Housing Market: Part 7 - The Grand Finale

This post will, hopefully, conclude our discussion of the housing market.

We’ll take a look at long-run housing prices in the US, once again value the median US house, and conclude with a few notes about valuation and monetary economics and how they drive housing.

Even though we’ve covered most of these points before, it’s worth bringing them together.

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A long-run look at US house prices

Robert Shiller, the legendary American economist and Yale professor, maintains an index of real house prices in the US over time. It goes from 1890 to 2021, and he updates it monthly. You can access it here.

Source: http://www.econ.yale.edu/~shiller/data.htm

This graph beautifully illustrates the cyclicality of real estate prices and the ever-growing amplitude of the effects of the short-term credit cycle on house prices - especially since 1971. This swelling amplitude is because, as we have previously covered, the short-term credit cycle (7-10 years) lies on the long-term credit cycle (75-100 years).

It’s interesting to note that buying in the 1890s and holding to the late 1990s would have given you no real return from capital appreciation.

Zooming in and focusing on more recent history, we can see that, in real terms, the price of housing in the US is now above its 2008 peak.

Housing Bubble V.2.0. The previous collapse was brutal, will this will be worse?

But, what are houses in the US worth to the owners?

The intrinsic value of the average US house

The relevant data (and sources) for our valuation of the median US house, as of June 2021, is as follows:

Inputs
10-Year Treasury Bill Yield = 1.61%
Average LTV Ratio = 83.90%
Fixed-rate Mortgage = 2.17%
Corporate Tax Rate = 27%
Median Household Annual Income = $79,900
% of Income Spent On Rent (2019) = 30.48%
Rental Vacancy = 6.8%
Average REIT Operating Margin (2015 - Q1 2021) (%) = 22.59%

Stable Valuation
FCFF = $3,802.61
WACC = 3.23%
Stable Growth Rate = 1.61%

Output
Intrinsic Value of Median US House = $234,475.58
Median Sale Price US House = $347,500
Price/Value = 148.02%

This overvaluation is truly remarkable, especially considering that capital costs are, on average, the lowest they’ve been in modern history.

I can already envision the next round of angry emails we will receive from disgruntled readers:

“But the sale price is a huge part of your return and property prices only go up. You’re dumb! Have fun being poor! Bye, Felicia!”

We have addressed this pricing mistake previously, but we will tackle it from a different angle this time by introducing the concept of aggregate ownership.

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Aggregate ownership and the pricing fallacy

Aggregate Ownership: At every stage of an assets life, it must be owned by someone. The owners cannot, over the entire course of the assets life, make a return greater than the total amount that the asset produces.

If I own a business and hold it forever, the total return I get is everything it pays me in dividends from now until the end of time. Intrinsic valuation is discounting and summing all those dividends back to today by adjusting for time-value and riskiness.

If I sell the business, and that person holds it forever, the total return that they will get is the sum of dividends after the purchase date and until the end of time.

If that person sells the business and the next person holds it forever, the total return they will get is the sum of dividends from the purchase date until the end of time.

So on and so forth.

We can quickly see that, regardless of how much the asset was bought/sold for, the total return that all the owners will get, in aggregate, cannot be larger than the total dividends from now until forever.

Or, to put it another way, you can consider everyone on earth as being one single owner of all assets. We can all play musical chairs with these assets if we want to. We can pass them back and forth at ever-increasing prices and feel like we are getting wealthier - but we aren’t. It is the opposite; the transaction and frictional costs make us poorer.

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A final note and summary of how we got here

Bubbles and Ponzi schemes are excellent investments for early entrants but are painful for late entrants. As a society, we are throwing everything we have at keeping this party bus rolling because we really really don’t want to endure that pain. It’s as simple as that.

The fractional reserve banking system (see our series on that) enables the proliferation of credit. This proliferation of credit leads to rising prices. Rising prices beget more credit because of flawed, Goodhartian, price-based risk weighting metrics under the Basel accord that make loans appear less risky as prices rise.

To keep this party going, we need to continually lower interest rates and ensure an exponential flow of money to the debt market.

We create an exponentially growing supply of base money…

… that never makes its way into the real economy…

… remaining trapped within the financial economy…

… and can only make its way into spending through mortgages…

… and other increasingly risky lending activity.

Of course, as we illustrated in our series on bubbles, none of this is remarkable, novel, or even new — we keep doing the same thing over and over and convincing ourselves it’s different this time.

Richard Cantillon, in his “Essay on the Nature of Trade in General”, published in 1755, explains that:

“If the increase in cash proceeds from gold or silver mines located in a state, then the owners of these mines, the entrepreneurs, the smelters, the refiners and in general all those who work there will in any case their expenses according to their profits increase. 

They will consume more meat and more wine or beer in their households than they used to, they will get used to wearing better clothes and nicer lingerie, better furnished houses, and other more exquisite comforts in life. They will therefore give employment to some artisans who previously did not have so much work and who will now increase their expenses for the same reason; all these increases in expenditure on meat, wine, wool, etc. necessarily reduce the proportion of the other inhabitants of the state, who initially do not participate in the riches of the mines in question. 

The haggling in the market, or the demand for meat, wine, wool, etc., which is stronger than usual, will in any case drive up their prices. These high prices will cause the tenants to use more land to produce these things in another year; these same tenants will profit from this increase in prices and, like the others, will increase the expenses of their families. Those who will suffer from this inflation and increased consumption will therefore first be the landowners during the term of their leases, then their servants and all workers or employees with fixed salaries who receive their families from it. 

All of these must limit their expenditure according to the new consumption, and this will force a great number of them to leave the state to seek their fortune elsewhere. The owners will lay off many of them and it will happen that the rest of them will ask for a wage increase in order to be able to live as they were used to. 

That is roughly the way in which a considerable increase in the money from mines increases consumption and, while decreasing the population, results in greater expenditures for those who remain behind. "

Richard Cantillon - Treatise on the Nature of Commerce in General, Chapter 6, Part II - Written in 1730, published in 1755

Under the current central and fractional reserve banking system, the increase in the money supply no longer comes from mines but instead from central banks. As the money supply grows, the pressure on the financial system to distribute it builds.

This money is necessarily distributed through loans because banks have no other methods. As a result, the total debt grows, speculation increases, prices rise, Ponzi financing becomes the standard, and finally, we reach the precipice and enjoy a Minsky Moment before the dominos fall.

The Minsky Instability Credit Cycle

We will leave you with this:

In his 1992 paper, “The Financial Instability Hypothesis”, Hyman Minsky argues that the critical mechanism that pushes an economy towards a crisis is debt accumulation by the private sector.

He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.

• The hedge borrower can make debt payments (covering interest and principal) from current cash flows from investments.

• For the speculative borrower, the cash flow from investments can service the debt (cover the interest due), but the borrower must regularly roll over the principal.

• The Ponzi borrower borrows based on the belief that the appreciation of the asset's value will be sufficient to refinance the debt but could not make payments on interest or principal with the cash flow from investments. Thus, only the appreciating asset value can keep the Ponzi borrower afloat.

Suppose the use of Ponzi finance is mainstream enough in the financial system. In that case, the inevitable disillusionment of the Ponzi borrower can cause the system to seize up. When the bubble pops, and asset prices stop increasing, the speculative borrower can no longer refinance (rollover) the principal even if able to cover interest payments.

As with a line of dominoes, the collapse of the speculative borrowers can then bring down even hedge borrowers, who cannot find loans despite the apparent soundness of the underlying investments.

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Disclaimer: 
This publication is not financial or legal advice. This research is an independent analysis. Please do your research and invest your way.