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The Inoculated Investorhttp://inoculatedinvestor.blogspot.com
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Don’t Expect Real Estate Prices to Go Right Back Up
Anyone who knows me is aware that I have a unique perspective on real estate. My family is in thecommercial real estate business and I worked in the business for a number of years before becoming asecurities analyst. However, even as an analyst I have continued to follow the sector very closely. Not somuch the REITs as the regional banks. If you think about it these banks are not much more than real estatecompanies. While their main business is not to own properties (at least not by choice), a large percentage of their loan books are tied to real estate. Aside from some business or what are known as C&I loans, themajority of the loans on the books of the banks I follow are tied to commercial real estate, residential realestate and construction.In addition, if you read my contributions to Seeking Alpha or follow my blog you are keenly aware that Iam not so bullish on US real estate right now. My bearishness even extends oversees as I have come to theconclusion that theAustralian and New Zealand housing markets could be on the precipice of a large fall.Of course, there is no shortage of housing and commercial real estate bears. My friend Whitney Tilson of T2 Partners has done a fabulous job in documenting where we are in terms of the housing bust and warning investors that there are a number of factors that will continue to put pressure on prices. On the commercialreal estate side, Deutsche Bank Analyst Richard Parkus has been the most outspoken bear, recently proclaiming that  New York City real estate is in for a tough stretch.  However, I want to look past of all the near term uncertainty in assessing the prospects for real estateappreciation over the next decade. Over the next few years foreclosures, interest rate resets, CMBSrefinancings, and short sales could very well push prices lower or prevent any significant uptick in values.But for someone interested in commercial real estate investments and who may soon be in the market to purchase a residence, it is important to understand the history of real estate appreciation directly after a busthas occurred. I am fully aware that there is no credible way to call a bottom or a top in the market. Nevertheless, it is important to have realistic expectations regarding how long it could take for prices torecover from their recent falls on both a nominal and inflation-adjusted basis.On that front, this first chart and the associated data are not particularly promising:
Chart and data courtesy of  http://bubblemeter.blogspot.com/ 
 
The Inoculated Investorhttp://inoculatedinvestor.blogspot.com
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This chart shows the progression of New York City metropolitan house prices from January 1987 toFebruary 2009 on both a nominal and inflation-adjusted basis. First, median prices hit a nominal peak of $184,798 in August of 1988. Then, as a result of the commercial real estate bust and the early 1990srecession, prices began to fall, dropping 15.4% to $156,173 in March of 1991. This fall was not particularlydramatic in comparison to what we have seen nationwide in the US over the last 3 years. However, thescary thing is that it took until April of 1998 (when the median price reached $184,755) to get back to the1988 peak level. For anyone counting it took nearly 10 years for someone who bought in August 1988 tosee his or her house worth the original purchase price. In the meantime this hypothetical person was likely paying interest on a mortgage that valued the house at well more than it could be sold for. That extrainterest is not trivial and represents a real cost to borrowers whose houses have dropped in value.The data on an inflation-adjusted basis is even less encouraging. Specifically, real house prices hit a peak of $322,866 in November of 1987. From there prices bottomed at $229,659 in February of 1997, representinga 28.9% fall. Unfortunately, it took until October of 2001 (when real prices hit $323,353) to get back closeto the 1987 peak. It appears that inflation caused the recovery process to take significantly longer as 14years passed before someone who bought in 1987 was fortunate enough to have his or her house worth theoriginal purchase price.So, the next logical question is where are we now in terms of NY housing prices? Well, according to theCase-Schiller Composite 20 Index, prices peaked at 215.83 in June 2006. As of the April 2009 data theindex was at 170.33, signaling a 21% drop. In fact the index in April was back to near where it was in Mayof 2004 (170.52). In comparison, from the peak in September 1988 of 85.54 the NYC index bottomed at72.29 in April 1991 (a 15.5% drop). It then took until May of 1998 when the index hit 85.52 for prices toreturn to the 1988 peak levels. That’s a little less than 10 years and the drop back then was not as severe asthe current fall has been. You can only imagine how long it could take for prices to get back to the 2006levels if history were to repeat itself, especially if prices have further to fall as Deutsche Bank AnalystParkus is calling for (his current prediction is that they will fall 40% more). Before anyone who owns a piece of New York real estate or who bought in the last 3 years decides to jumpout of the window, I think I should make a few points. First, New York City is a much nicer place to livenow than it was in the late 1980s and early 1990s. Murder rates areway down.There is not a person waiting at every intersection willing to clean your windshield for a few dollars. The gentrification that hasoccurred on the Lower East Side, Alphabet City and the Upper West Side over the last decade has beenastonishing. What this means is that the flight to the suburbs that occurred when the City was a muchtougher place to live may not occur this a time, a fact that could mitigate the magnitude of a housing bust.Furthermore, New York still attracts wealthy Americans and foreigners who want to live in such a vibrantcity. At some point that demand could also help limit the ultimate fall in prices. In truth, all of these factorslead to the supposition that the fall in prices may not be as dramatic as the doomsday forecasts indicate andthat the subsequent recovery in prices may be faster than that of the country as a whole.
 
The Inoculated Investorhttp://inoculatedinvestor.blogspot.com
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Chart courtesy of T2 Partners
The above chart illustrates just how far off the long term trend line US houses deviated from roughly 2000to 2006. Whether you favor the Lawler or Schiller data, the data indicates that the subsequent depreciationhas brought prices back near the trend line. Could prices “overshoot” and go below the trend line?Absolutely. However, as I argue above there are a lot of fundamental reasons why NYC real estate willrecover at a faster rate than the national housing market.Having said that, I see a couple of risks that investors and potential owners of real estate should keep inmind. First, buying the recent dip in housing prices could prove to be disastrous. As many value investorslearned in 2008, buying stocks at each dip did not produce the returns that strategy had garnered in previousmarket downturns. These value pretenders as Seth Klarman calls them temporarily lost sight of intrinsicvalue and became anchored to previous prices. Just like stocks, housing has an intrinsic value that can bemeasured. In February, a very smart guy I know named Jeff Bernstein of UrbanDigsposted an analysis of the appreciation in real estate prices in certain Manhattan neighborhoods versus the rise in equivalent rent.He took data from the website of real estate appraiser and consultant Miller Samueland tried to determine if prices had deviated from an inflation-adjusted equivalent rent value. I will spare you the nuances of thedata and you canread more about the way that Jeff went about the process, but I think this chart says it all:
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