Cracks In the Foundation

May 2, 2022

Markets are doing strange things. Too much money, chasing too few ideas, in a world where money can be moved easily, is leading to exceptional moves in the financial markets, housing markets, currency markets, debt markets, really any market.

Warren Buffet spent the weekend railing against the ‘casino’ that has been created by policies and practitioners of the markets, but most won’t care a tiny bit about what the man thinks. Regulations allow this activity to continue, participants in markets demand the returns provided by the practices and it seems nobody is getting hurt.

Of course some are getting hurt. Another nugget from the Berkshire Hathaway annual meeting over the weekend is Buffet’s statement that inflation ‘swindles almost everybody’. But there are more getting hurt, but its more death by a thousand cuts.

As most everyone knows, real estate prices are rising rapidly in most first world economies causing average citizens to pay exceptional purchase prices. The pain really hasn’t started yet, but paying that house off will be difficult and take a long time. It will be made worse by rising interest rates. Of course if you rent, then rising rents will impact your spending power for a long time as well, and likely prevent those who rent from saving to purchase a home in the future. Again it robs future opportunity.

But there are cracks in the story about real estate’s never ending rise. The Chinese real estate market has been in the dumps for many months now, and companies like the oft mentioned Evergrande are bumbling along trying to stay solvent. The Chinese government is helping with policy shifts to protect both owners/buyers of property and prop up a variety of real estate behemoths until they can normalize their balance sheets.

In the US real estate is not expected to correct this year as the massive amounts of corporate cash is put to work with these ‘hard’ assets. The difficulty for typical homebuyers who lack the funds for large down payments however will grow more acute as interest rates rise, making affordability difficult later in the year or perhaps in 2023.

Rising rates ARE expected to impact housing markets in places like Canada where price growth has outstripped incomes for a very long time, making home ownership very difficult for people. The young and less affluent seem to get all of the attention, but even those who are successful, well employed and have multiple breadwinners in the family are significantly impacted as well.

Like other asset classes, this narrowing of participation bodes ill for the market in general. A healthy market requires many participants and the housing market is losing participants with every increase in prices.

While the difficulties in the Chinese real estate market offer lessons for other countries, there are few such markers of pain in North American markets. Media is still writing the stories as though the danger signs are big wins. The Globe and Mail recently put up (another) story of ridiculous behavior amongst buyers ‘$705,000 over asking’ (April 26). These stories are trotted out almost weekly. ‘$830,000 over asking’ (April 21), ‘$321,000 over asking’ (April 20), ‘$459,000 over asking’ (April 11).

To put that in perspective, the median household income, pre-tax, in Toronto is about $80,000. The idea that people should celebrate paying 4-10x the median, pre-tax income ABOVE the asking price for a home is a bit sickening. Back to Warren Buffet’s comments, the people turning this into a casino like environment should be ashamed.

The cracks are appearing in the headlines however. It is just a tiny, tiny thing, but a German company has been taken to task over their practices. Adler has been acquiring apartments in Germany at a rapid pace. Apparently they have overstated asset values and are now having trouble recovering money from partners. KPMG has refused to sign off on their financial statements, finding numerous discrepancies and stating that they can’t verify important details. Adler’s shares have tumbled in concert with this revelation and this morning members of the board have offered to resign as a result.

The net effect of this sort of revelation is that there may be a LOT of real estate available on the market at distressed prices in the near future. The company owns 52,000 apartments in Germany.

The likelihood of a similar event happening elsewhere increases as interest rates rise. Again it is hard to see this in North America yet, where (very large) market participants are still swimming in excess cash, but if the bubble pops, elevated asset prices will make the downside risk exceptional.

Finally it is worth noting as you contemplate where to park money while these market events unfold, that real estate is considered an illiquid asset. In this crazy market, homes have been selling in days (particularly in Canada) or weeks (in most major centers in North America).

For comparison, here are some statistics from two very different Canadian markets In Toronto, during the last two ‘down’ markets (2001-2 and 2007-8), it took about 30 days to sell the typical home. That number is now six days. Prince George, BC which is less active, the 2007-2008 ‘down’ market it took 60-80 days to sell a property. Currently it takes less than 40 days.

The cracks in the foundation of asset prices are starting to show everywhere and central banks are currently only TALKING about reigning in liquidity. The effects of those actions will begin in earnest shortly and increase for many quarters. There are likely to be a lot more cracks in that time.

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