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By Liu-Yue (Louie) Lam, Co-Founder, CEO, & Chief Investment Strategist, Oxstone Capital Management

Recently, many prominent investors have sounded the blue sky alarm on real estate and have even recommended real estate as the best investment to own going forward.  Although I always respect the wisdom of these highly regarded sages of investing, I still remain cautious and use history as a guide.  U.S. real estate market was just recently in the biggest real estate bubble in history.  I still believe the impact of the U.S. real estate bust will be felt for many more years.  Real estate usually goes through very long boom to bust cycles that last anywhere from 8 to 17 years.  Although, I believe we are getting closer to a bottom now than a few years ago, I still believe the U.S. real estate market has another 15% to 20% declines before reaching a final bottom.  Thanks to new policy measures to help distressed home owners as well as the Fed’s continuing to hold interest rates at an all-time low, the free market price discovery mechanism has been delayed time and time again from working its creative destructive magic.  As long as the banking industry is forced to delay the foreclosure process due to political populist support, the real estate market will be delayed in reaching a final bottom.

The current economic recovery is certainly helping banks dig themselves out by continuing to slowly write-off loan losses with profits supported by the generosity of the Fed’s highly accommodative monetary policy.  However, there will still be a day of reckoning ahead as the Fed will have to eventually pull back liquidity as inflation begins to rear its ugly head.  After 2+ years, the Fed cannot continue its accommodative policies indefinitely with inflation already showing up considerably in gasoline prices and food markets.  At the same time, banks will have to eventually recognized real estate losses on legacy loans.  Banks cannot continue its extend and pretend policies forever because U.S. real estate prices will most likely not recover its 2006-07 highs for many more years.  We can use the Japanese real estate boom-bust cycle from 1990 to 2011 as an example.

Here are some of the key factors that make direct real estate investing questionable:

Expansion of Cap Rates

Most G-7 government finances are in serious fiscal disarray.  Recently, S&P even issued a negative credit watch on U.S. sovereign credits.  There are significant repercussions to this very possible negative future event (a credit downgrade in the global benchmark – U.S. Treasuries) that are not yet fully priced into all risky assets.  I cannot imagine the chaos that will occur in the financial markets as all asset classes across the risk spectrum get re-priced if the risk-free benchmark is no longer considered risk-free.  The bottom line is that creditors will begin to demand higher risk premiums to compensate for higher credit risk.  This will also lead to an expansion in cap rates, which will lead to significantly lower real estate valuations.

State and Local Fiscal Woes Lead to Higher Property Taxes

Local and state governments became heavily dependent on property tax revenues during the boom years.  Many local governments even formed their budgets on the faulty assumption that real estate will always go up, and therefore property taxes will continue to go up too.  It appears they may have gotten the last part of the equation correct – property taxes will continue to go up.  You can expect local and state government deficits will lead to higher future property taxes as governments look to raise additional revenues from every possible source.  Higher property taxes will further depress real estate values.

The Impact of Higher Inflation

Inflation will be much higher in the near future as money printing measures by the Fed, the Bank of Japan, the Bank of England, and the ECB are debasing currencies and adding fuel to inflation.  Higher commodities costs will feed into material costs needed for regular capex maintenance and higher energy costs will lead to higher fuel and utility costs.  This will lead to lower net operating income and therefore lower real estate values for many less energy efficient and outdated commercial real estate properties.  In addition, inflation will likely outpace property owners’ ability to pass on the costs to renters in higher rents.

Re-pricing of Commercial Leases

One negative side effect of banks eventually releasing their shadow inventory is the eventual flood of post-foreclosed properties making their way back onto the market.  This will lead to a re-pricing of commercial leases as the newly post-foreclosed properties use their lower cost advantage to cannibalize on surrounding higher cost commercial properties by competing for the limited number of tenants, and offering lower rents to quickly lease up their properties.

U.S. mortgage finance reform the Wild Card

After 40+ years of subsidizing real estate loans, there are now serious discussions on mortgage finance reform.  The U.S. government may no longer make it a part of government policy to directly finance the American dream of home ownership.  The current discussions revolve around eliminating federal guarantees on home loans and privatizing Fannie Mae and Freddie Mac.

The wild card for real estate markets is what will happen once the government stops subsidizing mortgages?  I expect real estate assets will have to re-price for higher risks and lower values in the near future.  Banks will go back to doing traditional risk adjusted portfolio lending rather than just underwriting to offload to government agencies.  In addition, new regulations such as the Dodd-Frank Act will require much tighter underwriting standards.  Both banks and borrowers will be required to have more skin in the game with banks holding on to a higher percentage of the loans they originate and consumers required to put higher down payments, which will all likely lead to lower returns for investors.

Although, there will always be exceptions to the rule and in direct real estate investing there will no doubt be incredible investing opportunities in distressed properties as well as investing in the right location.  Remember, any asset can be a buy at the right price, and any asset can be a sell at the wrong price.  Direct real estate investors should keep in mind some of the key factors mentioned above in formulating their real estate valuations and return expectations going forward.  Any real estate investor expecting to cash out quickly on another real estate boom will be very disappointed and may have to wait for a very long time.

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