Happy New Year! If you’ve been following our newsletter, you know that we are generally optimistic about the economy and real estate in 2014. However, there are still some lingering issues from the last few years that you should be aware of. The Federal Reserve’s ending of quantitative easing, the debt ceiling, and the sequester are all on our radar. In addition, the entrance of large real estate investment trusts into the single-family home market is significant and worth watching.
First, let’s address the Federal Reserve’s ending of quantitative easing, often called “the taper” in the media. At the beginning of 2013, many analysts were worried by this aggressive stance from the central bank. There were many fears of the Fed pursuing this strategy. Here are three of the misconceptions that dominated the discussion.
Quantitative easing is printing money
Politicians, journalists, and consumers often refer to quantitative easing as “printing money.” Is this true? No. When the Fed buys bonds from banks it does so by crediting those banks’ accounts at the Fed with reserves that didn’t exist before. But it’s misleading to call this process “money printing” because it doesn’t actually do anything to increase the amount of money in circulation. In fact, in our monetary system, most money is created by private banks and not the Federal Reserve. When the government buys bonds from banks, it merely raises the price of that particular type of bond and lowers the interest rate. Lower interest rates should encourage consumers to take out loans, but it won’t actually lead to more money in the system unless banks create money through making loans. And banks won’t do that unless they identify profitable lending opportunities.
Quantitative easing will eventually lead to inflation
The fears that quantitative easing will eventually lead to runaway inflation are unfounded. If the government literally began printing money and started mailing out new $100 bills to citizens, that would lead to price inflation. That didn’t happen – or mine got lost in the mail. But quantitative easing isn’t the equivalent of mailing out $100 bills — it’s merely the managing of long-term interest rates much in the same way the Fed has always managed short-term interest rates. This is not to say that Fed policy can’t ever lead to inflation — keeping interest rates too low for too long can encourage the sort of spending that would cause prices to rise too quickly. But the idea that interest rates are too low right now doesn’t make a lot of sense given the large amount of slack in the economy as shown by high unemployment and stagnant wage growth.
Quantitative easing is responsible for recent stock market highs this last year
This also means that those who argue that recent stock market highs are the result of QE are wrong. Fed bond buying will cause bond prices to be higher and interest rates to be lower, and this will encourage investors to choose stocks over bonds at the margin. But no amount of federal bond buying is going to cause a particular stock to be a good buy if an investor doesn’t think that stock will provide a return. QE may boost profits by reducing the interest rates firms have to pay on their debt, but it’s not going to create profit simply by doing this. A much more concrete reason for record stock prices is that corporate profits and profit margins are at all time highs, due to lower payrolls and efficiencies of the markets.
Now that we’ve dispelled some of the misconceptions surrounding quantitative easing, let’s talk about what the tapering of quantitative easing will do.
Interest rates are going to rise
If the economy is improving, inevitably the cost of lending money will increase because of the greater demand for loans. This includes the money lent to the twelve Federal Reserve banks and the amount those banks charge to their members. Following the announcement that the Federal Reserve would slow in their monthly purchases, the yield on 10 year US Treasuries went up. As the demand from the Federal Reserve purchase slows down, the actual bond values / rates will be able to find a true value. Initially the lack of demand will drop bonds values. Treasury yields are determined by supply and demand. Treasuries are initially sold at auction by the Treasury Department, which sets a fixed face value and interest rate. If there is a lot of demand, the Treasury bond will go to the highest bidder at a price above face value. This lowers the yield, because the government will only pay back the face value plus the stated interest rate.
As Treasury yields increase, so do the interest rates on consumer and business loans with similar lengths. Investors like the safety and fixed returns of bonds. Treasuries are the safest, since they are guaranteed by the US government. Other bonds are riskier, so they must return higher yields to attract investors. As Treasury yields rise, so do interest rates on other bonds and loans. As investors bid up yields on Treasuries in the secondary market, it also mean that the Treasury Department itself will be forced to pay a higher interest rate to attract buyers in future auctions. Over time, these higher rates can start to increase demand for Treasury products. That’s why higher Treasury yields can increase the value of the dollar.
As Treasury yields rise, banks and other lenders realize they can charge more interest for mortgages of similar duration. Thousands of other interest rates in our economy are directly affected by the 10 year rate, and so if that number climbs and stays there, that is going to be a sign that a significant slowdown of economic activity should be ahead.
Higher mortgage interest rates have taken a toll on housing market activity already, but further rate increases will see the recovery slow rather than reverse. Sales activity initially dropped when rates spiked, but the latest data suggest this was a period of adjustment rather than the start of a weaker trend, which fits with the fact that housing remains very affordable. The market has not fully recovered. If higher rates show a long term slowing of the economy, then possibly regulators would loosen credit. The great unknown is how regulators and the tightening of lending caused by Dodd Franks will influence their ability to lend.
Home sales should slow down
Lending rates are heavily influenced by the yield on 10 year US Treasuries. Because the yield on 10 year US Treasuries is now substantially higher than it was earlier this year, mortgage rates have also gone up. That is one of the reasons why this last year the number of mortgage applications hit a new 13 year low. When rates go higher it will affect affordability and the consumers’ ability to buy. Initially sales will slow. However, if history is a teacher, rates creep up initially signaling a slow down, then consumers aggressively pursue home purchases in the fear that rates will continue to rise.
Texas should be an exception – the lack of residential inventory across all major metros continues to be the main accelerant for sales. Values continue to increase and most sellers receive multiple offers. 2014 should be a continuance of 2013, although appreciation should show at the end of the year.
So what’s the point then of putting quantitative easing in place and what effect has it had? By buying long-term government debt and mortgage bonds, the Fed lowered the interest rates companies and consumers must pay to borrow money. On the margin, this will lead to a bit more investment and slightly higher stock and home prices. The theory is that by boosting wealth through these channels, consumers and businesses will be more confident and willing to spend. The end result is QE has had a slightly positive effect on the economy. But though the press often refers to QE using terms like “massive” and “unprecedented,” it doesn’t mean that it is a particularly risky policy or one that deviates much from what the Fed normally does. And that’s why we shouldn’t get too worked up about its being wound down.
If the US is unable to reach a longer budget agreement and the US begins to default on payments, rating agencies and investment banks will become involved and potentially declare a default. Then you would have a sprint for the exits.
That is a big ‘if’. Under Ronald Reagan, we raised the debt limit 18 times. Under Bill Clinton we raised it eight times. Under George W. Bush we raised the limit another seven times. By the time Obama took office, it had became routine. Hopefully, bipartisanship will allow the parties to quit fighting and come to a solution. So the ‘doomsday’ they speak of has little chance of happening. It’s a possibility, but most analysts and myself hope that reason will prevail and Congress and the White House will be able to come to an agreement.
REITs entering the single-family home business
Blackstone and other large equity groups have been aggressively purchasing single family residential homes this last year. This is a new development, and one that deserves watching. What are the implications for consumers, and for the broader single-family home market?
Let’s start with a reminder that all real estate is local – a purchase in Georgetown does not affect a purchase in West Austin, much less other Texas metros and so on. And again there is not really a national real estate market, each market is unique in sustaining its values.
Therefore these purchases have little bearing on Texas values, or any other states. Blackstone invested in distressed markets, where they could get deep discounting.
Why? Because real estate was /is one of the most undervalued hard assets in the world. According to our sources, they were unable to buy anything in 3 out of the 4 metros in Texas.
Secondly there is no affect on those areas of the country that were largely immune from the recession, such as Texas, because of their inability to purchase large numbers of deeply discounted properties. The commercial equity opportunities they have secured in Texas with the strength of the market should continue to be a great investment. Blackstone is a well run equity group who looks for maximum returns. To think that they would undermine values is not logical thinking. If their past financial history is any indication, I assure you that in those areas they invested, they did not over pay, and when they sell any of those assets, it will be at a profit.
Blackstone has approximately 32,000+/- single-family homes in its portfolio, valued in the $5 to $7 Billion range. Nationally, there are 132,452,400+/- units valued at over $100+ Trillion. Their investment is a small, small fraction of the overall residential market in the US.
Blackstone has taken the economies of scale normally applied to apartments and have directed them to single-family housing. They have the largest investment in those areas, again to sustain a profit. At the top of the boom, there was over 1.6 million homes being built annually. Construction has lagged, and we have been about one million homes short a year for the last six years. With the present household formation, we are close to 10 million homes short for the population. And you do not have enough developed land to build on locally, regionally or nationally.
Many think this is a new idea of equity securing millions of dollars of residential real estate. It is not. In the Texas savings and loans crash of the 1980s, when real estate assets dropped to $.10 on the dollar, many private equity groups bought into the Texas Metros, particularly Houston. Not only did they have an appreciating asset, but most secured an income producing asset. Their gamble of purchasing at the bottom the market made them multi-millionaires for years to come. A great strategy for investment.
So what should we expect this year? The housing market recovery is entering a new phase, the rapid bounce in home prices seen this year in our Texas metros which was driven by tight supply conditions, will soon start to moderate, and the next stage of the recovery will be characterized by strengthening activity among owner-occupants and mortgage-dependent buyers, the regional merchant builders, as well as a much more moderate pace of home price inflation.
Overall economic growth nationally, on the other hand, will accelerate in 2014, from around 1.8 percent in 2013 to 2.5 percent in 2014. Monthly employment gains have already climbed back to the 200,000 mark, a good sign of the economy healing. As the economy’s fiscal drag fades, it should more than offset the impact of rising long-term interest rates.
We will see the supply of homes for sale increase this year. In addition, rising prices and a reduction in negative equity are bringing willing sellers back to the market. Alongside a reduction in the number of heavily-discounted distressed homes for sale, this should drive a change in the composition of supply and trigger a loosening in overall market conditions as buyer demand increases.
How does that effect you locally? if you are renting, rent values should continue to escalate for a couple of years here in Texas through 2015. Prices in most real estate channels will continue to increase.
All of this leads to the question, if you have not thought about buying real estate, now is the time. The negative of the financial recession has passed, particularly in Texas. Now is the time to buy.