Oct162014

Is real estate the best asset class for the 21st century?

Will continuing population growth and shortages of housing and farmland make real estate the asset class to invest in during this century?

income_streamWhere is the best place to put your money today? At the bottom of the credit cycle, super-low interest rates inflate the value of all assets because investors are forced to take on more risk in a futile quest for yield. These flows of money inflate bubbles in most asset classes, and it sets up circumstances where money will flee risky asset classes as interest rates rise, causing yields to rise at the expense of asset values.

Bill Gross recently left Pimco and expressed very bearish opinions on future interest rates and the value of bonds. The stock market recently endured a 1,000+ point drop, and many market analysts expect increasing volatility. Commodity prices are crumbling, and volatility is likely to remain high with commodities too. So where do you put your savings?

Personally, I like cashflow-positive single-family rental real estate as an asset class. Commercial and multi-family prices are bid up like other asset classes by investors chasing yields. These are still reasonable cashflow investments, but the appreciation bonus may not materialize (many proformas still expect cap rate compression).

Investors turn to real estate because despite the housing bubble and bust, it’s still a better place to park money than the inflated (and crashing) investment alternatives.

Are the rich getting richer because they own real estate?

By Konrad Putzier, 7:00 am, October 10, 2014new_real_estate_religion

… The world is worrying about the rising cost of real estate.In a recent article, Fernholz argued that the rising cost of real estate will eat up an ever larger share of the world economy, with potentially devastating consequences.

… global capital has been accumulating in the hands of a small number of rich people since the 1950s and will continue to do so until inequality reaches dangerous proportions.

Dangerous to whom? If you want to see the extreme of earned income going toward real estate, look carefully at San Francisco. The high wages from technology workers ends up either financing huge debts to buy overpriced houses, or it ends up bidding up rents to insane levels.

The problem in San Francisco is caused by a chronic and worsening shortage of housing. Eventually, the cost of living will make business expansion in the area impossible, and the economy will suffer as businesses start looking for less expensive places to grow and expand. At first this will be on the fringes as the businesses need to be near the core of workers, but ultimately, it will drive businesses to completely new locations where costs are lower.

This trend is inherent to capitalism, Piketty argued, and can only be stopped through government intervention.

Do we really need more government intervention? Perhaps it’s better to argue we need carefully crafted and enforced regulation that levels the playing field.

Rognlie doesn’t dispute Piketty’s data, but claims the Frenchman misunderstood it.

He points out that 80 percent of the wealth accumulation in Piketty’s data is due to real estate. If you take housing out of the equation, the growth in private wealth is quite small, putting Piketty’s argument in doubt (see graph). …

housing-and-capital-in-germany-us-and-uk-private-wealth-housing-private-wealth-less-housing_chartbuilder-1

Real estate prices have been growing because population growth and urbanization make land in cities scarcer. The growing inequality noticed by Piketty is thus really a growing gap between income from real estate and income from everything else, Fernholz claims.

According to this reading, the rich are getting richer simply because they happen to own real estate. And as population growth and urbanization are expected to continue, growing home prices will consume an ever larger share of the world economy. This trend will suck capital from other, more productive industries and dampen growth.

This is happening right now in San Francisco because job growth far outstrips housing growth, and since technology businesses can’t easily move away from the core of skilled labor in the Bay Area, income gets diverted from consumption to housing payments, hindering the local economy. However, this is due to laws limiting growth. Change the laws, and allow more housing units to be built, and balance is restored.PREFAB-ABANDONED

The argument is compelling and relatable. It is also highly questionable – mainly because British economist David Ricardo made a very similar claim more than 200 years ago and turned out to be wrong.

Ricardo argued that explosive population growth in the early 19th century would make agricultural land increasingly scarce and valuable. After all, it had to feed a growing population. This, Ricardo argued, meant landowners could command ever higher rents for land to the point that rents would eventually make up an overwhelming portion of national income and stifle growth in other industries.

In hindsight, Ricardo underestimated the effect of technology. As new techniques and pesticides made agriculture more productive and trade globalized, farming land actually lost value compared to other assets. …

If farm production hadn’t increased so dramatically, Ricardo might have been right. Farm land became less valuable because crop yields grew faster than demand.

For residential real estate to experience the same outcome, housing yield and the total number of housing units available needs to increase faster than job growth. That doesn’t seem very likely in California.vacant_hinterlands

It is possible that Rognlie is repeating Ricardo’s mistake to underestimate the effect technology can have on land prices.Population growth and urbanization have driven up urban and suburban real estate prices, but will that trend necessarily continue?

New construction techniques and the trend to build higher and denser are already lowering housing costs, as is improved transportation. Office workers in Manhattan may have to pay a fortune for scarce apartments on the Upper West Side or Brooklyn today, but what if magnetic trains shorten the commute to the countryside to minutes within decades? As workers can move further and further away from their employment, land in urban centers will lose in value.

Land values are heavily tied to advancements in transportation and telecommunication. Remember when people thought everyone would telecommute and workers could live anywhere?

Right now, traffic congestion causes land values to rise near offices where jobs pay well. When a 20 mile commute takes an hour, the radius of location desirability is reduced, and land values concentrate near employment centers. If traffic were less congested, land values would rise in fringe markets as people move farther from employment centers without enduring longer commute times.stunning

Imagine taking this to its extreme. Imagine a world with the Star Trek transporter that allowed instantaneous travel between any two places on the planet. You could live in your cabin at Lake Arrowhead, step into a transporter, and be at work in a millisecond. This would eliminate proximity and commute time as a criteria for selecting a home. Small towns would flourish.

What impact would flying vehicles have on property values. It wouldn’t be as extreme as a transporter, but it would certainly open up a broader market for commuters because they wouldn’t face bumper to bumper traffic. It would probably drive up property values in remote coastal areas like Mendocino, Cayucos, Big Sur, or Avalon on Catalina island.

History suggests that growth in the value of a certain asset class is never as inevitable as it seems at the time. Ricardo was certain agricultural land would dominate global wealth, but the opposite occurred.

Two hundred years later, Rognlie thinks the same of urban land, and he could end up being just as wrong and real estate’s share of total wealth could start falling.

If Piketty is right, global wealth will then simply shift to a new, growing asset class – as it did in 19th century Britain.

In my opinion, real estate values will continue to grow and consume larger portions of the income of local residents in areas with growth restrictions. The value of these properties can’t grow to the sky, so there is a limit to how far it goes, but it can push up to the limit of affordability and push against it until the economy weakens due to lack of housing hindering business expansion.

Affordability Limit

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