Jan042016

High-end real estate continues to weaken

Higher interest rates create superior investment alternatives that will drain money out of high-end real estate investments.

high_end_airThe rich always get richer, and they use their wealth to buy real estate at ever-increasing prices — At least that’s what most people believe (particularly homebuilders). But is that really true?

Over the last decade the federal reserve lowered interest rates to zero to support inflated asset prices, especially home values. The rich did get richer, and they did buy real estate, which supported unjustifiably high house prices, leading to increasing wealth disparity and populist unrest.

As interest rates rise, these trends could easily reverse. The value of any asset is the future cashflow risk-adjusted by a discount rate. When the federal reserve lowered interest rates, they also lowered discount rates across the board, elevating asset values to stave off a crash. As the federal reserve unwinds interest rate support, risk-adjusted discount rates will rise causing asset values to be more volatile and perhaps even fall across the entire spectrum. In short, the rich won’t get richer.

Today, high-end real estate has extremely low cap rates, 1% to 3% at best. Many wealthy investors turned to high-end real estate as a safe haven because high-end real estate is likely to perform better than bonds that will likely be crushed by rising rates. But does that mean high-end real estate is immune to decline?

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The zero interest rate policy (ZIRP) of the federal reserve diminished cash returns on safe alternative investments: savings accounts pay a pittance, 10-year Treasuries pay 2%, and bond yields are low across the yield curve. Relative to other investment alternatives, high-end residential real estate — with it’s historically low cash returns — is a better investment; therefore, wealthy people buy expensive homes and inflate prices. Couple that with the dumb money flowing in from overseas, and ultra-high-end residential real estate is doing relatively well — for now.

High-end real estate won’t be the best alternative once interest rates begin to rise. Why would anyone accept a 2% yield on high-end real estate when they can obtain the same in a short-term money market account?house-price-ratings

Kool-aid intoxication will prevent most from selling, but some wealthy investors will start moving money out of high-end real estate into safer investments, and this outflow of money will put pressure on high-end prices. What starts as a trickle could turn into a stampede as those who invested with hopes of appreciation see their investments going the other way.

Remember, real estate does NOT only go up.

Luxury home prices finally getting too high?

Denise Garcia, Tuesday, 29 Dec 2015

The tables have turned in the real estate industry as luxury listing prices fell for the first time since 2012, according to a Redfin report. The brokerage firm suggests that the drop in prices stems from wealthy buyers and foreign investors refusing to buy at the top of the market.

A strong claim backed by strong evidence. It wasn’t hard to see this coming (See last March’s post: Rising interest rates will harm ultra-high-end housing, and Wealthy Russians dump high-end US real estate)

Prices for luxury homes fell by 2.2 percent in the third quarter, compared to a year ago, according to the report.

“Luxury buyers don’t buy because they need a place to live, so they have flexibility to time a home purchase when the market is favorable,” the company’s report noted.

“I think that the report was accurate in that prices have almost retraced their all-time high, which was 2006,” Philip White, CEO of Sotheby’s International Realty, told CNBC’s “Closing Bell.” …

While many market watchers feared that the Fed raising interest rates may increase mortgage prices further, this market is not directly affected by those changes, White said.”A lot of our transactions are all cash, and even the slight short-term interest increase really doesn’t affect the mortgage rates in a significant way,” he noted.

His statements contain half truths that betray a limited understanding of how housing markets work. He is correct that the market for properties priced over $1.5 million depend less and less on mortgage financing and more on the opportunities the wealthy have to park money and preserve asset value. The cash buyer of a $5 million property isn’t affected by mortgage rates at all; however, that buyer is greatly impacted by the desirability of competing asset classes where they might earn a better return on that money. This is the factor Mr. White ignores, and it’s the problem that will continue to weaken high end real estate.

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