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How to know when to buy real estate – an investor’s approach.

If you’re looking to hit a home run on any investment, the best time to buy or sell is when nobody else wants to do it.  That’s usually when valuations are most distorted from long-term averages—the concept of fundamentals is just a figment of economists’ imaginations.  Today in early 2011, we’ve gone about four years out from the real estate market peak in early 2007.  Most people have vivid seven year memories of major historical events.  After that, even painful memories start to fade, e.g. 9/11.  So, by 2014, we should be in the midst of a resurgent housing market again.

This time line is marginally impacted by recent Federal stimulus programs which have tried to artificially prop up the real estate market.  While they’ve just delayed the inevitable full correction, which appears to be occurring now, I’m betting that we’re within 6-12 months of the bottom, mostly because it’s so unfashionable today to be a real estate bull.  Beyond this, you can always point to more pragmatic reasons like diminishing supply of quality products from record low new home starts, investors absorbing inventory, and increased global demand.  The overhang of “shadow inventory” homes are mostly lower quality properties in non-prime locations like exurbs which may not recover for another decade.  Those are not going to affect prices of good homes in prime urban areas.

On the other hand, if you’re just looking for a smaller, quicker gain on your investment, then the best time is to go with the herd when the direction is powerful and obvious.  Real estate doesn’t lend itself well to that type of trading, given the high transaction costs, but it’s less risky and some people manage to do it.  In that case, today is not a good time since we’re more likely at an inflection point in prices.

As for the commonly cited reason to buy now—low interest rates—the reality is that interest rates really don’t matter.  Today’s prices reflect the historically low interest rates.  If rates went up as many agents suggest, prices would rationally soften or drop to adjust for affordability.  In that case, the prices would be even better with higher rates.  We saw that occur as rates rose in the 80s and the reverse as rates dropped in the 2000s.  Prices went up as rates went down.  I’m betting that rates will stay low for another year before gyrating up and down.  Do not let the seemingly low rates lull you into the fallacy that rates can never go any lower.  It actually can go lower in the long-tail event that this country continues to be savers, even though some people would bet their lives against it.

The other reason to buy is the prospect of inflation as real estate is a great hedge against high inflation.  The current inflationary environment appears to be driven by increasing commodity prices globally.  So, while our Federal Reserve prints more money to respond to our prior debt driven consumption binge, our inflation rates doesn’t have to go up.  In fact, if our internal rate of growth continues to lag the growth in the supply of available labor, we will more likely have lower inflation rates as more people compete for fewer jobs and have less to spend.

We saw a variation of that when our savings rate increased for the last few years to deleverage our earlier debts.  Those savings have competed to create today’s low insured rates of return in interest and inflation stayed low with local demand still in balance with supply.  The upshot of all the savings is possibly a more sustainable economy.  If we return to our profligate ways, however, then interest rates and inflation will both shoot up as we accelerate towards sovereign insolvency.  So, if you’re betting on Americans returning to their old habits, then today is a good time to buy real estate.

Michael Cheng