Economist Marc Faber said on April 6 on Financialsense.com that U.S. real estate is a good asset to invest in. I strongly disagree. He worries too much about the risk of hyperinflation and this motivates him to seek out any type of tangible asset in hopes it will protect investors from inflation. However real estate in the U.S. is not the same as gold bullion because real estate is usually purchased with a mortgage that is underwritten by bank creditworthiness standards. When people buy gold they pay for it with savings instead of using borrowed money. If consumers have a drop in income or if interest rates go up then they will have less borrowing power which means less purchasing power and then the price would go down. During a period of high inflation people actually become poorer in real terms so they will be forced to buy a smaller home. If inflation were to return as it did in the 1970’s lenders would insist in being compensated by charging higher interest rates. When interest rates hit 22%, as they did in 1981, then almost no real estate will be purchased with the exception of a money-losing “owner carried back” mortgage Note that is at artificially low rate of interest.
Today’s mortgage market operates under strict underwriting rules where the self-employed borrower must use a two year average of income. Since small businesses encounter a lot of economic volatility then the owners of those businesses may not qualify for a loan because their 24 month average is not adequate even though they are currently earning enough income. Since many buyers are two income couples then if one family member is self-employed with shaky income then the entire family could not qualify even though they currently earn enough. From 1984 to 2009 the banks used “Easy Qualifier” loans that allowed people to lie about income. This caused people to get too much borrowing power and made real estate prices go too high. Today we are in a new era that does not compare with the 194-2009 era because lending standards have changed. In addition there are a lot more independent contractors today than in the pre-1984 era, so we can’t compare personal income of the pre-1984 era to today’s earned income. In the pre-1984 era people had a simple salaried job, while today they may have a mixture of salary and bonus or self-employment. (Bonus income requires a two year average for loan approval, so many people can’t use it to qualify for a loan).
Massive money printing hurt real estate
On a qualitative basis personal incomes in the U.S. have not improved as much as the numbers suggest because the unreliable nature of today’s independent contractor, self-employed, or salaried with large bonuses type of income can’t be fully relied upon to service a mortgage. The return to traditional loan underwriting recognizes that and is thus offering less mortgage credit than one would expect by simply looking at the nation’s per capita personal income. Ivy Tower economists fail to recognize this and conclude that the ratio of per capita income to today’s low mortgages rates somehow makes homes affordable, but that is incorrect. In investment analysis one must make adjustments for excessive risk. For example one could discount a cash flow using a more severe discount rate for an investment that is very risky, for example a company located in an unreliable Emerging markets country. For U.S. consumers using earned income to borrow funds and buy real estate, a lender must “discount” the borrower’s income by adjusting for the increased riskiness of personal income. Another mistake economists make is to not see that outside of urban high wage areas that personal income has not kept up with income earned by the urban elites, so that means homes for the bottom 90% of consumers have a potential pool of buyers who did not get the same share of income that they had received in previous decades. This explains why Palo Alto and Manhattan are bullish markets while the rest of the country prices are still declining.
The best hedge against inflation in the 1970’s was ironically short term bonds and cash because the high interest rates paid then compensated for inflation while stocks performed badly. Real estate in the 1970’s benefited because borrowers used artificially low 30 year fixed rate loans that were not priced to reflect inflation. I don’t expect that to happen if inflation of the 1970’s returns.
I am not forecasting a return of inflation, simply commenting that real estate is not an inflation hedge.