Why Are Condo Prices So Much More Volatile Than House Prices?

I have been searching for investment properties lately and recommending them to investors. Currently I have been focusing mostly on condos and townhomes. Questions I get a lot are, "Why do condo prices fall so much more sharply than house prices?" or, "Aren't they more risky?" The short answer is yes, they are more risky, if one measures risk by price volatility. Classic market theories do equate volatility with risk, however, no one really minds volatility to the upside, only volatility to the downside. I thought I would use this post to explain why I don't mind this volatility and why, at this point in time, I think it is a good thing.

Graphed above is an illustration I drew of real estate market cycles (click on the graph for a bigger version). Please don't draw too many conclusions from the exact size of the peaks and valleys, it is the relative sizes that matter. The left side of the graph is what I believe happens in a normal market cycle. The graph is normalized to a property's value as a rental property based on discounted future rents. A good way to think of these curves is as price/rent curves with the red line being the typical price to rent multiple for apartment buildings. Apartments tend to trade at or around this value, providing the owner with a fair return roughly equal to the market discount rate.

Houses, unsurprisingly, sell at a premium valuation. There are two main reasons for this. 1) Homeowners enjoy significant tax benefits that aren't available to renters and landlords. 2) The freedom to own your own home, not worry about rent increases or the owner deciding to sell, paint and make desired alterations all have a real value to homeowners which is reflected in the premium valuation. High end homes tend to trade at a greater premium due to the higher tax benefits and a relative lack of demand for renting high end homes that do come on the rental market. Most renters aren't willing to pay a lot more because of granite countertops and expensive moldings and wall coverings.

Condos are a bit of a hybrid. Their basic design and amenities are not significantly different from an apartment, but they allow the tax benefits and freedom of personal ownership associated with a house. Condos tend to be purchased by both owner-occupiers and by investor-landlords. In a hot housing market, the marginal buyer of a condo is an owner-occupier who place a premium on those tax benefits and personal freedoms that is similar to the premium places on houses. Many people purchase condos in hot housing markets because they can't afford a house. In a hot market, these buyers bid up condos until they trade near the price/rent multiples found on houses. However, when the market cools, demand tends to dry up for condos first. As demand falls from owner-occupiers, the marginal buyers become the investor-landlords who enjoy fewer tax benefits and place little value on the freedom to decorate and make upgrades. Consequently, in a bear real estate market, condos trade at price/rent ratios similar to apartment buildings. Thus, you can see the condo curve on the graph oscillates between the low tier house curve at the top of the market and the apartment curve at the bottom of the market.

Now, back to that question about risk. Yes, condo prices are more volatile than single family house prices. However, it is important to know where you are in the real estate cycle when you are looking to invest. Right now, the price/rent multiple on many condos and townhomes is at or below the price/rent ratio on similar quality apartment buildings. This signals we are close to the bottom of the bear market in condos. At this point in the cycle, the next leg should be the market recovery and on this leg volatility is your friend. Over the course of the next cycle, which tends to run eight to ten years, condos should appreciate faster than houses as owner-occupiers begin to return to the condo market.

Now, this isn't going to happen overnight, but when buying at current multiples the rents you collect significantly exceed your monthly costs, providing a very good cash flow return on your investment. So you get paid to sit and wait for the eventual recovery.

Price vs. Wages

There was an interesting Wall Street Journal article this week that took a look at real estate prices vs. average wages and concluded that real estate is still expensive. The author shows a graph of average wages from the US Bureau of Labor Statistics graphed against the S&P Case Schiller 10 City Index. The graph shows that price/wage ratios are still higher today than they were at the peak of the last real estate cycle in 1989.

There are a few problems with this analysis. First, national average wages are being compared to prices in the 10 larges cities, when wages in these cities tend to be significantly higher than the national average. Second, this chart doesn't take into account mortgage rates. Real estate, like any asset can be valued by discounting future expected cash flows. When the discount rate is low a higher price is justified. In 1989 mortgage rates were north of 9% and today they are at half that rate. Third, looking at national numbers obscures what is happening in local markets. A better analysis would calculate the price/wage ratio for each city based on each city's average prices and wages.

For San Diego, Prof. Piggington's Almanac for the Landed Poor (a great blog that has been tracking the build-up and burst of the local bubble since 2004) has produced just such a graph found here. As you can see, the local price/wage ratio has declined enough that it is back in the middle of the historic price/wage range, without even taking into account the increased affordability due to low mortgage rates. To adjust for mortgage rates you would want to look at a ratio of wages to the fully ammortized mortgage payment required to buy the average house. Prof. Piggington graphed this as well here. As you can see, on a mortgage payment basis, housing in San Diego is more affordable then it has been since at least the 1970s. Now, I wouldn't expect today's low mortgage rates to persist forever, but even if rates came back to the 6-7% range, homes would remain pretty affordable on a historical basis.

Prof. Piggington author Rick Toscano goes on to graph price/rent, mortgage payment/rent and other ratios in the full post and is an excellent read. Each measure shows that the San Diego market as a whole is no longer in bubble territory. It is important to note that Mr. Toscano and piggington.com are not cheerleaders for the real estate market. The blog was created to point out how horribly overpriced real estate was back in 2004 and recounted the bursting bubble somewhat with glee.

As I've said before, real estate markets are fractured. While the average home sold in San Diego has come down to reasonable levels, there are many segments of the market that have only experienced modest declines (La Jolla, Del Mar, etc) where homes are still extremely pricey by any measure. There are other more modest areas (Oceanside, most of East County, etc) that have cratered to the point where prices are incredibly cheap on distressed properties. The problem is that in many of these communities it can be difficult to get a loan, particularly in multi-unit condo and townhome complexes. That is because banks won't extend loans when a certain percentage of units are non-owner occupied, and in many complexes, half the units are bank owned or owned by investors who purchased them after foreclosures. These properties can only be purchased for cash, but for those with the cash you can get quite a bargain with 10% cap rates and price/annual rent ratios below 6.

More Speculation of a Bottom

A recent article (paid subscription required) published by San Diego Source in The Daily Transcript summarizes a discussion by seven local real estate experts. The consensus was that a bottom is currently forming on the lower end of the market, which re-enforces what I have been seeing. I won't republish the entire article due to copyright issues, but here is a link to the bubbleinfo blog that did republish it if you want to read the whole thing.

These experts further confirm that it is investors who are putting the floor on low end home prices. Mark Goldman, professor of real estate at San Diego State University said, "It’s a great opportunity for first time buyers. But the restrictions are getting so tough that first-time buyers can’t hop in and if they can, they’re being outbid for these by investors -- all cash." Guy Asaro, president of homebuilder McMillin Homes added, “Everyone in the money world recognizes historic opportunity to buy property at below replacement cost. Once this stuff is gone, it won’t be at this price ever again because we can’t replace it at this price whether it’s new or used.”

Obviously Mr. Asaro is a biased source, however, what he says is true. Many homes on the lower pricing tier are selling at far below replacement cost. The laws of economics say this condition simply cannot persist over the long run. For it to persist, houses would have to become an obsolete asset, and I highly doubt that is the case.

How Long Will the Downturn Last?

Of course there is no way to know for certain how long the current real estate downturn will last. Depending on who's opinion you read you may conclude that it will be over tomorrow or it will never end. The truth, no doubt, lies somewhere in between. I like to look at history for clues, and the saying goes, history does not repeat, but it often rhyms. So, several years ago, in anticipation of the coming real estate downturn, I did some research into what has happened in previous downturns. I used data from OFHEO (Office of Federal Housing Enterprise Oversight) and looked at every housing downturn that has happened since they started keeping records in 1975. I graphed the results below. (Please click on the chart to see the whole thing)

As you can see, there have been about a dozen localized real estate busts in the last 35 years prior to the current national bust. In all but a few cases, real estate prices regained previous peaks within about 8 years, the biggest outlier being Houston, which didn't regain its previous peak for almost 15 years after the bursting of the oil-embargo fueled bubble in Houston's oil revenue dependant local economy.

Another thing to remember is that these are nominal prices. Homes were overpriced in most of these markets at previous peaks and so on an inflation adjusted basis most didn't regain previous inflation adjusted peaks until the recent housing bubble caused them to become overpriced once again. Houston has never fully recovered on an inflation adjusted basis.

What does this tell us about the current real estate downturn? I think it tells us not to expect to see 2005 prices again for at least 5 years, which would be 8 years from the peak here in San Diego. I would bet, given the magnitude of the bubble that occured, it may take somewhat longer than average this time around as well. However, another conclusion can be drawn. Looking at any one of the most severe downturns, similar to the current downturn, if you bought a property anywhere near the bottom and held it for 5-8 years, you would have made a very good return on your investment. Even in Houston, which was the slowest to recover, prices appreciated about 23% in the first 5 years of the recovery. If you were able to purchase with 50% down, that would have been a 46% gain on your investment, in addition to the cash flow being collected from rents.

The difficult part, of course, is finding the bottom. In my previous entry, I explained why I think the bottom is at hand in certain segments, but not in others.

Calling the Bottom

Based on evidence I have seen first hand, backed up by recent data, I am calling the bottom on the lower tier homes in San Diego. Since I am looking to invest in properties, I have had screens set up through the MLS listing service that alert me when properties that meet my price criteria in various areas of the county hit the market, or when there is a change to the listing. Comparing the alerts I was receiving 6 months or 3 months ago to today I can see a trend.

Three to six months ago I would receive alerts that properties met my criteria, then a month later, I would see an alert that the price on the same property, still unsold, was being dropped even deeper. Now I never get alerts of price declines. Also, some areas where I used to receive daily alerts of properties listed in my price range I now rarely receive alerts because properties are listing (and selling) for higher prices. El Cajon is one such area. Other areas, such as Oceanside, where I used to receive alerts for properties with prices well below my maximum price points, I still receive alerts, but the prices are now closer to my maximums.

One explanation could be that owners have suddenly started listing their properties at unrealistically high prices and the properties will sit on the market. However, all the data shows an increase in home sales so this is obviously not the case. Instead, it seems that first time home buyers, buoyed by the federal home buyer tax credit and plunging mortgage rates are now stepping up to the plate. Also, many investors are seeing the same opportunities I am seeing and are buying properties.

Here is an AP article that appeared today that helps confirm what I have been seeing. The article is about soaring home sales and plunging prices, but also includes this tidbit:

"However, in a positive sign, seller asking prices are starting to rise in places like San Diego and Orange County, Calif., where declines have been severe, said Lawrence Yun, chief economist for the Realtors. That could be an early indication that prices are stabilizing in the most distressed parts of the country."

Now, I normally take anything said by the Realtors with a grain of salt, but in this case, it confirms what I have been seeing on my own lately.

Also I would like to stress that I believe this is the bottom only on the low to lower-mid range of the market. I think the upper-mid to high end of the market still has a bit further to drop here in San Diego. The Case Schiller tiered index data is only current through December and can be found here as well as graphed below for San Diego. As of December, the data shows the bottom tier was still in a down trend, which I believe is correct. We will need to wait for the January, February and March data to see if prices have actually stabilized.

Glimmer of Hope for Southern California Home Market

I read an interesting article today in the Wall Street Journal (subscription required for some content) titled the same as this post. The main point of the article, for those without access, is that for the first time in 10 months, the median home price in southern California (as measured by MDA Dataquick) did not go down last month. Instead it stayed steady at $250,000, but still down 39% year over year. The article speculates about the market bottoming.

Personally, from everything I have seen, I think the low end of the market has bottomed or is extremely close here in San Diego. In some areas of the county, condo and townhome prices are down over 60% and are now selling for in the area of 6 times annual rent with Cap Rates north of 10%. Sales are up 56% year over year and it is largely these lower end Bank REO properties that are selling, mainly to first time home buyers and investors.

I think the higher end of the market still has some pain ahead. Most people in this segment were able to ride out the earlier market declines and simply pulled their homes off the market rather than cut their asking prices to reasonable levels. As the recession progresses I think you will see more forclosures and forced sales of mid to high end homes.

Welcome

As a Value Investor, I have been taking a great interest lately in the real estate market. Value investors try to buy assets that they expect to generate strong cash flows that are selling for significantly less than the value of those cash flows. The term is usually applied to stock investing, but really can be applied to any asset market, including real estate. With the recent plunge in home values, real estate is becoming attractive to value investors for the first time in a decade.

On this blog, I will point out interesting articles and data as I come across them and write about my thoughts and interpretation of those articles and data. I will look at various markets, but focus on the San Diego market where I live work and invest.