Coronavirus and Real Estate – First Impressions
Friday February 21st, was the last day before the market meltdown. On that Friday the Dow Jones industrials closed a little under 29,000. The following Monday the markets closed down 1,000 points. Tuesday, another 1,000 point drop. Wednesday gave us a reprieve and Thursday we were hit with another large loss. By Friday the 28th, the market was down almost 5,000 points. The Feds immediate response was to drastically lower rates.
For the last 6 months to 1 year, I had been considering refinancing from 23 yrs left on my 30 year loan to a 15 years loan. During that first week of market turmoil I locked in on a very favorable rate, making lemonade from the lemons. At the same time, I was running valuations on income property with a associate who was also an expert in the field of income property. On Friday March 6th, two weeks into the market meltdown, it was our conclusion that the Coronavirus would be a net positive for Real Estate. Lower interest rates would help Real Estate overall. Two weeks later, both of us no longer feel that way. The Coronavirus will negatively impact Real Estate, but by how much?
Anecdotal & Emotional Reaction
This week I stopped into to speak with my escrow officer. She mentioned that within the office there are usually about 200 open escrows. I asked how the coronavirus has affected their business. She said, “There has been an issue with one buyer quarantined, so they couldn’t close, one buyer who couldn’t get their employer to verify income, and one buyer that “May” have cancelled because of Coronavirus, but they may have canceled anyway”. She further stated that “There certainly were some nervous buyers, but all have been proceeding with closing escrow”. So from my minimal investigation, I don’t see the coronavirus hurting the market immediately.
Going forward what might happen
As I mentioned my apartment expert associate and I both agree that overall the net effect will not be positive, but how much might the market be negatively affected? To start with some type of hypothesis lets look at three things, Interest Rates, Buyers Incomes, Other Investment Opportunities and Property Valuations.
Interest Rates
As I mentioned previously if the only fall out from the Coronavirus was lower interest rates, then that would be a net positive. While rates did immediately bounce below the premarket crash rate 3.75%, rates have now gone higer to about 4.0% for a 30 year fixed rate. Going forward I expect rates to drop, as bond yields have dropped. Plus I think that over the next year the Fed will continue to provide massive liquidity to the financial market, as it is pretty much the only tool they have. So I will say that rates will be net neutral to slightly positive going forward for the Real Estate market.
Buyers Incomes
It doesn’t take a rocket scientist to see that many businesses are temporarily shutting down. This year may be a bust for many buyers incomes and their resultant ability to qualify for a loan. Yes, most will not loose their jobs, but some will. Plus buying a home is not just about your current income, but about your confidence in the future, which may be shaken. This will certainly produce a net negative.
Desire to Own a Home
Strangely, being held up at home doesn’t really bother me. The desire to interact less with people and go out as often doesn’t really bother me much. Why? Because I am completely content hanging at home, making nice home cooked meals and enjoying my back yard and taking the dog out for a run in the fresh air. Having a home gives me great piece of mind, knowing that if I am shut it, it is at least in a place that I enjoy. We may actually see less homes on the market because of this, so less supply might balance out buyers with less purchasing capacity. This might be a net positive.
Other Investment Alternatives
Four weeks into the meltdown the Dow is down from 29,000 to bouncing off 20,000. Down almost 30%. However, I will say that a majority of this drop is due to a market that was fundamentally overvalued. When stocks go up in price due to multiple expansion and hit record high valuations, and when 80% of new issues don’t have any earning and everybody is riding a wave of euphoria which drives Tesla from 200 to 900 and then back to 300, then the market is ripe for a fall. There has been much commentary that we are in an “Everything Bubble”. If it were not for the coronavirus, the market was ripe for a fall and another pin would have appeared.
Now that the stocks are more tasty, might this cause some money to flow away from real estate towards stocks? One one hand some might say yes since there are better valuations now, but technically even at today’s prices stocks remain richly valued. Might this recent crash scare away potential buyers? Overall, I see drop in the stock market a net neutral with regards to how it affects real estate prices. Some buyers might reach for safely and predictability of real estate, other buyers may feel newly poor and pull back on all investment decisions.
Searching for Yield
The overriding need of most investors in today’s market has been investments that generate some type of yield. As baby boomers enter retirement, they have a huge need for income. The typical Cap Rates (Net Cash Flow) for Los Angeles income properties has been around 3-4%. Nothing too exciting, but when coupled with the fact that this 3-4% is likely to be coupled with 3% property appreciation it blows away the alternative of a 1% or 2% bond. Financial markets maybe more about a good place to hid, rather than huge gains going forward and Real Estate may be exactly this safe haven, while still returning some cash flow. Lower yields and a fragile stock market should likely produce a net positive for Real Estate going forward.
Current Real Estate Valuations – How Fragile is the Real Estate Market?
This is probably the biggest positive for Real Estate prices being stable going forward. Over the last several years I have written that home prices are essentially at fair market value. My metric for valuation is simple. Take the average home in the 90808, 90815 zip code, which is a $750,000, 3 bedroom 2 bath home with about 1,600sf. Put down 10% on this home at current interest rates and then compare the total payment to the rent. Right now this medium home would have an all in payment of around 4,100-4,200. To compare this payment to rent, multiply the payment by 75% which takes into consideration the tax advantages of home ownership. Rent for this home would be in $3,100 – $3,200, which is very comparable to the payment times 75%. Why is this number important?
In 1990 and 2006, using this metric, I had home valuations 25% and 40% overvalued. Both of these years represented market tops and prices dropped significantly going forward for 5 years into the market bottoms of 1995 and 2011. Homes now, are not fundamentally overvalued, as long as interest rates stay low.
I will reiterate what I have said many times before, homes values will take a hit if interest rates rise. For every 1% increase in rates, a buyers payment goes up by 10%. If rates were to go up 2% then homes might be 20% overvalued. Going forward, I see interest rates potentially a net positive. Rates are right around 4%. It is likely that they will stay there or be slightly lower during the next year.
Summary
After I look at all of the pros and cons listed above. The only major con that will overwhelm the Real Estate market will be buyers loosing their jobs and not having a steady income. This will happen if jobs and industry have to shut down for more than 2 months. If this is just a 2-3 month slowdown in production, then deferred demand will come back after the dust settles. This happened after Sept 11, 2001. People were glued to their televisions for several months. After the news repeated itself and people got bored with the news, December, which is traditionally very slow was gangbusters.
So then the question is….. Will the coronavirus be somewhat contained in the next 2-3 months and can all get back to work? Or will it be a prolonged 12-18 month issue? If we can get back to work after a 2 month assessment, all should be well. If this extends beyond 3 months, we may see the market soften into 2021. But as we speak buyers are not walking away from their escrows and I think I just lost out on a deal for my buyer competing against 5 other offers, even though we bid $42,000 over list. So coronavirus be damned, people are still buying homes.