Don't Count on Manhattan RE as an Inflation Hedge
A: A new argument floating around out there is that future inflation threats are good news for Manhattan residential real estate - so buy now and protect yourself against the dreaded 'inflation monster'! Umm, no. Not this time around anyway and right now deflation is the battle. These are anything but normal circumstances and unless you were asleep at the wheel, we just witnessed a housing boom of unprecedented proportions fueled by parabolic credit that the system allowed for at the time. Now fed/treasury policy has been to print/borrow their way out of this mess. If your looking for a real estate related inflation hedge, income producing property is a better way to play it because you will generally benefit from rising rents; but you still have market risk there that is linked to the strength of the local economy. I would argue that the type of inflation we see will be the result of fiscal & monetary policies, showing up as an unintended consequence that further stalls future economic growth. I don't see wage inflation threats. Outside of that I would want to know, 'where did we come from' and 'what allowed housing to boom so fast', to figure out if future inflation is good news for property prices.
Q: Where did we come from? Well, from a level a lot lower than where we are today. In 2001-2002, you could buy a doorman condo unit for about $500-$650 per square foot or so; I'm ballparking here so lets keep range wide to account for variable sell side features. Then something happened. BOOM. Money was cheap, lending standards were very loose, banks wanted to pump & dump loans, loan products were designed to allow people to buy more house than they would otherwise afford, more loan products were designed for the buyer whose credit was too weak to get an affordable loan, and appraisals were easy to come by to make the deal work for all parties involved in the transaction. The secondary mortgage market was alive & well and RMBS were traded actively. Banks created loans, packaged them up, sliced and diced them, rated them and resold them to investors as structured credit products. Bank earnings soared and housing began to become a very hot asset class that everybody wanted a piece of. In the beginning housing was still fairly affordable given salaries and price/rent ratios - the asset boom had not yet occurred! But that would change quickly.
That is where we came from. When I look at the market now, I see that housing prices appreciated about 100% or so, more in high end I'm sure, from 2001-2002 levels. Take a look at DEC 2008 S&P / Case-Shiller New York Condominium Values Index, and you can see the runup since 2001: 
Ask yourself, did incomes follow suit with a related rise to justify the higher prices? Rents certainly rose, but not to levels that would justify where prices went. The price rise was more a function of a parabolic credit boom and cheap/e-z money.
Paul Fried, chimes in on this past Real deal article titled, "This time, inflation may have different impact":
Paul Fried, a principal at AFC Realty Capital, a national boutique investment bank, said real estate might be a hedge in inflationary environments — as long as it's not the sector that went through the inflationary period.Exactly. Moving on to the system in place that allowed the boom to occur.
"Normally, you would think it would be good to hold real estate in an inflationary period, but you're assuming real estate is not the asset that's in the inflationary cycle," he said. "Right now, real estate values are at historical highs as a result of going through an inflationary cycle caused by cheap monetary policy."
Q: What allowed housing prices to boom? When I look at the credit/mortgage markets now, I see something very different than what was in place during the boom times. Today, I see:
1) a frozen securitization market - very low bids for toxic MBS, flawed ratings models
2) more expensive money; especially for jumbo loans, weaker credit quality borrowers
3) elimination of exotic loan products that allowed buyers to buy more house than they can afford - now you can only buy what you can afford to buy
4) a significant tightening of lending standards - banks now actually check to see if you can afford the property before committing to the loan
5) appraisals using negative time value - for markets deemed to be declining, appraisals are negatively adjusted for time. No more e-z appraisals to make the deal work.
6) banks cutback on lending / hoarding cash for own balance sheet repair and corporate survival
The combination of where we came from and what has changed that allowed the boom to take place, must be taken into account when looking into the future. In short, prices are still high and the system of credit that was in place during the boom, has deconstructed itself.
For now deflation is the enemy the treasury/fed are fighting. But many look at recent policy, bailouts, and fiscal stimulus as ultra-inflationary and something to be on guard against if it comes early. Me? I think it's a ways out and any inflation we see in the early phases will be confined to food, energy, health care, metals, etc..That first inflation wave will be painful, an unintended consequence, because it will hurt consumers at a time when they are already hurting from years of deflationary beat downs.
But lets assume inflation comes, what will happen? Well, for one, rates will rise! Given the artificial lowering of rates by our fed through rate cuts, lending facilities, and quantitative easing, the snap-up of rates may be quite fierce - unless of course you think that the fed can keep low rates forever and ever, without any consequences at all. I wonder about things like, how will housing perform if mortgage rates are 200-300 basis points higher? I think early signs of inflation will move the markets that make money more expensive, and that means inflation as an unintended consequence of policy, will act to depress real estate a bit further as the latter stage of the housing cycle plays out. I want to buy towards the end of that phase, not in anticipation of it for a hedge.
For most people, buying a house means taking on a mortgage; DEBT! If debt is more expensive, well then, the borrower can afford less house. How will confidence in housing as an asset class be viewed if/when inflation does appear? Will people be so sick of housing that the asset class is simply, unsexy? Will people be afraid of taking on debt? These are the questions that remain unanswered right now.
Inflation as an argument to buy real estate, to protect your precious dollars? I don't buy it at all right now or in the near future, given what type of inflation I see down the road, where we came from and the changes that have occurred that allowed the housing boom to occur in the first place. Buy a home because you can afford to do so, need a place to live, and you are happy with the products and the value out there right now; not because someone tells you it is a hedge against inflation!
Posted by Donald
Wed Mar 18th, 2009 12:41 PM
According to Peter Schiff, were going to have Zimbabwae style inflation. $100 bills will be cheaper to use in the bathroom than toilet paper. However, lately Schiff has been wrong so I doubt we will have that kind of inflation.
Posted by Noah
Wed Mar 18th, 2009 12:47 PM
yes I hear the hyper-inflationists too, but I dont see it. I see stagflation as more likely outcome. Too much money at a time when there doesnt have to be too few goods.
Peter Schiff got bunch of calls right, but also got many wrong. He predicted dollar destruction, as you say, yet here we are seeing dollar strength as debt deflation roars on. As Fisher Debt Deflation Theory suggests you would see; further swelling of dollar.
I see inflation in food, energy, health care, metals, etc..the stuff that ends up being an unintended consequence of prior policy. Just my two cents
Posted by Brian
Wed Mar 18th, 2009 01:14 PM
I agree with the analysis. This makes me think, why wouldnt a rational investor/buyer ask for 15-20% less even next year and with this in mind, sellers will have even less bargaining power for anything for sometime to come.
Posted by jeff
Wed Mar 18th, 2009 01:53 PM
STAGFLATION - The fed can heavily influence rates, especially with its new broadened powers, but at the end of the day, debt buyers have to cooperate (China in particular). They are cooperating now out of enlightened self interest and panic. When things stabilize we are likely to see long-term pressure on rates, my guess is this keeps the dollar flattish, but if the dollar weakens as our creditors seek to diversify their holdings we will see significant pressure on import prices (most of the goods we consume). This combo could produce stagflation, high interest rates are the stag, expensive imports are the flation. Alternately the economy could just be slow as molasses in winter for years, without much inflation. Neither is going to cause a big bull run in residential housing prices....unless we do much more to promote immigration.
Posted by John
Wed Mar 18th, 2009 02:06 PM
Good post Noah! As someone who initially thought about real estate as an inflation hedge, but couldn't really figure it out, I'm curious to hear your views on the subject. Just goes to show that as the Fed tries to do what they didn't do in the 1930s, the traditional playbook is worthless. There are just too many unknowns to plot a course through this right now.
As far as Manhattan real estate goes, I think Brian's comment is spot-on. If you need to sell, better cut your price and move it quick, as trouble is looming. Conversely, if you need to buy, you've got to extract as much from the seller as possible to pad a dismal future.
Posted by lars
Wed Mar 18th, 2009 02:56 PM
The only inflation that will fuel real estate is WAGE INFLATION; and I agree with you, Noah, I see nothing that suggests to me that the FED will succeed in producing wage inflation anytime soon.
This issue is the fundamental reason I disagree with many who say the FED can inflate the debt away. If they do, without wage inflation, they will bankrupt the citizenry, which is not a recipe for stable government.
Posted by lars
Wed Mar 18th, 2009 03:09 PM
Well the great experiment of QE has begun.
The FED is going to destroy the dollar and America with it. Bernimkumpoop should be made to swallow evey last $ he prints. This guy is truly dangerous, and the rest of us poor idiots are going to pay for this academic's horrible mistakes.
Posted by cfranch
Wed Mar 18th, 2009 03:31 PM
Yesterday's housing starts number supports Noah's argument. The biggest cause of the upside surprise was construction of rental apartment units. Home builders are signaling that their future revenue stream will be from rentals not sales. Odd that the stock market viewed this as a positive but we are having a very nice bear market rally.
Posted by Bob
Thu Mar 19th, 2009 02:44 AM
Great Article.
I'd argue that although the Dollar has been strengthening, don't rule out Schiff's prediction of a debasement of our currency down the road. It almost seems at times that this is their underlying goal. I am hedging with Silver, Gold, Water, Food, Guns, ammo and agricultural commodities. Renting never looked better, staying on the sidelines on Long Island and waiting this one out.
Posted by Matt Gerchow
Thu Mar 19th, 2009 05:37 AM
There's no place like Manhattan. People enjoy living there whether it is for work or just for all of the activity.
As long as employment remains steady in New York, prices will continue to rise. But, with the recent stock market crash and the volatility right now, it is difficult to make long-term predictions other than...it has to improve at some point.
Regards,
Matt Gerchow, CEO
Real-Estate-Investing.com
Posted by Matt Gerchow
Thu Mar 19th, 2009 05:41 AM
There's no place like Manhattan. People enjoy living there whether it is for work or just for all of the activity.
As long as employment remains steady in New York, prices will continue to rise. But, with the recent stock market crash and the volatility right now, it is difficult to make long-term predictions other than...it has to improve at some point.
Regards,
Matt Gerchow, CEO
Real-Estate-Investing.com
Posted by Bodz
Thu Mar 19th, 2009 07:04 AM
I agree that real eatate is no better an inflation hedge than the stock market. It is true that in the inflationary 70's, real estate surged year after year while the stock and bond market lost about 2/3 of its real value. But housing's outperformance was probably coincidental - it came after house prices had stayed flat for a generation before that time. The stock market, meanwhile, entered the 70's after the secular bull run of the 50's and 60's.
Today, NYC house prices, even after the slight dip, are still in the top 10% of their historical valuation range. Will we see a repeat of 1989-1996 when nominal Manhattan house prices fell 40% and real house prices fell 60%?
That said, my advice would be to have a fixed rate mortgage on your house. That is the best inflation hedge.
Posted by Bodz
Thu Mar 19th, 2009 07:09 AM
I agree that real eatate is no better an inflation hedge than the stock market. It is true that in the inflationary 70's, real estate surged year after year while the stock and bond market lost about 2/3 of its real value. But housing's outperformance was probably coincidental - it came after house prices had stayed flat for a generation before that time. The stock market, meanwhile, entered the 70's after the secular bull run of the 50's and 60's.
Today, NYC house prices, even after the slight dip, are still in the top 10% of their historical valuation range. Will we see a repeat of 1989-1996 when nominal Manhattan house prices fell 40% and real house prices fell 60%?
That said, my advice would be to have a fixed rate mortgage on your house. That is the best inflation hedge.
Posted by Neophiliac
Thu Mar 19th, 2009 10:13 AM
I think this argument misses one key point. It may very well be true that buying real estate now is not a good investment. But if we stop looking at housing as investment for a moment and look at it as what it is - a place to live, I think you'd see a different side of the coin. First, as Noah seems to at least imply, in an inflationary environment rents are likely to rise. That means cost of housing to a renter (yours truly) will rise. Second, interest rates (both long and short term) are also likely to rise as Fed starts to battle inflation. That means cost of ownership in the future will also be higher, even if the price of housing itself drops.
So it seems to me that for someone who is looking to buy so as to lock-in on 'affordable' housing costs, rather than to protect one's cash against inflation, this IS a good time to buy (maybe not just this moment, but in any event before low mortgage rate bonanza ends). In other words, this year (or thereabouts) might be the only time when we will see a combination of both depressed prices and low mortgate rates. The future likely holds one or the other, but probably not both.
Or am I missing something here?
Posted by Noah
Thu Mar 19th, 2009 10:35 AM
great point Neo..But I do see low rates for quite some time. At least a year or so. The longer term pressure on rates I dont think will kick in until much later, 2011, 2012?
Maybe rates rise a bit in 2010, but not much. Thats my thinking at least for now, and that may change if an event occurs somewhere or perception of US ability to repay its debt gets questions; i.e. 10 yr treasury CDS moves way higher
But for most of 2009, I see rates for most part, fairly low. As they do rise, I just think the early phase will work to depress economic growth further for a bit. In other words, rates wont rise because growth is getting too hot, and wages are rising.
Posted by JT
Thu Mar 19th, 2009 01:39 PM
Once again, you are confusing 'price' inflation with 'monetary' inflation. Deflation will make everything cheaper as the consumer cuts back when faced with year over year declining household incomes.
Treasury yields are set to rise as investors demand higher yields for buying on the run securities which will in turn will depress the price of currently held treasuries.
Consumer spending decreases will continue to squeeze the prices of food, energy, and health care. None of these will rise unless there is a sizable shift in the supply curve as a result of the sizable shift in the demand curve. The supply curve shift will not be able to keep of the swiftly downward moving demand curve for quite some time.
The price spikes of food and energy were caused by extremely leveraged speculation. That scenario will not play out as leverage is gone for years.
Treasury yields and borrowing costs will have little to no effect on prices of food, energy, health care, etc. as this deflationary cycle will persist through the end of 2010.
Monetary inflation is irrelevant as the expansion of cash and CREDIT truly define monetary inflation. Look at the expansion of the money supply during the Great Depression's money supply expansion and the persistent deflationary environment. You realize that inflation will not occur until the money is lent and if mark to market is suspended these zombie banks will never lend.
If all the ailing companies were forced to go chapter 11 then the inflationary period would begin much sooner.
Inflation will occur but not this year or next...2011 is when inflation will occur just when we attempt to grow.
Cheers!
Posted by Noah
Thu Mar 19th, 2009 02:45 PM
JT - I dont think I do.
price inflation - too much money chasing too few goods
monetary inflation - expansion of credit/money supply
We have had overcapacity, overinvestment for how long? Certainly I dont see the 'too few goods' part of price inflation occuring anytime soon. The 'too much money' part, sure, as we print and debase our currency
I think any future inflation will be from monetary side at first, further stalling economic growth at the time - I think the stuff we need will rise, not assets like houses. I stated that deflation is here now, and that inflation is a far away worry. But the initial onslaught of inflation that I think we will see will be in food, energy, health care, etc.. I have gold as an anti-paper money (fiat currency debasement everywhere) trade.
Global demand destruction for commodities started early-mid 2008, leading to the destruction of those assets; oil, gas, corn, etc..
Oil fell from 145 to 33 or so in like 8 months time. Thats destruction. With oil destroyed, credit contracting, investments R&D contracting, projects being put on hold, etc.., and the coming debasement of US dollar, I think you will see another round of price rises in raw commodities for food/energy. If demand does tick up, say in 1-2 years, I think prices could rise big time again for that 'stuff we need to survive'. That form of inflation will crunch consumers after years of deflationary beat downs.
I hear your point on monetary inflation, money supply. Base money supply is soaring right now, but its being hoarded in excess reserves. We discussed that many times here. Its not being lent out, as you say. I think the next phase of this crisis will be a generalized crisis in confidence in global currencies. How will commodities priced in dollars react? I dont think we will see wage inflation that will lead to higher prices of assets outside of food/energy/etc.. You?
Thanks for comment JT! CHEERS !!!
Posted by JT
Thu Mar 19th, 2009 04:30 PM
This recession is a full on depression in some parts of our country (i.e. CA, MI, FL, etc.). The depression will spread to many parts of this country.
Demand destruction will accelerate As this depression spreads through crushing unemployment numbers though all of 2009. The U3 number is over 8% but the U6 number is near 14% and the BLS BirthDeath model added 134K new jobs in February...WTH?!?!?!?!
Take a look at the second to last table:
http://www.bls.gov/web/cesbd.htm
I think that you can add the 134K directly to the report 651K number for an eye popping 785K jobs lost in February. Don't be surprised if the March number show more than 1 million jobs lost when you account for the BLS birthdeath black box ridiculousness.
Price inflation is a function of the supply and demand curves for each unique commodity. What will cause the demand curve to shift up which would mean reversing its current, down hill with no brakes, course? Answer: Not going to happen.
Demand was driven purely through speculation mostly at hedge funds which will contract 66% from their peak numbers in 2007 back to their 1997 number by 2012. Hedge funds are dead and that can be seen with fund of funds putting their money with traditional institutional asset managers that started hedge funds to keep clients. The controls are in place for their mutual funds and pension fund client and ponzi schemes cannot happen at these well run firms.
The American consumer got screwed in all of this and they are going to keep cutting back until the national savings rate is sustained about 10% by the end of this year. Consumer spending will account for less than 60% (try 50%) when the dust settles and our GDP will remain at this level for years with negligible growth.
It is high time the America got use to eating like this:
http://www.greatdepressioncooking.com/Depression_Cooking/Welcome.html
Leveraged purchases of commodities is a suckers bet and bound to leave the investor destitute for years to come unless there is a supply shortage. A massive downward shift in the supply curve is the only way price inflation can rear its ugly head. The dollar has been getting crushed lately but there really is no where to run except the Nori.
Gold is a good hedge but when you do buy something else and what do you buy?
If China allowed their currency to float it would get absolutely crushed. China is done. The tail never wags the dog and China's consumers will only save more and will not increase spending during this global recession (*depression*).
The technicals are extremely misleading until you look as the patterns of the 1930s and then it is chilling.
Monetary inflation will be brutal at the end of 2011 persisting for numerous years. It will be demoralizing just when we start to see stable, slow growth.
There is really no way out of this.
Posted by Noah
Thu Mar 19th, 2009 04:47 PM
ugh, depressing when you finish that. But I always enjoyed your comments JT!
Thanks
Posted by Sam
Thu Mar 19th, 2009 11:21 PM
As expected, the FED fired its last bullet. Mr. Bernanke does not seem to understand or want to understand that you cant get something out of nothing, i.e. you can't create demand for real goods and services by printing money, because money is a medium of exchange and not a good based on labour that produced it that you can exchange for other goods. Money is implicit in this transaction: A construction worker exchanges his labour (that built a house) for a pound of meat that a farmer produced (using his labour). That is real economy, that is exchange of goods. What Mr. Bernanke does, is he pushes a button on his computer, adds money to his electronic account and then thinks he can exchange it for something valuable. What is he giving in return? Nothing really. So there is no real economic output as a result of this exchange transaction on the side of the FED, so there won't be jobs created and goods exchanged for other goods. Mr. Bernanke's academic theories, being tested on real living people, are falling flat on its face and we'are headed for Great Depression 2.0, because "the student of Great Depression", the "helicopter Ben" just does not get it - You can't create something out of nothing. We are in DEMAND DEFLATION and until it runs its course the slump will go on. The FED's action can slow down the decline, but they will not stop the trend.
Posted by JT
Fri Mar 20th, 2009 08:46 AM
Noah-
It may seem depressing because we are in a depression but there is no way out. We cannot spend our way out of this and the dollar bears will get smashed sometime later this year when ALL of Europe is in a 1930s style depression.
Norway and New Zealand should come out of this before anyone else but so what...who are they going to sell their commodities too? At least their currency will retain its value but that will make trading with them more expensive than trading will other countries with worthless currency.
The vast majority of Americans live pay check to pay check and losing millions of jobs is Kryptonite to aggregate demand as the consumer drives our economy. Foreclosures, auto loan, and credit card default are going to keep rising for years. Alt-As are starting to pop and prime jumbos are being downgraded as record numbers go into default. This recession is just starting to hit the upper middle class. The 90% tax on bonuses for firms that took more than $5B in TARP funds. That should be the straw that breaks the camels back in the NYC apartment market.
The only saving grace is over capacity is everywhere and 'price' deflation has nowhere to go but down and it will take a very long time for the supply curve to catch up to the demand curve.
Reading technicals and expecting them to indicate the future is inadvisable if you draw on the experience of the last two (even three) decades.
It is always about cash flows and the fundamentals that support those cash flows.
It is scary but losing your job is not the worst thing that can happen to you by any stretch of the imagination.
Keep up the great work!