Real Estate & Inflation

Shelter from the (Inflation) Storm?

Inflation presents a mixed bag for real estate, particularly residential housing. On the one hand, inflation favors hard (vs. paper) assets; witness investors' recent appetite (if not lust) for gold, silver, oil, and even winter wheat.

As the original hard asset, real estate would seem poised to join in this advance. After all, Economics 101 says that repaying (fixed) debt with cheaper dollars benefits debtors at the expense of creditors.

On the other hand, inflation can also usher in higher interest rates, which are anathema for debt-financed housing; in the early 1980's, when long term rates briefly hit 14%, real estate transactions temporarily ground to a halt.

Fixed Housing Costs

How things will play out this time remains to be seen. However, the nice thing about real estate is that, in a world where the price of everything suddenly seems to be increasing, house payments remain locked in -- at least for people with fixed rate mortgages.

By contrast, renters can expect multiple price hikes as landlords pass through their increased costs (and take advantage of stronger rental demand brought on by tighter credit).

Commission "Triple Whammy"

Multiple-choice Economics Quiz

Given that it's a Presidential year, a quick, multiple choice economics quiz seems in order:

Which embattled U.S. job category has suffered the biggest drop in income the last three years?

A. Airline pilots being squeezed by industry mergers and rising energy prices.
B. Textile workers losing their jobs to their counterparts in China and Vietnam.
C. "Rust Belt" factory workers also affected by outsourcing.
D. Realtors stung by the national drop in home sales and prices.

Correct answer? "D." While the unprecedented national drop in home prices grabs headlines, the effect on realtors is going little-remarked. Thanks to a triple whammy of falling sales, lower prices, and contracting commissions, realtor income nationally is down a stunning 50%(!) since 2005.

Here is the math behind that number: sales of (existing) single family homes have fallen from almost 8 million in 2005 to a (projected) 5 million or less in 2008. According to the Standard & Poor's /Case-Schiller price index, prices are down nationally at least 15% from the peak three years ago, reducing the price of the average U.S. home from $235k to $200k. During that time, average realtor commissions have shrunk from 5.5% nationally to 5.25% (this number is a blend of full and discount service rates).

Because commissions are a function of all three variables -- sale volume, price level, and commission percentage -- the interaction of the individual drops compounds the overall effect on net commissions. Bottom line: realtor commissions have dropped from almost $100 billion in 2005 to about half that this year.

That $50 billion pie is split amongst 1.2 million realtors. To put that in perspective, the top 25 hedge-fund managers earned $16 billion in 2007. The top-ranked manager, John Paulson, personally made $3.7 billion. How? . . . . drumroll, please . . . by betting against the subprime mortgage market.

Windfall Profit . . . Not

While realtors' income has been crushed the last three years, two of their biggest expenses -- gas and health care -- have risen dramatically (as independent contractors, realtors have to pay for their own health care insurance). The slim thread of good news is that, due to a drop in the number of realtors, the much-smaller "commission pie" is now divided into slightly bigger slices. As a result, the average realtor's income isn't down quite as much as the 50% overall drop would suggest.

Against this backdrop, the (just-settled) Department of Justice's antitrust suit against realtors seems curious, at the very least. The suit, which focused on how home listings are displayed on the Internet, in essence accused full-service realtors of charging too much. If that's true, they're certainly doing a very bad job of it (vs., say, OPEC and big oil companies).

"Zestimates" Wildly Off Target

Zillow's Secret (Agenda)?
Maximizing Online Ad Revenues

"Yuppie Crack." That's what a technology pro I spoke to recently called Zillow and its admittedly addictive array of real estate search and pricing tools. Unfortunately, if you're relying on a "Zestimate" to price your home, you'd frequently be better off throwing darts, or simply picking numbers out of a hat.

According to Zillow's own "Data Coverage and Accuracy Table," its data for the Twin Cities -- which carries a "four star" ranking for accuracy, the company's highest -- can be expected to come within 10% of a home's eventual sales price just 54% of the time. Put another way, the odds of a Zestimate mispricing your home by more than 10% are practically 50-50. The chances of a Zestimate being off by more than 20% are almost 1-in-4!

Based on my experience as a realtor, if anything those numbers overstate Zillow's likely accuracy (company disclaimers are careful to characterize Zestimates only as "starting points").

To take just one example, a home that I'm currently helping the owner prepare for market has a Zestimate of $764k. Because the home hasn't sold in several decades, Zillow's "proprietary algorithms" rely on recent, nearby home sales to fill the vacuum.

Unfortunately, Zilllow doesn't know that my client's home needs a new Kitchen; requires substantial repairs to the roof and exterior; and needs all new mechanicals (plumbing, electric, and heating/cooling systems) as well as extensive landscaping. The three contractors who I've brought in to estimate the required work have come up with budgets of $150k-$250k. Likely selling price? Around $500k.

A mile away, Zillow makes the opposite mistake. Another client's home is located on a block of rehab's and tear-down's that are dramatically changing the neighborhood's character. However, because the work is being done by the homeowners themselves rather than as "spec" projects by builders, there are no resale statistics that capture the block's upward trajectory. "Zestimated" price? $645k. Actual fair market value? North of $800k.

It's not just home updates (or lack thereof), condition, floor plan, and neighborhood trends that Zillow fails to take account of. It also fails to recognize geographic markers like freeways; school district boundaries; and the presence, if any, of nearby foreclosed properties that have yet to show up in the published sales statistics that Zillow tracks.

So what gives? Zillow's real secret likely isn't its formula for calculating home prices -- it's the company's business model.

Zillow doesn't want to sell or even accurately price homes; rather, its goal is to attract and keep as many eyeballs online as possible. Why? So that it can maximize its online ad revenue, which (apparently) is its main source of income.

"Gut Check" Questions

Buyer's Market Tests
Sellers' Resolve, Patience

Every market poses its own "gut check" question.

In a strong Seller's market, the "gut check" question Buyers must wrestle with is, "how much do I really want this particular house?" That's especially true if there are multiple offers, and the winning offer is likely to be over the asking price -- sometimes well over. My advice to Buyers in this predicament is, "the right price to offer is the price you can live with if you get the house . . . and if you don't."

Today, Sellers are having to face their own version of this question. In a strong Buyer's market, many Sellers receive offers well below their asking price -- if they receive any offers at all. Often their realtor can work with the prospective Buyer to improve the offer . . but not always. The question such Sellers must ultimately weigh is, "If I pass on this Buyer's offer, am I willing and able to wait for another?"

In the final analysis, "fair market value" for any given property, at any particular moment, isn't about the comp's (comparable sold properties), general market statistics, historic cost, etc. Rather, it's what a financially qualified Buyer is willing to pay.

Negotiating 101

"Would Your Client Take $__ for Their Home??"

Listing agents (representing the Seller) know that there are three cards you never show the other side: the client's bottom-line price; terms; and motivation. Which doesn't mean that Buyers don't try to find that out. One of the most common ploys, in the early, informal stages of negotiating, is for a would-be Buyer to verbally ask (through their agent), "would the Seller take $__ for their home?"

The problem with such a hypothetical question is that it flushes out the Seller's price, but doesn't obligate the Buyer to buy. Especially in a soft market, if the Seller answers "Yes," the chances are fair that any resulting offer -- assuming there is one -- will come in below the just-tested price.

An experienced agent will parry the question by asking the Buyer, "are you offering $__?" If they answer affirmatively, their next sentence is, "Great! Put it in writing."

If the Buyer subsequently makes an offer at that price, and the Seller agrees to it, there's a deal. However, if no offer is forthcoming, the Seller hasn't revealed their position.

"Loss Aversion"

Psychology, not Economics,
Holds Key to Buyer Behavior

Economists trying to explain the slow housing market may be barking up the wrong (academic) tree. Rather, it is their colleagues in the psychology department who may have the best insight into what's underlying buyer's actions (or lack thereof): a behavioral phenomenon called "loss aversion."

In study after study dating back decades, psychologists have documented that people perceive gains and losses very differently. Irrational as it may be, a financial loss causes the average person roughly twice as much psychic pain as a similar-size gain causes them pleasure. As a result, people are far more likely to govern their affairs to minimize pain than to maximize pleasure.

What's that got to do with the current buyer's market?

Basic math suggests that a weak market is a bonanza for move-up buyers. The middle-market, $500k house they have to sell may be off 10%, or $50k, but the upper bracket, $1 million house they aspire to buy is also marked down 10%. Ten percent off of a much more expensive house translates into a much bigger absolute discount -- in this case, $100,000. Truth be told, given the recessionary environment and tighter credit markets, in many Twin Cities neighborhoods the formerly $1 million house could probably be had for the high $800's now.

The Move-Up Conundrum

So why aren't the move-up buyers moving up? Because the $50k loss they're contemplating hurts more than the $100k (or more) they stand to save.

It's impossible to prove whether loss aversion explains move-up buyers' hesitation. However, a good test would seem to be the behavior of buyers not affected by loss aversion (or at least not as much).

Fortunately, such a group exists: they're called "first-time buyers." While first-time buyers are understandably nervous about the market declining after they buy (just as loss aversion theory predicts), by definition they don't have to realize a loss on an existing property first.

Based purely on anecdotal data I've seen, the lower end of the market does in fact seem to be much healthier than the middle and high ends. Neighborhoods that traditionally attract first-time buyers -- Longfellow, Nokomis, parts of Kingfield, St. Louis Park's Birchwood neighborhood (west of 100) -- have surprisingly little for sale under $200k or so that has a decent amount of space (more than 1,000 FSF), some kind of yard, has been reasonably updated, and can legitimately be called "move-in ready."

Of course, it's also true that there are a lot more people who can afford a $200k house than a $1M house, especially in a soft economy.

Wall Street Bust, Midwest Boom?

[Why (Some) Twin Cities Real Estate is Headed Higher - Part Two]

Commodities Boom, Weak Dollar Benefit Twin Cities Companies

The Twin Cities may not be Dubai or even Houston, but thankfully it's not Wall Street, either. As companies like Citigroup and Merrill Lynch write off tens of billions (never mind Bear Stearns) and lay off thousands, some of the biggest corporate winners are located . . . here. In turn, that bodes well for the local housing market, which ultimately is driven by two things: job growth and interest rates.

Consider:

--In contrast to Citigroup, Merrill Lynch, Lehman Brothers, and Bear Stearns, whose stocks are down anywhere from the 50% to 95% (ouch!) the last year, a relatively obscure, Plymouth-based company, Mosaic, has appreciated almost 300%, or $40 billion (yes, billion!). Thought that 3M, Target, or United Healthcare was Minnesota's most valuable, publicly-traded company? Think again.

--In fact, the state's most valuable company likely isn't a publicly-traded company at all: it's a $100 billion, media-shy behemoth named "Cargill." Minnetonka-based Cargill is to agriculture what the old Standard Oil was to petroleum: a multi-national, vertically integrated, seeds-to-grocery shelves conglomerate. Because it's privately-held, it does not have to report financial results, but it's clear that what's good for Mosaic is great for Cargill (assuming there's a difference: Cargill insiders own about two-thirds of Mosaic's stock).

--How do you know when farmers are flush? They're quiet (maybe they're afraid of jinxing it). To a non-farmer like me, it seems like farmers are always complaining about something: it's either too hot or too cold, too dry or too wet. If somehow the miraculous occurs -- growing conditions are perfect and there's a bumper crop -- farmers inevitably complain that excess supply is depressing prices.

Upper Midwest 'Black Gold'

Not this year. Demand for corn (food and ethanol), wheat, and soy beans is soaring -- and with it the land needed to grow it. Minnesota is to farm acreage what Wall Street is to finance and Saudi Arabia is to oil; if farmland has conservatively risen 50% in the last three years (Barron's; 12/31/2007), Minnesota's roughly 25 million acres of farmland has appreciated almost $20 billion since then. To put that in perspective, that gain is about twice the cumulative drop in Twin Cities residential real estate since the market peak.

The clearest beneficiaries of this boom are companies that sell to farmers. That includes John Deere (capital equipment); Monsanto (seeds); and Mosaic (fertilizer). However, farmers' newfound bounty is also bullish for commodities traders, local and regional banks, and other ancillary services. To take just one example, seats on the suddenly-hot Minneapolis Grain Exchange quadrupled, from $72,500 to $285,000 in 2007 alone ("Will Grain Exchange Boom Last?"; Minneapolis/St. Paul Business Journal, 1/4/2008).

If "what's good for General Motors is good for America," the local equivalent is "what's good for agriculture is good for Minnesota (and the Twin Cities)."

--Further burnishing the Twin Cities' luster: an outstate boom in ethanol refining (18 plants producing 680 million gallons of ethanol a year); Minnesota-headquartered food processors such as General Mills, Hormel, and Land o' Lakes; the weak dollar's positive effect on export-driven companies like 3M; and the Twin Cities' historic role as the business and banking center of the Upper Midwest.

The Middle East may be oil-rich, but the Middle West is (farm)land-and-commodities rich. In the middle of an epic, world-wide commodities and ag boom, it would seem that there are worse places to be.