Are foreigners buying up the American Dream?

We have seen the stories about large pension investors and  private equity getting into the business of buying up SFRs  to fix them up, rent them out and then sell them off for a large profit once the market recovers.  With the strong rental market and the recent uptick in housing prices, this would appear to be a winning strategy, at least so far.  However, once the herd gets a whiff of short-term success, money starts crowding into the market chasing these higher yields.  This results in more competition driving up prices on an ever shrinking pool of “distressed” housing and making the returns that the early entrants enjoyed, harder to find.

Now we can add the foreign buyer, who is not only chasing higher yields, but as the WSJ points out, is also trying to take advantage of favorable foreign exchange rates.  With this new development, investors who are looking to buy SFRs not only need to beware of the institutional yield chasers but the ForEx speculators.

This does not bode well for a sustained housing recovery because both the institutional investors and foreign buyers are treating SFRs as commodities that can be traded for yield or ForEx gains, much like they did when they were packaging and selling off subprime mortgages.  However, owning and operating SFRs for rent is an inherently inefficient business model for institutions because it requires too many levels of administration from the money manager, to the asset manager all the way down to the local mom & pop property manager whose job it is to collect the rent, mow the lawns and unclog the toilets when the tenants call.  As with subprime lenders, once you are done paying the fees to all of these service providers, there is not a whole lot of yield left for the investors.  When the initial wave of fast home appreciation fades and the yields no longer justify all of the fees being incurred to operate the homes, it is reasonable to expect that the money will leave this new cottage industry as fast as it entered. . . and then where will home prices go?

Risk Still Present in the Market

In an interview with the WSJ, housing guru and creator of the S&P/Case-Shiller Housing Index Robert Shiller states that despite recent improvements in housing prices, risk still remains in the market.  While Shiller sees upward momentum, he is not ready to say the market has bottomed out.  He does not see much enthusiasm in the market and has concerns regarding the impact of the high level of government support for housing (i.e. low interest rates and the government backing almost 90% of all mortgage originations through Fannie & Freddie).  While one could say he is cautiously optimistic, he attributes much of the recent price spikes in some indexes to a slowdown in foreclosures and some markets overshooting on the downside.  In conclusion, he sees today as an “OK” time to buy a house as most homes appear to be fairly priced and mortgage rates are near historic lows.  He is predicting modest price appreciation more in line with historic norms of 1% – 2% per year.  If you are buying a home to live in, now is still a good time to buy but if you are buying a home strictly as an investment, you will want to be careful.

Is another bubble starting to form?

As housing inventory continues to drop and sales continue to increase, we are beginning to see annual home price appreciation approach double digits in select markets. While it is exciting for those thinking of selling their homes to hear stories of new listings getting bid up over list price and being put into escrow within days of going on the market, we are reminded that this is not necessarily evidence of a sustained and healthy market recovery. As reported in Investors Business Daily on February 14, 2013, this may instead be a sign of another bubble forming within the larger housing market.

Buyers should beware that data showing signifcant year over year price increases may be indicative of substantial activity from investors and flippers.

Over the past 18 to 24 months, investors have been snapping up foreclosures at liquidation prices, fixing them up and then reselling them.  However, most home price indexes don’t take into account the renovation costs.  For example, if an investor purchases a home out of foreclosure 12 months ago for $150,000, invests $50,000 to fix it up and then sells it for $230,000. This will show up in the local market statistics as a 53% increase even though almost 2/3 of the appreciation was due to the improvements. It only takes a few foreclosure flips in a local market to skew the averages and make price appreciation in that market appear much higher than it truly is. As such, both buyers and sellers need to be aware of what data is behind the statistics before buying into significant price increases in a local market.