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Real Estate: The Bubble, the Bust, and Beyond

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With a decline of 24% in U.S. home prices since its record high in March 2007, this year marks the longest real estate bear market since the beginning of World War II. There is much public debate about when housing’s problems will end and a new bull market will begin. Financial history can provide us with some important insight into the longstanding pros and cons of real estate investing and clues to its future as a popular investment choice.

With shelter being of primal concern to all people, real estate is one of mankind’s oldest types of assets and has been one of the most effective ways to amass wealth and power in all civilizations (past and present). Homeownership has always been an important part of the “American Dream” and continues to be the largest asset owned, as well as the reason for much of the high debt burden held by most investors.

There have been five mega bull markets in housing that have exceeded five years in duration since 1850. Their average annual return was 120% higher than normal yearly appreciation (11% versus 5%). The 19-year run of the 1971–90 market marks the longest advance in housing prices. After a brief market correction, the second longest housing advance began, the 15-year run from 1992 to 2006.

Real Estate

While most parts of the U.S. enjoyed these housing booms, the western states had the best overall appreciation over the last 33 years, followed closely by the northeastern states. The steadiest performance came from the southern region (annual declines occurred only 3% of the time). This is especially astounding when you consider the substantial number of major hurricanes and tornado storms that caused tremendous damage in this region.

Although the 24% decline in U.S. housing prices over the last five years is widely believed to be the worst on record, there have been six severe housing bear markets that have exceeded three years in duration since 1850. Their average total decline was 50%, and it took 12 years on average for prices to return to the previous bull market high. While the six-year decline during World War II marked the longest continuous decline over the last 160 years, the four-year decline during the Great Depression was far worse with a total decline of 58% from 1929 to 1932. This led to the federal government’s creation of mortgage giants Fannie Mae and Freddie Mac to help stabilize the housing market.

Since real estate bull markets can last for decades and be experienced by many generations of investors, it is somewhat easy to understand how today’s knowledgeable and technologically advanced investors bought overpriced properties with “nothing down” and indebted themselves at lethal levels with risky adjustable rate mortgages during the recent bull market. As with other past bubbles, the myth that real estate can’t lose value became a reality for rich and poor alike, who ignored how rising interest rates sent real estate into a nosedive in the late 1960s and early 1980s. History reminds us that illiquidity has always been the Achilles Heel of housing and makes an exit in the beginning of a bear market problematic. Even today, real estate is a throwback to the Buttonwood Tree era with transactions done at a slow pace through networks of brokers centered on MLS publications and websites that post property listings for sale. In this decentralized, cumbersome and expensive transaction structure, a typical transaction can take months to complete. As in previous real estate bear markets, this one is marked with over-leveraged properties that are difficult to sell, and extensive government action is being used to block foreclosures and influence mortgage rates.

Museum of American Finance

With the nation’s focus on U.S. housing prices’ continued decline and how Wall Street’s securitized mortgage “creations” nearly destroyed the world financial system, real estate investment trusts have quietly made up most of the ground they lost with a 70% advance since 2008 and outpacing the S&P 500 Index’s 50% gain. This raises a long-running debate: Which is the best way for investors to own real estate—direct ownership in investmentproperties or liquid, exchange-traded investments that focus on real estate?

Die hard real estate investors believe owning “brick and mortar” is the best way to play the real estate game, and the time dealing with the problems surrounding the “four Ts” of investment property ownership (tenants, taxes, toilets, and termites) is the price paid for success. Clearly, today’s investors have another route to successful real estate investing through real estate investment trusts (REITs) that actively invest in residential, commercial, and industrial real estate around the globe.

Both types of real estate investments produced impressive returns from 1974 through 2007 (REITs rose 580% and non-leveraged U.S. homes advanced 531%). Since then, REITs are the clear winner; investors can also use REIT preferred shares for income generation with average dividend yields of 7%. In fact, the Morgan Stanley REIT Index has recovered all its losses from the 2008 financial hurricane, and U.S. housing prices have declined 19% and are near bear market lows.
The bottom line is that direct ownership can use higher levels of leverage (margin on stocks is limited to 50% of value), but REITs are more liquid during volatile real estate conditions, cheaper to buy and sell and perform better during housing bear markets.

Successful investing is as much about identifying the overall trends (i.e., when to buy or sell) as it is selecting individual investments (i.e., what to buy to sell). While many people think low mortgage rates alone will cause a housing rebound, there are other indicators to watch, such as home prices, new home sales and months for sale.

The Winans International Real Estate Index (WIREI)™ is the only index that measures U.S. home prices since 1830 and posts new housing data without a two-month lag found with other popular real estate indexes. Since 1960, when the WIREI crossed above its 20-month moving average, there was strong evidence that the bear market was reaching its end.

Similar to stock market volume, the number of new houses sold and the number of months they were on the market measure overall housing activity. Generally speaking, continuous increases in sales volume along with a dramatic decline in the amount of time it takes to sell a house precede any improvement in real estate prices. 

Over the last 60 years, housing bear markets ended when “Months for Sale” dropped below 3.5 months. Unfortunately, the WIREI is still in a downtrend, nationwide sales activity is still weak and the average months to sell a new home is nine. It could easily take another year to dry up excess housing inventory and for mortgage credit to ease enough to stimulate new home purchases.

Kenneth G. Winans is a successful investment management entrepreneur and an award-winning author in finance and history. For 29 years, he has conducted landmark investment research and designed leading market indices in stocks and real estate. He is a regular guest on TV and radio shows nationwide and has had much of his work published as headline articles by leading websites, magazines and newspapers.He has been a trustee of the Museum of American Finance since 2009.

This article originally appeared in the Summer 2011 issue of Financial History, a publication of the Museum of American Finance



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