Why Homebuyers Have Become Speculative Bond Traders

by Louis Navellier | January 9, 2014 10:23 am

As I was thinking about what to write in this week I remembered a short conversation I had with an acquaintance a couple of years ago, before the real estate market began to “heal,” as Fed officials are fond of putting it. At a holiday dinner party in 2011, as we were sitting at the table, one of the guests, a software engineer by trade, asked me if it this was a good time to buy a house.

I did not give the conventional answer. “That depends on if you are buying a house to live in and if you can afford to buy a house. Many people cannot afford the houses they live in, especially in this area.”

“This area” was right outside of Washington, DC, where this software engineer was renting a one-bedroom apartment – a great deal for a bachelor living in one of the richest counties in America.

“But I want to buy it as an investment,” he elaborated. “The housing market is down. I will live there five years and then I will sell it and buy another house. Then, I will live there for another five years and sell that one and buy another. I know people that live in their houses for free after doing this three times.”

I hope that I managed to maintain my composure – at least on the surface, that is. What he said may have been technically true for some local real estate markets, but this scenario assumes a never-ending drop in long-term interest rates, and as a result, a never-ending rise in the price of income-producing assets.

A house is a decent deal if the mortgage payment (including the real estate taxes) roughly approximates the rental income one would receive, should one rent that same property. In reality, a house costs a lot more, double in some cases, even if the equivalent of a mortgage payment roughly equals the likely rent.

There is a giant sucking sound that one hears when moving into a new house. Start with the new furniture, and the endless renovations and maintenance, particularly if the home is not new. There could also be a significant rise in real estate taxes, with regularly-updated assessments, especially if the real estate market is rising. Then, the local government may decide that homeowners in their jurisdiction can be taxed more to balance their always-growing budget. Homeowners reading this surely can come up with a longer list…

Owning a house is marketed as The Great American Dream. But a house, as we have seen in many cases in the past 10 years, can turn into The Great American Nightmare. Many homeowners are still sitting on negative equity after the biggest real estate bust in US history and the worst recession since the 1930s.

Long-term Bond Yields Can’t Fall another 1441 Basis Points from Here

From September 30, 1981 to July 25, 2012, the 10-year Treasury note yield fell from 15.84% to 1.43% (based on closing values). Whoever told the quasi-bond-trading software engineer that he can flip a house three times and then live in a home for free must have been riding the slope of this long-term decline in interest rates, fueling a real estate boom based on constantly falling financing requirements for houses.

If a first-time home buyer thinks that he can repeat that “trade” (i.e., the three-fold home flip), he is blind. Instead, he would be embarking down a dangerous road, as, in my opinion, that trade cannot be repeated.

Ten Year Treasury Constant Maturity Rate Chart

With long-term rates still historically low, there won’t be a 1441 basis point decline in interest rates to help finance any new triple house flip. The Washington DC suburbs are very nice, but they certainly are not the City of London or the borough of Manhattan, where the limit of available land makes real estate unique. Real estate, in general, is unlikely to keep appreciating as fast as it has in the past 30 years, so I doubt that there will be a successful three-fold house flip starting from where the bond market is now.

Every economy is different and every central bank is different. We don’t have too many recent cases of 10-year government yields dipping below 1%, but there are two—Japan and Switzerland. These two sub-1% rate drops happened for completely different reasons. In Japan, there was a busted credit bubble and a busted banking system that led to a real estate decline that fed on itself. Even though the Japanese have tried to fix their banks, negative demographics and a persistent 15-year deflation, as well as a debt-to-GDP ratio more than double that of the US, have resulted in a dead real estate market. There are not too many Japanese trying to do a triple-house flip, despite their much lower interest rates (see chart below).

Long-Term Government Bond Yields Chart

In Switzerland, the sub-1% decline was driven by safe-haven buying based on fears of the dissolution of the euro. The euro storm has calmed down and the Swiss 10-year government bond yield has risen to the glorious level of 1.1%, but all is not well in Europe and it is difficult to say how long the euro mess will stay dormant. Still, Switzerland is a banking center where capital hides, so its interest rate structure likely reflects more than the local economic dynamics. My point is: Even if US Treasury yields fall below their record 2012 levels, I don’t think that such an event can push the real estate market significantly higher.

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