes) were still underwater on their mortgage as of the fourth quarter of 2011 -- and count me as one of them! This figure has dropped a paltry 0.2% since the third quarter of 2009 despite massive efforts by the U.S. government and the financial sector to buoy home prices and make home loan refinancing easier for homeowners.

I'd also love to see if new home loan mortgage applications dry up with the 10-year Treasury yield spiking nearly 40 basis points over the past two weeks. While there is no precise correlation, the 10-year Treasury yield often moves in tandem with the 30-year mortgage rate. A rise in the yield often leads to a rise in the 30-year mortgage rate and vice versa. A few months back I expounded on consumers' hypersensitivity to even slight blips higher in mortgage rates, so this move up could put a stranglehold on this small glimpse of homebuilding green shoots.

I'm not a complete dolt; I do feel the housing sector will rebound at some point. I just feel we are nowhere near that turning point despite what the data right now are suggesting.

Housing bulls, let me hear from you in the comments section below: What am I missing here?

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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. He's digging in his heels against the housing sector. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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  • Report this Comment On March 30, 2012, at 2:41 PM, mbushman wrote:

    "Housing bulls, let me hear from you in the comments section below: What am I missing here?"

    Ultra, this is great analysis (as were the last two pieces on this topic). But I will give you the "bull" argument (or, more accurately, why I am going long real estate right now).

    I can buy a 10 year old detached house in a decent neighborhood in Las Vegas for $75k (bank-owned). Typically, there are $5k-$10k in renovation and repair costs on top of that to get it ready for rental.

    I then rent out the property at a top-line number of $1100/mo. After most of the expenses (rental mgmt fee, certain utilities I am responsible for as owner, property taxes, HOA fees, insurance), I am left with $770/mo. I say "most", since this is leaving out income tax AND capital improvements.

    Income tax I am going to continue to ignore - you can figure that out for yourself for your income bracket (and/or leave it out, since one pays taxes on any income / capital gains, so this is really not so much an expense of owning the house, it is more accurately an expense on the income, I think?). But capital improvements are (will be) a 'real' cost. So, I am setting aside $270/mo into a "sinking fund" to build a capital improvements reserve. No definitive idea yet if that is too much or too little (seems high to me if anything - $3200/yr on capital improvements seems rich? but rather err on conservative side here). This is a non-cash expense (for now!), but happy to treat it as a "real" expense for the illustration.

    That leaves me with pre-tax $500/mo (yes, I picked $270/mo to make the math easier).

    Let's further guess that the house has a one month gap of emptiness at the end of each rental period. So, effectively only rented 11/12 of the year (sometimes may be worse, but sometimes will also be better (have a tenant renew = 0 gap)).

    $500/mo for 11 months is $5500/yr.

    $5500/yr on an $85k investment is 6.5%.

    So, I am effectively getting a 6.5% coupon on my $85k investment PLUS whatever capital gains appear on the house.

    I see that you are pretty bearish on house prices, near AND long term. But I look at it this way:

    I am buying theses houses for $75k (OK, $85k, after making them ship shape / "good as new"). They topped out around $250k at the peak of the market (for real - they have sales history showing a transaction in that price range). I am not unrealistic enough to think they are going back there, probably ever (inflation adjusted).

    But the number that is relevant is "replacement cost", IMO. Build price on these is anywhere from $80-$120 / sq ft (broad range, depends a lot on finish quality etc). The size and quality I am getting, that works out to a build price of something like $135k.

    So, I think that is a FLOOR for what these houses can be worth when the market recovers (inflation adjusted, assuming build price rises with inflation). I will freely admit that may take 10 years (heck, 15!), since there is a lot of inventory to work through the system. But I am getting the 6.5% coupon that whole time.

    And if I can get a 6.5% coupon on a 10-15 year investment that also has the potential to appreciate 50% in face value (if they go from $85k to the $135k build price)? I will buy that all day long.

    The obvious big risk here is that Vegas could dry up and blow away (semi-literally). But I am willing to roll the dice on that one (OK, enough of the bad jokes). Seriously, I am of the opinion Vegas is not going away, not soon.

    So - you tell me what I am missing!

  • Report this Comment On March 30, 2012, at 3:34 PM, FutureMonkey wrote:

    mbushman -I don't disagree with the wisdom of owning rental property as part of your portfolio, but what you are missing in your analysis is discussion of risk.

    -- high opportunity risk with very limited liquidity.

    -- capital risk

    -- loss of purchase power since the capital investment may not keep up with inflation (although I suspect rent does).

    -- cash flow risk (if small number), if you have a large number of units your cash flow can be managed fairly well.

    -- Changing tax/property laws

    -- Time -- purchasing property is time and labor intensive (unless you also find it entertaining).

    The best way for this to work out is if you have the time and expertise to do it well in a neighborhood you are very very familiar with. Done poorly that 6.5% coupon is not nearly high enough to justify the risks or time committment. I'd be much more interested in a partnership/pool of investors and I'd be looking at commercial properties I could also run my main business out of; combined with rental residential properties. That said, I'd demand more than a 6.5% return even with pooled risk.


  • Report this Comment On March 30, 2012, at 5:32 PM, mbushman wrote:

    Just responding to a) show my appreciation for your thoughts and b) make sure I follow.

    On high opportunity cost and limited liquidity - understand that to mean that for every house in Vegas I buy, that is 100 shares of PCLN I cannot buy (or whatever), correct? And that in terms of limited liquidity, you mean it is a lot easier to liquidate 100 shares of PCLN than it is to liquidate a house?

    100% agreed - very well pointed out and I fully support the idea that this is a play for a relatively High Net Worth individual, and only then with the portion of one's portfolio that a) represents appropriate diversification of asset classes and b) is 'long term investment" money.

    Capital risk...not sure I know what you mean. Capital risk means loss of the capital invested. Do you mean capital improvement set asides for the property are insufficient? Or do you mean to the house itself (like there could be an earthquake and insurance does not cover that)? Or just the risk that house prices keep dropping (or never recover) for the next 10-15 years? Maybe some combination of those?

    Valid risk - one should always keep in mind that any asset can go up or down in value. But as I said, I am banking on the fact that a) Vegas will remain a tourist / business conference destination for the foreseeable future and b) I am buying the house for 2/3 what it costs to build. Under that scenario, barring declaration of a SuperFund site next door, if Vegas is still there and thriving in 15 years, it is reasonable to expect someone will buy a house from me for roughly what it costs to build a new one. Maybe a 10% discount for "used"? But then maybe I could equally argue a 10% premium for "better location" (since new building will have to push further and further out)? Bottom line, there is no doubt the prices of houses (and any asset) COULD be down 10-15 years from now, but for me, on balance, the likelihood is more to the upside. Still, a risk, as you say.

    Loss of purchase power I think is a misplaced concern, if I understand the concept correctly (serious question - haha). You say you agree that rent increase is likely to roughly match inflation, so part of that rental income (what I call the coupon) is what will compensate for the loss of purchase power, right? Like is in a bond, if you get 4% on a 10 year bond, that is x% for the inflation and x% for the risk return. Same way, if I get a 6.5% coupon on the house, some part of that covers "loss of purchase power" = inflation and the rest is my risk return. I think?

    Cash flow risk is a valid point and I agree this investment concept works much better with a pool of houses. This is even more true as regards the capital improvement fund - since it is unlikely 5 houses would all need major repairs at the same time, if one has a pool of houses it spreads the risk a bit.

    Changing tax/property laws is a biggie. No way for me to predict that, but I agree could quickly turn a winner into a loser (or vice versa).

    Time - well, you got me on that one. I actually really do enjoy it - but I have WAY too much free time on my hands - haha.

    One you did not mention (that I subsequently remembered) is liability - there are some risks to being an owner of rental housing in terms of liability for tenants (both damages to them and damages they may cause). An umbrella insurance policy can address that, but there are limits to that coverage, and it is not cheap.

    I do appreciate the thoughts - not just trying to get in a verbal jousting match!


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