Landmark Links July 12th – We Know Nothing

sgt-schultz

Lead Story….  There is an old investment joke about Albert Einstein going to heaven that goes like this:

Einstein dies and goes to heaven only to be informed that his room is not yet ready. “I hope you will not mind waiting in a dormitory. We are very sorry, but it’s the best we can do and you will have to share the room with others” he is told by the doorman.

Einstein says that this is no problem at all and that there is no need to make such a great fuss. So the doorman leads him to the dorm. They enter and Albert is introduced to all of the present inhabitants. “See, Here is your first room mate. He has an IQ of 180!”
“Why that’s wonderful!” Says Albert. “We can discuss mathematics!”

“And here is your second room mate. His IQ is 150!”
“Why that’s wonderful!” Says Albert. “We can discuss physics!”

“And here is your third room mate. His IQ is 100!”
“That Wonderful! We can discuss the latest plays at the theater!”

Just then another man moves out to capture Albert’s hand and shake it. “I’m your last room mate and I’m sorry, but my IQ is only 80.”
Albert smiles back at him and says, “So, where do you think interest rates are headed?”

Believe it or not, there was a time that it was considered foolish to speculate as to the future direction of interest rates.  For better or worse, that time has clearly passed.  On a personal level I try to avoid interest rate projections whenever possible and nothing loses my attention quicker than a one sided statement like “interest rates have nowhere to go but up,”  which we’ve been inundated with for several years.  Why?  Simple: I HAVE NO IDEA WHERE INTEREST RATES ARE HEADED AND NEITHER DO YOU, so let’s not waste time on  something that’s complex to the level of being unknowable.  My preference is to look at interest rates (especially at the long end of the yield curve) as an indicator that tells us about the economy as opposed to something that fluctuates based on the whims of where economists, consultants, finance bloggers or even the Federal Reserve think that they ought to go.

Two weeks ago, I read a post on John Burns Real Estate Consulting’s typically-excellent Building Market Intelligence blog that suggested that finished lots could be substantially overvalued – as much as 26%!  The post is relatively short so I’ll post the entire thing here:

In 2013, finished lot values (shown in navy blue below) spiked back to mid-2005 values. Since then they have climbed modestly. Today’s low mortgage rates support the high lot values, but lots are 26% overpriced if rates were to rise back to a long-term norm of 6.0%.

BFLVI2

Methodology

To help our clients assess housing cycle risk, we calculate intrinsic finished lot values in 24 markets around the country and intrinsic home values in approximately 100 additional markets. Intrinsic values are those one would expect over a very long period. We assume that 6% is the normal mortgage rate over a long period like this. (6.45% is the median rate over the last 25 years.)

Valuation

Today’s finished lot values make sense in the current 4% mortgage rate environment (red line above) but won’t make sense if rates rise to 6% (green line above). Most home buyers are highly sensitive to mortgage rates, which is why the difference is so dramatic. The intrinsic valuations vary widely by market, too, with Dallas’s finished lots the most overvalued market in the country and Charlotte’s the most undervalued.

Conclusions

Our analysis, which includes interviewing brokers and running cash flows, concludes that finished lots are 3% underpriced nationally as long as rates remain where they are. If rates rise to 6%, finished lots would be overpriced by 26%. Our research subscribers get the detail for each market and the methodology.

Any regular reader of this blog knows that I have nothing but the utmost respect for the JBREC team and link to their posts regularly but I have some real issues with this analysis, not because they chose to apply a higher interest rate to stress land values but rather because I believe the methodology that they used to be flawed for several reasons:

  1. Flawed Scenario Analysis: I have absolutely no issue with scenario analysis and actually favor it as a means of establishing a range of values where variables can not be pinpointed.  We use it in almost every underwriting that we do.  However, they only ran one scenario here: rates rising.  What if rates fall?  Brexit, anyone?  Then what happens?  I would assume that finish lots would be undervalued if they did fall?
  2. Counterfactual: The Burns Intrinsic Finished Lot Value Index is based on a conterfactual.  In that regard, they are trying to take a condition that currently doesn’t exist in the market, change one variable and reach a conclusion based solely on that variable.  This may work great in a laboratory environment but doesn’t work so well when interest rates are completely intertwined with all other facets of the economy.  When it comes to finance, counterfacutals are challenging because they are garbage-in-garbage-out and you can make them say almost anything.  Want to make something look overpriced?  Just change an input and voila, you’ve just come up with a bear thesis.  Same thing goes for showing that an asset is undervalued.  In this case, the index is using a historic average that isn’t applicable to today’s economic conditions and then applying it across the board. Which leads us to my biggest beef:
  3. Oversimplification: The entire analysis is an exercise in oversimplification.  In their index, JBREC is implying that, since rates have averaged 6%+ over the past 25 years that they will return to that level.  At the time that the JBREC post was written, the 30-year mortgage rate was 3.56% (it’s substantially lower today).  That means that mortgage rates would need to rise 69% to get back to 6%, which, while steep is clearly not outside the realm of possibility – IF we have substantial economic growth. The problem that I have is that the index doesn’t take into account the economic conditions over the past 25 years that allowed for mortgage interest rates to average 6%.  The economy drives long-term rates, not the other way around.  Income and GDP growth would both need to be substantially higher as would the labor force participation rate (which is largely driven by demographics).  If these conditions were present, it would lead to the long end of the yield curve (upon which mortgages are typically priced) to rise – which could lead to 6% (or greater) mortgage rates due to inflation, which is currently nowhere to be found.  However, rising incomes would help to blunt the impact of rising interest rates when it comes to home, and by extension land affordability.  In other words, it’s fine to increase the assumed mortgage rate but only if you adjust the other complex economic variables necessary to achieve that rate, which constitute a far more complex analysis.  Otherwise you end up with a scenario that won’t happen because it can’t happen: interest rates do not function in a vacuum.  They don’t typically rise 69% without a substantial increase in inflation, meaning that 6% mortgage rates would not result in lots that are 26% overpriced because incomes would be rising as well.  It doesn’t appear from the JBREC post that they took income growth commensurate with that type of increase in long term rates into account.

Are lots overpriced today?  Perhaps they are but it has more to do with increased regulatory and development/construction costs and fees outpacing the rate of home price inflation than it does about mortgages being hypothetically 69% higher.  The reality of the current world economy is that deflation is everywhere, a VERY different dynamic from previous periods of economic expansion.  Negative interest rates are no longer a text book hypothetical and are becoming more prevalent around the world. For example, Switzerland’s bonds now yield negative all of the way out to 50-years. Former Treasury Secretary Larry Summers wrote an excellent op-ed in the Washington Post last week outlining four take-aways from today’s incredibly low interest rates that provide a bit more background as to why I have issues with JBREC’s index (highlights are mine):

First, with differences between countries, neutral real interest rates are likely close to zero going forward. Think about the U.S., where growth has been relatively robust by recent standards. Growth has averaged little more than potential for the last one, three or five years while the real Federal funds rate has been about -1 percent.  There is no good reason to think given sluggish investment expectations that the neutral rate will rise to be significantly positive in the foreseeable future. The situation is worse in other countries with more structural issues and slower labor-force growth. Substantial continued reductions in Fed estimates of the real neutral rate lie ahead.

Second, as counterintuitive as it is to central bankers who came of age when the inflation of the 1970s defined the central banking challenge, our problem today is insufficient inflation. In the U.S., Europe and Japan, markets are now expecting inflation that is below target even with full employment over the next 10 years. This is despite a 70 percent rise in the price of oil. Evidence from markets and some surveys suggests that inflation expectations are becoming unhinged to the downside. The policy challenge with respect to credibility is exactly the opposite of what it has been historically — it is to convince people that prices will rise at target rates in the future.  This is likely to require some combination of very tight markets and mechanisms that give confidence that during the best times, inflation will be allowed to exceed target levels so that over the long term, they can average target levels.

Third, in a world where interest rates over horizons of more than a generation are far lower than even pessimistic projections of growth, traditional thinking about debt sustainability needs to be discarded.  In the U.S., the U.K., the Euro area and Japan, the real cost of even 30-year debt will be negative or negligible if inflation targets are achieved. Indeed, the conditions Brad DeLong and I setout in 2012 for expansionary fiscal policy to pay for itself are much more easily satisfied today than they were at that time.

Fourth, the traditional suite of structural policies to promote flexibility are not especially likely to be successful in the current environment, though some structural policy approaches such as removal of restrictions on investment are still desirable.  Indeed, in the presence of chronic excess supply, structural reform has the risk of spurring disinflation rather than contributing to a necessary increase in inflation.  There is, in fact, a case for strengthening entitlement benefits so as to promote current demand. The key point is that the traditional OECD-type recommendations cannot be right as both a response to inflationary pressures and deflationary pressures. They were more right historically than they are today.

What I like about the Summers analysis is that it looks as interest rates as a barometer of the economy and inflation (or disinflation in this case) rather than try to predict their future trajectory.  So when will we see inflation (leading to an increase in long-term rates)?  At risk of sounding like I’m making a projection – after trashing the practice for several paragraphs – it will be when we stop hearing the constant refrain of investors “searching for yield.”  In an environment where there is strong real economic growth, fixed income investments are less attractive because inflation eats away at returns and investors turn to growth strategies as a way to benefit from said inflation.  I have no clue when/if this will occur but you can be certain that it will coincide with robust real economic growth that could make the JBREC index assumption of 6% mortgage rates a reality once again.

Economy: Recent non-farm payroll reports have looked as if they were pulled from a random number generator. Barry Ritholtz of The Big Picture is spot on in explaining why no one individual NFP report should be taken too seriously (but the trend should be):

The month’s data for June 2016 was a very robust 287,000 following last month’s very punk 38,000 for May 2016. The unemployment rate ticked up 0.2 to 4.9 percent in June — offsetting the drop last month by the same amount. The phrase “Assume its noise” should be foremost in your thoughts as you read the BLS release.

Also, those 35,000 striking Verizon workers muddied the water both months, but if you have the a PhD. in applied mathematics, you might be able to perform the arithmetic functions of ADD 35,000 to MAY and SUBTRACT 35,000 to June — it should not throw you too much.

Let me remind readers (again) that the monthly employment situation report has a margin of error of 100,000 jobs. So last month could very likely have been as high as 173k (38 + 35 + 100) and this months could very likely be as low as 152k (287 – 35 – 100). If you understand this simple math, you should be able to understand why I insist on noting the actual BLS official monthly number ain’t all that.

Everything Old is New Again: Forget about the Brexit.  Graphic Detail, The Economist’s excellent infographic blog gives us a closer look at the Amexit (h/t Elizabeth DeWitt):

Commercial 

Ejected: Mall owners are pushing out department stores in favor of specialty retailers.  See Also: How malls can survive in the age of Amazon.

Profiles

Fad: Hipsters with nothing better to do are obsessed with new “augmented reality” game Pokemon Go where they search for Pokemon characters in the real  world. Nintendo, which created the game saw it’s stock surge nearly 25% on Monday adding a cool $7.5 BILLION to it’s market capitalization on a day when there was virtually no other news that would have moved the stock.  However criminals are taking advantage of players as easy marks and one player in Wyoming found a human corpse while searching for a Pokemon.  IMO, this is the lamest thing since adults were collecting Beanie Babies for hundreds of dollars.  That being said, anything that led to this meme can’t be all that bad:

Chart of the Day

WTF

Assault with Extra Pepperoni : A North Carolina couple is facing charges after assaulting each other with pizza rolls.  Whoever said a picture is worth a thousand words clearly had the two mug shots in this article in mind (h/t Bhavani Vajrakarur).

Walk of Shame: An intoxicated thief in Tennessee was caught in bed with a scantily clad mannequin that he stole from a Hustler store.  He claimed that he thought it was a Pokemon.

LOL: Women are using Tinder to con desperate men into doing chores because guys are complete suckers if we think there is even a slight chance of getting laid.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links July 12th – We Know Nothing

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