The U.S. housing market continues to roar, prompting increasingly ominous media reports of a housing 'bubble.' A national bubble remains unlikely, but there are increasing indications that prices in some prime markets - such as Washington D.C., New York City, Boston, San Diego, Los Angeles, and San Francisco have climbed beyond what could be reasonably expected given the fundamentals.
Commercial real estate has increasingly been lumped into these bubble stories even though commercial valuations have significantly trailed house price growth. Not surprisingly, commercial real estate appreciation in hot housing markets has generally been stronger and is fairly highly correlated with home price growth across markets.
Even in heated markets, a slowdown - rather than a crash & is considered by experts to be the most likely outcome. House prices have never experienced a significant nominal decline at the national level, while regional busts have been preceded by negative economic shocks.
From an investment standpoint, several academic studies have observed the similarities and a correlation between the long-term total return performance of the real estate and the U.S. stock markets. However, even though nominal total returns for these two asset classes are similar, there are substantial differences in liquidity, transaction costs and tax treatment.
The real estate market typically is highly leveraged and offers investors beneficial tax advantages (depreciation and 1031 tax deferred exchanges). But real estate is characterized by being highly illiquid with low turnover rates and relatively high transaction costs (on both the buy and sell sides). There is also no orderly or regulated market for real estate and each transaction is unique with prices dependent on highly individual factors.
The stock market, in contrast, is very liquid with high volume (minute by minute pricing on hundreds of thousands of shares) and fractional transaction costs. Tax advantages are available with specific, restricted types of accounts (i.e., retirement accounts), and favorable capital gains tax treatment if stocks are held for a minimum of one year. The stock exchanges are both highly organized and regulated with prices largely determined by volume.
The long-term performance of these two asset classes offer investors an annualized total return of approximately 10%. Total return is the combination of current income (net rental income and stock dividends) plus price appreciation (or minus depreciation).
Common to these two asset classes is the importance of return of cash flow. As a matter of fact, for all investments - stocks, bonds, treasury bills, options, real estate, etc - the analysis boils down to the level and timing of cash flow and its underlying predictability.
Over the past five years, although real estate prices have increased substantially, in the major markets listed above, the underlying cash flow has not. A property purchased five years ago with a current income of 9.0% has now tripled in price but its rental income has remained virtually unchanged. Consequently, that same property at today's price now has a current income of only 3.0% (assuming no increase in operating expenses or taxes).
The stock market, as measured by the S&P 500 Index, traded at an average of 31 times earnings in 2000. Since then, the earnings of the S&P 500 have increased 50% and at today's valuation represents only 16 times expected earnings.
So to make a direct comparison, a piece of real estate with a 3.0% current income is similar to a $100 share of a stock that trades at 33 times earnings ($100 divided by 3%). That means that, in general, real estate is significantly overvalued relative to stocks.
We do not foresee the real estate prices depreciating dramatically over the near term. We believe real estate values could remain flat for several years while management attempts to raise rental rates to catch up with the recent price appreciation. In the meantime, we see the way to continue to make money in the real estate is market through the stock companies that strategically add value to the real estate market.
We see major home building companies, such as Toll Brothers (TOL), better able than their smaller counterparts to cost effectively put new home communities on the market. Toll Brothers has done a superb job of catering to upscale older home buyers who are willing to pay a premium for their dream home. We also believe companies like American Woodmark (AMWD) and retailer Lowes (LOW) will continue to prosper as improvements add incremental value to properties owned by individuals, families and businesses.