The Ignorant Investor

Reading the New York Times business section today, I came across the statistic that total returns on REITs have averaged around 20% annually over the last five years. Those are massively impressive gains, and it's worth looking at what's driving them.

Now mentally you have to take yourself all the way back to the year 2000. You think about what homes were built of then (wood, mostly), and you think about where they were built (small plots of cleared land), and you ask yourself: what's changed in this product since then? We haven't seen any great technological improvements in house construction. A house in 2005 is pretty much built the same way as a house in 2000, or, for that matter, as a house in 1985. Walls, a roof, a front door. Bedrooms, a kitchen, bathrooms. Same old, same old. Compare that with the changes in information technology that drove the stock market boom in the late '90s; bubble it may have been, but underneath it was a fundamental change in the way business worked.

So if the technology of home construction didn't change, perhaps this boom is driven by a lack of inventory? No, it doesn't seem like it. As far as I remember, back in 2000 people there weren't too many people wandering homeless across the landscape or living in tents. If we look at rentals, today they're still about where they were 5 years ago, so housing as a whole can't be undergoing some kind of shortage. From the standpoint of having a roof over your head, there's no difference between a roof you own and one you don't. A housing shortage would lead to both skyrocketing home prices and rents. So the rise in home prices can't have been caused by a desperate need to secure shelter.

Instead, I'd say that booming home sales are being driven by the mere desire to own one's home rather than rent it, a desire that appears to be fueled not only by cheap credit and tax breaks (besides the deduction for mortgage interest, within generous limits capital gains from a home's sale aren't taxed at all), but by the expectation that the investment in a home results in a significant short term gain. After all, for the many people in this country who expect to 'trade up' homes every few years, the expectation of gain over the long term can't be a factor in their decision making.

What this indicates to me, even in my ignorance, is that expectations have been built into the market that cannot be sustained. Credit is not always cheap, capital gains are often a wish, and the expectation of rising values is merely psychological. Kick anyone of these props out from under home prices, and the other two will fall in turn.