— Warren Buffett
This quote by Warren Buffett speaks to his contrarian approach to investing. In general his successes came not by investing in divas of the stock market, but businesses that were either going through hard times or just being underappreciated. Today you’re starting to see a “cheery consensus” evolve in the housing market.
In the fall of 2011 companies such as USG Corp. (USG) (sheetrock producer) were being valued at as little as $700 million. Today the company is valued at over $3 billion. Has anything changed in the last year and a half to justify the correction? USG will still be losing a lot of money in 2012 and as the CEO noted in a conference call, the business will break even when the housing market is churning out about 1 million housing starts – a number we have yet to hit.
Housing has certainly turned the corner, but given the cyclical nature of the housing market, was that so hard to predict? Even at $3 billion I wouldn’t describe USG being priced excessively high. I, like the rest of Wall Street, am also cheery about housing. The economic fundamentals of housing are pointing to a dramatic rebound. We have a combination of artificially robust demand, an inadequate supply of houses and attractive pricing for houses.
I say artificial demand because the Fed has been aggressive in bringing down the cost of home ownership. Mortgage rates have teetered around 3.5%. Let me just reiterate, ordinary consumers can borrow for 30 years at 3.5% and that’s simple interest, not compound.
These rates are obviously fleeting. Say rates were to move to 6% tomorrow. You would see monthly mortgage payments increase more than 30%. Though the Fed will likely keep this easy money going for some time you should be cognizant that when it happens, it will have a negative impact on housing demand.
The second point I mentioned was an inadequate supply and in this respect, I’m speaking about regions such as California and others states that do not have judicial foreclosure such as Florida. Judicial foreclosures slow the process of removing defaulting mortgagors. I’ve been investing in real estate in Stockton, Calif., formerly the foreclosure capital of the U.S. Nowadays if you can get your hands on a foreclosure you would be very lucky. The foreclosures in Stockton, like elsewhere in the nation, are drying up and short-sales are moving with haste. Below is an MLS chart showing sales in the San Joaquin County as a whole in which Stockton is located:
The Gurufocus side bar crops out the part to the right, but "for sale" listings continues its decline through 2012
Combine this low inventory of housing with low prices and the cheapest financing in 40 years, and you have a recipe for bidding wars on houses. Regions such as San Diego, the San Francisco bay area and Stockton are all seeing highly competitive housing markets. Another factor further complicating the dilemma of low inventory and sales are the appraisers. I have nothing against appraisers, just their approach to valuing assets. Appraisers don’t appraise intrinsic value — they appraise based on what’s been selling.
Suppose a four-bedroom, two-bath house with 1,500 square feet sells for $300,000 as many did in Stockton in 2006. Now suppose a near-identical property was listed for $270,000. The appraiser will likely appraise it higher and the bank will close the deal. Fast forward to 2012 and suppose that same house sells for $109,000. Six months later an identical property is being offered for $135,000 and I offer that price. The appraiser does their analysis and concludes that the property is only worth $125,000. Consequently the bank refuses to lend on the $135,000 and the deal falls through the cracks.
Why was I willing to pay so much more? Because it’s worth even more than the asking price. I wrote in a column last year about an investment property I picked up for $109,000 and expected a 20% return on equity (pre-income tax). It has since exceeded that figure when you include house price appreciation. With a similar house being offered at $135,000 you would still be able to earn a return on equity in the low teens in addition to any house price appreciation. As sheetrock prices, lumber prices, land prices and other material costs increase the cost to build a house goes up with it (never mind permit costs at $50,000 which the City of Stockton charges just to build a single family house).
In summary, today’s prices are still very attractive in many regions, and this rounds out my third point. The Blackstone Group is also in agreement with me on this one. The private equity firm announced it would be steering capital towards real estate in the greater northern California region in addition to Riverside and other inland California regions. Though they withheld disclosing what cities in northern California, I would imagine both Stockton and Sacramento are cities they’re active in. However, as Wall Street and other investors crowd out investing in rental properties, rental rates will come down.
If you take a tour of any neighborhood in Stockton today you will see “For Rent” signs everywhere, sometimes on every other unit, if they are duplexes. Six year ago it would’ve been “For Sale” signs. Even though it is a negative for my profits it is a positive for the roughed up city. As rents come down so does the cost of living in the city, and this should beget better economic times for this bankrupt town.
As the three-year timeout for mortgagors who went the short-sale route lapses, you will see even more buyers coming into the housing market. That’s likely why the Blackstone Group says there’s a two-year window to buy residential real estate. If you’re not betting on housing you better not be betting against it.
Disclosure: Long USG