Houses Love Inflation

03/04/11 Laguna Beach, California – Inflation is not the only reason to risk diving back into the housing market, but it may be the best reason.

John Paulson agrees with this logic. Paulson is the hedge fund manager who placed various negative bets on various mortgage-backed securities during 2007 and early 2008. As these securities plummeted in value during the crisis of 2008, Paulson became a multi-billionaire…and a celebrity.

But now that housing has crashed, Paulson likes the other side of this trade. He thinks US houses are a buy. Paulson’s extremely prescient bearish call on housing does not automatically validate his current bullish call, but his opinion probably deserves at least polite consideration.

“Paulson made three big financial calls [late last year] that you need to know about,” The Wall Street Journal’s Brett Arends reported at the time, “First, he said that gold could go to $2,400 an ounce based on the fundamentals – and that momentum could carry it to $4,000 an ounce… Second, he said you should get out of bonds while you can: You’re much better off investing in blue chip stocks with good dividend yields than bonds. And third, he said you should buy a home. Now.”

“If you don’t own a home, buy one,” Paulson said. “If you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home.”

Why would the man say such a thing? In a word: inflation. Paulson anticipates resurgent inflation – not the kind that boosts stock prices and turns mutual fund managers into rock stars, but the kind of inflation that causes the prices of every day goods to soar, and turns homeowners into geniuses.

“Paulson sees inflation coming by 2012 or so,” Arends wrote. “The explanation isn’t hard to find… Put simply: We will get inflation because we have to. It doesn’t get any more straightforward than that. We are the most indebted nation in the history of the world… The debt orgy has been everywhere… There is only one plausible route out of this appalling situation. The government needs inflation. The country needs inflation. That will shrink these debts in relation to the economy, asset prices and incomes.”

Accordingly, when Arends wrote a Journal story entitled, “Ten Reasons to Buy a Home,” he did not neglect to include inflation among his “Ten Reasons.” In light of Bernanke’s QEI, QEII and all the QEs-to-be-named-later, Arends’ other nine reasons seem much less compelling.

His Reason #4 for example, is: “It’ll be yours.”

Hmmm… Is that automatically a good thing? In this respect, isn’t a house somewhat like a spouse? “It’ll be yours” may seem like a great thing when you are “closing escrow,” but only time can render the ultimate verdict.

“A big problem with both houses and spouses as investments is that neither can be counted on to deliver a reliable short-term profit,” we remarked in a 2005 column entitled, Houses and Spouses. “Indeed, a short-term commitment to either a house or a spouse can result in a significant loss of capital.”

Arends’ Reason #10, “Sooner or later, the market will clear,” is also a pretty feeble reason to jump into the market. “Sooner or later” is rarely a solid principal upon which to make a timely investment decision.

Nevertheless, Arends does offer some valid reasons to buy a house:

Reason #1: You can get a good deal. Especially if you play hardball. This is a buyer’s market… We’re four to five years into the biggest housing bust in modern history. And prices have come down a long way – about 30% from their peak, according to Standard & Poor’s Case-Shiller Index.

Reason #2: Mortgages are cheap. You can get a 30-year loan for around 4.8%. What’s not to like? These are the lowest rates on record.

In fact, at one point late last year, 30-year mortgage rates actually fell below the 30-year Treasury yield!

Arends continues:

As recently as two years ago, 30-year mortgage rates were about 6.3%. That drop slashes your monthly repayment by a fifth. If inflation picks up, you won’t see these mortgage rates again in your lifetime. And if we get deflation, and rates fall further, you can refi.

Interestingly, when you combine Reason #1 together with Reason #2, an astonishing picture emerges – a picture of generational-low housing affordability.

No question about it; housing is very cheap, even before considering the impact of inflation, which is considerable. The following chart depicts home prices in inflation-adjusted terms. Specifically, it shows the median home price, expressed as a multiple of per capita disposable income. Based on this calculation, home prices are as low as they have been in 40 years.

But for most homebuyers, the price of the home is only one part of the true cost of a home. Mortgage rates matter as much, or more, than the purchase price itself. To illustrate this phenomenon, examine the chart below. It utilizes the actual, historic 30-year mortgage rates – coincident with historic median home prices – to create a picture of real world housing affordability over the last thirty years. Thus, this chart shows the average monthly mortgage payment on the median-priced home, expressed as a percentage of per capita disposable income.

Again, the picture is unequivocal. Home prices are very, very cheap, relative to incomes. But clearly, “cheap” does not preclude “even cheaper.” Home prices could certainly continue sliding. Even if that occurs, however, mortgage rates might continue rising, which would cause the effective price of a home to increase. Furthermore, no one should be buying a home with an eye toward “flipping it” in a few months. The observations in this column testify to the long-term potential of housing, based on the prevailing depressed prices – not to the short-term potential.

The long-term investment performance of housing relies principally on two inputs – purchase price and inflation rates. Obviously, buying residential real estate at both a housing market low and an inflationary low would be the optimal entry point. And that’s exactly what today’s circumstances seem to be offering.

Inflation is usually very kind to residential real estate, as the chart above illustrates. The top half of the chart displays the inflation-adjusted performance of median home prices, compared to the S&P 500 Index during the hugely inflationary 1970s. Housing trounced stocks during that timeframe.

But once Paul Volcker took the reins at the Federal Reserve and quashed inflation, housing languished relative to stocks. Incredibly, after adjusting for the effects of inflation, home prices have barely budged since 1979!

But even if the housing market does not rebound on cue and even if inflation does not revive for a year or two, the housing market has probably become cheap enough to offer an exceptional hedge against inflation.

Even forgetting inflation, housing is very cheap. Remembering it, housing is cheaper still.

Regards,

Eric J. Fry
for The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial’s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.  Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research —  institutional research products dedicated to international investment opportunities and short selling. 

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry  supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts.  His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

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• May 1, 2012 -- Is It Time to Buy a House?
• April 6, 2012 -- Buy a House!
• January 10, 2011 -- Buy a House… Then Buy Another
• June 19, 2009 -- Trends in the Post-Bubble Era

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