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

Landmark Links June 24th – Follow the Money

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Lead Story…. Urban Dictionary (my go to source for all things slang) defines a tiger mom as:

“A mother who is overly strict with her child in order to foster an academically competitive spirit.  This form of upbringing is intended to direct a child towards financially successful careers at the potential risk of feeling emotionally unfulfilled and/or socially inept.”

Just my opinion, but it sounds like a rather terrible way to grow up.  I’ve always assumed that children who were raised in such an environment would be the ones most likely to end up driving the porcelain bus in a dorm bathroom once they go to college and finally obtained their first taste of freedom from overbearing parents.  However, there is a relatively new trend where tiger moms, typically from China are following their children to college to ensure that their offspring’s hard work doesn’t get flushed down the drain in a torrent of booze and late night parties. From The Economist (h/t Jeff Condon):

EVERYONE knows that Chinese students are flooding American campuses. Less widely known is that their mothers are coming, too. Last year 394,669 pupils from China were studying at American universities, secondary and primary schools, the largest contingent of all international students. Increasingly their parents are moving in with them, buying local properties or investing at least $500,000 in businesses to try to qualify for a green card.

The tiger mums usually come to America alone, leaving their husbands behind. “When I wasn’t here, my son would survive on instant noodles and energy drinks for several days without eating fruit or vegetables,” says Wenxue Hu, mother of a masters student studying applied mathematics at the University of Pennsylvania. She gave up her job as a corporate finance director in Shenzhen to cook for him in Philadelphia. Through a local church she met other Chinese tiger mums, most of whom entered with a tourist visa that allows them to stay up to six months each time. New Haven, Connecticut now boasts a “Yale Chinese grandparents’ village”, with 15 residents. The old folk live under the same roof as their children, mostly PhD and post-doctoral students at Yale who are too busy to take care of their own offspring.

On one hand, I suppose this keeps kids more focused on school helps to make good on the massive investment the college represents.  On the other, college is supposed to be the time when young people strike out on their own, make mistakes and learn from them – rather than continuing to live under the thumb of their mothers.  As you can probably imagine, this is having a massive impact on housing markets in markets around top universities.  Again, from The Economist (highlights mine):

Last year China became the largest source of foreign property investment in America, pouring in $28.6 billion. Roughly 70% of inquiries from the Chinese indicated that education was the chief motive, says Matthew Moore, president of the American division of http://www.juwai.com, a Chinese international-property website. In Chicago estate agents anticipate more Chinese parents buying expensive condominiums. In Irvine, California, about 70-80% of buyers of new-builds are Chinese parents whose children attend, or plan to attend, nearby colleges, says Peggy Fong Chen, the CEO of ReMax Omega Irvine. Other college towns such as Los Angeles, Seattle, Boston and Dallas, see a similar trend.

The Irvine statistic surprised me a bit.  Irvine has long been a hot spot for Chinese buyers and much of that demand has been driven by it’s phenomenal schools.  However, I’d always assumed that the demand was driven more by it’s public schools than surrounding colleges such as UC Irvine.  Then again, UCI’s student body is 46.2% Asian and 11.7% international with a student body of around 24,500 undergrads and 5,500 graduates so it’s not hard to see how this could drive demand for housing if there are 3,500 foreign students at UCI and even a small percentage have parents who move with them and buy a home. According to The Economist, buying a house can make good financial sense, as well as  cultural sense for a Chinese investor/parent:

For the rising middle class in China, parking their wealth overseas also makes good business sense. The near-bubble in housing prices at home and the depreciation of the yuan have made them nervous, so diversification becomes pressing. As property prices shoot up in some college towns, more Chinese buyers are drawn in, says Susan Wachter, a real-estate professor at the Wharton School of the University of Pennsylvania. Ownership, rather than renting, becomes more attractive, because their children can rent extra bedrooms to classmates to cover utility and tax bills, while also being able to benefit from future price rises.  Some tiger mums also try to help their children get married by making the down-payment or even meeting the full cost. In Chinese culture, owning a property gives a sense of security and helps to attract a spouse.

Coming out of the Great Recession, there has been no better housing bet than going where the Chinese investors want to be.  If their buying demand is really being dictated by higher education, I would imagine that this is a trend that could continue for quite a while, especially given the ever-rising cost of college at top schools and the growing number of newly-wealthy people in China that can afford it.

Economy

Say What? Every now and then, Jose Canseco emerges from his steroid-induced coma, pulls a needle out of his butt and goes on Twitter to impart his wisdom of all things finance – which I try to cover here whenever possible.  This week our roid-addled friend opined on the Brexit vote and the it was everything that you would expect financial advice from Jose Canseco to be. Update: UK citizens declined Jose’s advice and voted to leave the EU.  Market chaos this morning and Jose declined offers to go on air with both Bloomberg and Yahoo finance because they wouldn’t pay him (I’m not making this up. You NEED to follow him on Twitter). 

The Whole Story: We often hear about how the top 1% of Americans is doing dramatically better than everyone else.  While that is true it misses a larger point: the upper middle class (defined as any household earning $100,000 to $350,000 for a family of three) is growing rapidly as well.  According to a new study from the Urban Institute:

“The size of the upper middle class grew from 12.9 percent of the population in 1979 to 29.4 percent in 2014. In terms of shares of total income, the middle class controlled a bit more than 46 percent of all incomes in 1979, while the upper middle class and rich controlled 30 percent. By 2014, the rich and upper middle class controlled 63 percent of all incomes, while the middle class share had shrunk to 26 percent.”

This goes a long way towards explaining why the luxury segment of the housing market has done so much better than lower segments in recent years.  If you don’t have time to read the full report, the Wall Street Journal put together an excellent summary.

70 is the New 65: According to PIMCO, demographics support rates staying lower for longer.  See Also: The yield curve is nearing its cycle low.

Commercial

Sea Change: Someday we are going to talk about department stores the way that our parents talk about switch board operators.  They are being eaten alive by internet retailers.  Great news for class-A distribution warehouse space.  Not so great news for retail.  I could go on but this chart from Bloomberg tells the story better than I can:

Residential

Non-Starter: When is a starter home not a starter home?  When no one can afford it.  Yes, inventory is extremely low nationwide but in some markets buyers are dropping at a quicker pace than inventory is, leading to softening prices.  From Trulia:

One might think that falling starter home inventory over the past year would cause starter home prices to rise, and for the most part, that’s what has happened in most markets. In places like Portland, Dallas, and Colorado Springs, Colo., large decreases in starter home inventory has led to double-digit increases in starter home prices. However, price movements aren’t just determined by changes in supply (inventory) – they’re also affected by the number of home buyers actively bidding on homes. In fact, in 20 of the 74 markets where starter inventory has dropped, demand has fallen at faster pace and so prices have fallen.

For example, starter home inventory has fallen by about 20% of the past year in both Columbia, S.C., and Charleston, S.C., but starter home prices have actually fallen in these markets by 0.8% and 5%, respectively. And these two cities aren’t outliers – 18 others large metros that have experienced a drop in inventory have also seen price drops, including New York, Kansas City, and Montgomery County-Bucks County-Chester County, Pa.

Don’t get too excited though if you’re a prospective homebuyer.  Trulia found that affordability is still getting worse in many of the hottest markets:

Starter homes continue to experience the largest drops in inventory over the past year, followed closely by trade-up homes. While starter home buyers in California have seen some of the largest decreases in affordability, those in central Florida are non-California metros in the West are starting to feel their pain. But a fall in inventory for trade-up and premium homes is occurring at a time when demand for those homes is rising, so those buyers are feeling a tighter pinch than starter home buyers in markets where demand has fallen enough to keep prices from rising.

 

Profiles

Unintended Consequences: Rule 34 states that: “If it exists, there is porn of it – no exceptions.”  As skeevy and disturbing as that sounds, it’s been scientifically proven to be pretty much true.  There is a corollary to Rule 34 that if you provide free wifi, it will be used to watch porn.  This should be obvious by 2016 unless you are incredibly naive, which the City of NY apparently is.  The city announced an initiative earlier this year to convert former payphones in Times Square to wifi-enabled screens to provide free internet to citizens.  But well-meaning project went horribly wrong when homeless men figured out that they could use the ill-conceived devices to stream porn in public.  For those of you unaware of the history of Times Square, it used to be a haven for peep shows and seedy adult video stores until it was cleaned up back in the 90s, thanks mainly to then-mayor Rudy Giuliani.  From the NY Post (for whom this story was tailor-made):

“I used to come here in the ’70s, and I remember thinking Times Square was as skeezy as you could get, but I was wrong,” said former New Yorker Richard Herzberg, 61, who now lives in Dallas, Texas.

“This is as skeezy as Times Square could get. I mean, in the old days there was plenty of porn, but you could only see it behind closed doors. So at least there was that level of modesty.”

To their credit the city responded by installing filters (which will likely be compromised any day now).  As you can imagine the homeless guys weren’t too happy about losing access to their free porn:

“I was watching porn on one of them things on, like, Saturday,” said a homeless man who identified himself as Hakeem, 44.

“Then on, like, Monday or Tuesday, all of a sudden I couldn’t,” he added.

“Once word got around, it stopped. It sucks, man. It was great.”

Looks like the NYC homeless population will have to find their porn elsewhere for the time being.

Mad Money, Questionable Ethics: Multiple studies have shown that Jim Cramer’s stock picks basically suck and don’t come close to beating the S&P – while taking substantially more risk, yet he continues to use his CNBC show as an infomercial to promote his $59.95/month stock picking service.

Of Buggy Whips and Floppy Disks: Apple is indicating that headphone jacks are on the way out.

Chart of the Day

Growth of Upper Middle Class

 

WTF

I Wonder What He Had For Lunch: A Swedish soccer player was ejected from a game recently for ripping a fart.  I know that soccer players are notorious for being drama queens but this feud between the ref and player over whether it was intentional or not is next level (h/t Tom Farrell):

The referee explained himself. “I perceived it as deliberate provocation,” Kako said, adding that he’d once given a player a yellow for peeing by the field as well. “He did it on purpose and it was inappropriate. Therefore, he received a yellow card.”

Ljungkvist then re-litigated the matter to Aftonbladet, which definitely is a newspaper. “To provoke anyone with a fart is not particularly smart or normal,” he said. “It’s nonsense – I just broke wind and got a red card. I spoke to the referee afterwards, I was annoyed, but there were no bad words. I just said he was a buffoon.”

Follow Friday: Every now and then I stumble across a must-follow Instagram or Twitter account.  City Subway Creatures (@subwaycreatures), an account that posts pictures of the odd folks who ride the NYC subway system is one such account.  Follow them today.  You won’t regret it unless you don’t have a sense of humor or are easily offended – then don’t both.

Indecent Exposure: Meet the inmate who stripped naked and ran into a court room in the middle of a trial to yell: “Court is back in session“!  He is now facing additional charges.

Special Delivery: Meet the Wyoming man who was arrested for going door-to-door selling cocaine and meth. When asked for comment, he replied “it wasn’t going to sell itself.”

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

Visit us at Landmarkcapitaladvisors.com

Landmark Links June 24th – Follow the Money