Profiting from real estate's decline
Being "right" too early can be a big investment mistake. Back in July 2002 Amey Stone wrote Housing: Is It a Bubble If It Doesn't Pop? in which I commented on the coming real estate collapse. We revisited the topic in May 2005 with Getting Crushed in a Housing Collapse in which I recounted how I bought my house at the market peak in June 1986 only to watch its value decline about 20% and to wait nine years before it recovered to the June 1986 price.
From what I've read, the latest surge in housing peaked in about July 2005. This is also about the time that housing stocks reached their high – from which they've tumbled about 40% through September 2006.
It has seemed to me for years that the flood of money that the Fed pumped into the economy when it began cutting interest rates in January 2001 has – in effect – kicked the aftershocks of the dot-com collapse down the field. More specifically the flood of cash took the wind out of one bubble and pumped it into another one – namely real estate.
The value of real estate more than doubled from $12 trillion to $25 trillion between 2000 and 2005. Since the Fed began raising rates, though, it appears that this balloon has slowly begun to burst. Foreclosures are skyrocketing -- up 53% in the last year -- and prices are reversing direction even as $500 billion worth of Adjustable Rate Mortgages (ARMs) will reset their interest rates at a higher level by the end of 2006. This will probably accelerate the foreclosure rate and throw more properties onto the market as banks attempt to minimize their losses on the loans.
The potential problem is not limited to residential real estate -- it could affect commercial real estate as well. Having lived through the early 1990s collapse of the commercial real estate market -- which wiped out New England's second biggest bank -- Bank of New England in around 1990 -- I am attuned to possible signs of a recurrence. With antennae buzzing, I note that on the national level, commercial real estate loans climbed to $1.3 trillion in 2005, up 16% on the year.
The Office of the Comptroller of the Currency (OCC) has found that a third of nationally chartered banks have commercial real estate loans that amount to 300% or more of bank capital. And the OCC has said that banks with more than 100% of their capital in construction loans or more than 300% of that capital in commercial real estate generally need more thorough scrutiny from regulators. Such scrutiny has in the past resulted in bank failures.
A collapse in real estate could slam the broader economy. Since Goldman Sachs estimated that the real estate boom accounted for 10 million new jobs I'd expect many of those jobs to disappear as builders cut back on new construction and consumers slow their pace of buying houses and borrowing to finance them.
The big question for the economy is whether investors who are taking their profits in real estate -- one estimate is that at least $125 billion could be available -- will reinvest them in the stock market. If so, the effect could be beneficial for the stocks in which this real estate cash finds a home.
But as money is pulled out of real estate and mortgages default there will also be some big losers -- potentially real estate developers who borrowed too much to build properties that are not likely to be occupied and issuers of risky mortgages to borrowers with limited incomes and poor credit ratings.
Big profits await the investors with the risk appetite and analytical skills to short the right stocks before they file for bankruptcy. I'll be looking for these kinds of opportunities over the next several months. And if you own real estate, such opportunities could be a prudent hedge.