Will Investors Seek Greener -- and Less Risky -- Pastures as Housing Market Cools?

February 15, 2006

After the stock market bubble burst at the turn of the millennium, investment capital began flowing in greater numbers into real estate. Now, as property markets begin to show signs of strain, will investment capital seek alternative strategies?


The explosion in real estate investment "started when the stock market tanked," says Dawn McLaren, a research economist at the W. P. Carey School of Business. "The concern is what will happen now that investors are beginning to realize they are coming to the end of the road in regard to property appreciation."


Small investors have been able to successfully mimic institutional capital flows from equities to real estate by buying investment homes. With interest rates at an all-time low and record home construction, it was relatively easy to acquire residential properties. Even with small-scale investors, there are two not-necessarily-compatible options: buying a house to live in, expecting appreciation so as to sell at a profit in the future; and buying a second residence for investment purposes.


With mortgage rates low, homebuyers have been able to trade up on houses. They buy a house, then after a few years of appreciation, sell and buy a bigger house -- still possible because the mortgage rate remained enticing. However, mortgage rates have jumped up significantly -- now over 6 percent -- so the ability to move to a larger home becomes slightly more limited due to a combination of the higher rates and inflated home prices.


Prices through the roof


As an example, the median home prices in the Greater Phoenix area vaulted an astounding 34 percent from $194,000 in January 2005 to $260,000 in December 2005, reports the Arizona Real Estate Center at ASU's Polytechnic campus. Appreciation increased nationally as well, though not as much. The latest numbers available from the National Association of Realtors show that appreciation was 14.7 percent across the country, comparing the third quarter of 2005 to third quarter 2004.


Appreciation will slow or stop when too many households are priced out of the market, notes Karl Guntermann, professor of real estate at the W. P. Carey School. "That can happen because of house price appreciation, rises in interest rates or both. In an area that is growing rapidly like Phoenix, new households are likely to prevent big price declines when investors sell, providing too much supply isn't added too quickly."


The twin burdens of appreciation and increased mortgage rates seem to be taking effect. The National Association of Realtors (NAR) reports that sales of existing homes dropped 3.1 percent nationally in December 2005 compared to December 2004. The Arizona Real Estate Center reports resale home market totals over the last three months of 2005 were below the same levels of 2004.


"Bidding wars for houses are over; homes stay on the market longer before selling," Guntermann asserts. "Real estate agents have a more normal 30,000 (plus or minus) listings compared to around 7,000 or so a year ago."


Nationally, the construction boom is looking a bit threadbare as well. The Commerce Department reported an 8.9 percent drop in housing starts in December, the biggest decline in nine months. Even the boosterism of the National Association of Home Builders (NAHB) has gone tepid. It predicts construction of new homes and apartments to drop by 6.5 percent in 2006, with sales of new homes falling by a similar amount.


Housing as an investment


Where does that leave the small investors that have been putting their excess capital into second homes for rental purposes? Phoenix is a snapshot, with about 20 percent of the metro area home sales to investors, notes McLaren. Across the country, homes purchased as investments represented 23 percent of all sales.


There are two aspects to an equity investment: yield from dividend and capital appreciation.


"You can think of housing in the same way, as purely an investment as opposed to providing shelter, which is the way most people regard housing," explains Herbert Kaufman, professor of finance at the W. P. Carey School. "If you do so, the following example will illustrate the housing investment process. An investor buys a property which will be rented out until it appreciates sufficiently to sell at a profit. First there is a stream of rental income, which serves the same purpose as the dividend yield in an equity investment, and then there is capital appreciation, or profit on the sale of the building."


In recent years, rental income has been by very low –- in some cases not even high enough to service the mortgage -– but the expectation and in many cases the reality has been that the appreciation would not only be enough to recover those costs but offer a competitive rate of return in comparison to other types of investments, such as stocks and bonds.


The NAHB expects national home prices, which had been rising at double-digit rates in recent years, will slow to an increase of around 5 percent in 2006. Some observers say that could even take the heat out of the Greater Phoenix market.


As appreciation slows, investors need to do better in regard to rent, where single-family homes must compete with pricing of apartments units.


"Multifamily is doing OK," notes Jay Q. Butler, director of the Arizona Real Estate Center, "with vacancy rates in the 5 percent range." That is down from the vacancy high of 10 percent in 2003.


Apartment vs. home rentals


With the demand for condominiums still strong, a lot of high-end apartments will be converted to condos, Butler adds. "That would normally be good news because rental units will go out of the market, further tightening vacancy rates," he says. "Unfortunately, many of those condos will be purchased as investments and put back into the market as rentals."


Although low mortgage interest rates have been very important in sustaining a healthy home-buying market in Phoenix, the rapid increase in median home prices has greatly increased the monthly payment. Based on 85 percent loan-to-value, the payment that was $845 in 2004 (with an interest rate of 5.5 percent) jumped to $1,175 for 2005 (with an interest rate at 5.6 percent), Butler reports.


How does that compares with apartment rentals? In the second quarter of 2001, effective (with discounts taken into consideration) rental rates for Phoenix metro apartments hit $651 a month, reports REIS Reports Inc., a New York-based real estate research company. REIS estimates fourth quarter effective rates for Phoenix will only be around $648. While it does expect rental rate appreciation in 2006, REIS's estimation will only be to $669 a month –- far below the average home rental in Greater Phoenix –- making apartment living a much cheaper deal.


The easy money in real estate investing may be over, but other investments still will have to prove their worth. The S&P 500 rose 4.9 percent in 2005, no match for home appreciation in hot markets like Phoenix Daytona Beach, Baton Rouge and Fort Myers. But if appreciation does drop to 5 percent as the NAHB predicts, a healthy stock market begins to look better. In addition, the rates on certificates of deposits are moving closer to 5 percent, and that is a low-risk investment.


Are investors looking elsewhere? Here's an interesting statistic from the U.S. Department of Treasury: the amount of federal debt held by the public was about $3.3 trillion in 2001. That has climbed to just under $4.5 trillion in 2005 and is expected to climb higher in 2006. Kaufman says availability of Treasury bonds as investments should be plentiful and this may imply that returns could be attractive in this asset class. 


The percentage of global financial assets in the form of equity (stocks) rose to 29 percent in 2004, reports McKinsey Global Institute, an independent think tank. That's well below 1999, McKinsey adds, when booming stock markets boosted equity assets to 38 percent of total. Perhaps a stock market comeback is ahead.


Or as McLaren notes, "Money right now is in real estate. When the stock market starts to outweigh the gains in real estate, then there will be a flow of money going that way."