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Title: Housing Market Revealed 2006 - Is The Party Over For Real
Estate?

Author: Derek Polcyn

Article:
The international housing market has been red hot since 2000.
The original catalyst for the rise in real estate prices was
twofold. Firstly, due to the low interest rate environment, the
housing market benefited from a pent-up demand from renters who,
realizing that mortgage payments could be as low as rent,
decided to purchase their first homes. Secondly, after the
equity bubble burst, the price gains in the housing market made
many people believe that home ownership was a safe form of
investment. 

The price of an asset depends not only on its financial
fundamentals but also on qualitative factors (e.g., the amount
of speculation, sentiment of market participants, competition
with other assets, etc.). 

Fundamentals and Cyclicality

Prior to 2000, the real estate market and the economy were
always cyclical. For instance, the US housing prices tended to
weaken as the GDP and employment prospects declined,
particularly during the recessions of 1980 and 1990. The
economic downturn of 2000-01 defied many predictions by having
the opposite impact on real estate prices. Over the past five
years, real estate prices have increased approximately 10%,
outperforming equities by a wide margin.

Historically, real estate has been viewed by many as a good
hedge against inflation. During the last five years however,
real estate prices have exceeded the rate of inflation by a
gross margin. 

Given the significance and size of the U.S. real estate market,
our analysis will focus on U.S. real estate, which is currently
quite representative of markets around the world. 

U.S. Real Estate

In 2005, America's real estate boom was strong, with prices up
by 13%. But there were signs that the market was weakening.
Sales of existing homes fell this January to the lowest in
nearly two years. Meanwhile, the number of unsold homes rose to
the highest level since 1998. In addition, new homes continue to
be built at the fastest pace since 1973. In other words, while
the supply of housing is at the highest level, demand for homes
has fallen dramatically, rendering a downward price adjustment
inevitable. 

Due to the low interest rate environment, affordability ratios
are still within historical ranges, although they're approaching
a 14-year low. On the other hand, other ratios that disregard
the interest rate level (e.g., home price to rent, home price to
disposable income) appear to have escalated. 

The Supply / Demand Imbalance

In general, we see no evidence that the supply factors are
positively affecting the prices. For example, the rate of
population growth has not increased significantly and the supply
of land available for housing remains largely unchanged. In
fact, research by Goldman Sachs reveals that U.S. residential
investing is at the highest level in 40 years, yet new household
formation is growing at its slowest rate. 

Based on the experience of the last few years, we may see a
fundamental shift in sentiment, favoring home ownership. Up to
now, most of the baby boomers nearing retirement have decided
against downsizing their homes and opted for the financial
security of their current houses instead.

Other Asset Classes

Financial exposure to real estate is generally a good thing as
long as it is a reasonable proportion of one's assets, and the
investment environment is favorable (e.g., not in the midst of a
bubble or heading into a decline). In a diversified portfolio,
real estate investments can be a very good diversifier due to
relatively low correlations with other asset classes. 

Contrary to popular belief, holding a diversified portfolio of
various asset classes (with a large equity exposure) has been a
much better investment than buying a house during the last 30
years. For instance, a dollar invested in real estate in 1975
would grow to $6.07 while it would turn into $36.14 if invested
in the S&P 500. However, in calculating the exact returns one
must factor in taxation and deductibility of interest rates.

The Failure of Risk Management

As rising house prices lift the market value of collateral on
banks' existing loans, banks are willing to lend more, pushing
prices higher. In effect, banks have an incentive to lend when
property prices are rising, and to pull out when prices fall,
leading to extended boom and bust cycles. 

For the past few years a number of researchers have pointed to
the non-sustainability of the housing market, comparing it to
the high-tech bubble of 2000. Barring any fundamental change,
the primary question remains why real estate prices have defied
this historical market relationship for so long, and whether
will they will ever reach the tipping point.

InvestWELLFinancial.com

The full E-book is located at:
http://todaybooks.com/product_info.php?products_id=127



About the author:
Derek Polcyn, CFA, FRM, CIM, M.A. (Econ.) President and CEO of
InvestWELL Financial. Derek has been involved in capital markets
for over 12 years. He worked as an investment analyst at several
large North American financial institutions for over 7 years and
taught finance at college. 

 

 

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