May 3, 2023

Many of my recent posts have been pessimistic in nature about the current state of the local Denver and Colorado Real Estate markets.  Prices are declining, and the prices, both in real (accounting for inflation and interest rates) and nominal terms are higher than they have ever been in history.  

It’s been a bit of a falling knife right now with housing.  If you try to catch it, you may get the handle, but you may cut yourself.  We’ve got prices declining, and we may be in the early innings of this price deflation story, yet at the same time, we have borrowing costs that have skyrocketed (although in full disclosure we have settled into a tighter range for mortgage rates in the mid 6%s now that the Federal Reserve has signaled they are very close to be doing with their rate hiking).  

Who would want to try to catch a falling knife?  

It’s certainly a volatile time right now to be buying, but there are some points to consider for still making the “bull case” (i.e .bull market, opposite of bear market- financial terms) for buying right now, or investing in real estate.  

1. Inflation is still very high

Inflation is still persistently elevated, with the most recent CPI data still over a 5% year over year inflation rate.  While the prices of homes are down in general at 10-15% y-o-y, the real cost to own a house has risen dramatically, since the mortgage rates from last year are much higher.  We may see prices continue to decline while rates may trend higher.  That means a well-bought house today at 6.5% 30 yr FRM could prove to be cheaper than waiting for a lower priced house later at a higher interest rate.  

Owning vs Renting

Rent inflation is very high, especially on certain types of properties.  If you are renting, and the rent is very expensive, and you are a qualified buyer who could purchase an equivalent property at the same or better payment, then it certainly is worth still considering to buy now and lock in that rate.  Rent inflation may remain elevated with our housing shortage, especially in the single family home space.  

Security

When you are renting, your landlord could potentially either jack your rent, or present you with a notice to vacate at almost any time since leases are typically only a year.  This goes back to the “short duration” risk I spoke about in my last post.  

Real Assets

Asset prices in general have come down, including Real Estate but also including financial assets.  If you are fortunate to have built a portfolio of financial assets, you no doubt understand the importance of diversification.  Real or hard assets are considered by some to be an important part of any portfolio.  If you have all your money in stocks or bonds, using some of the funds for a down payment on a primary residence is prudent, both as a place to live, and as a real asset.  Obviously real property over the long term will always go up in dollar terms in the Denver area.  We live in a big and desirable metro area where we will always struggle to have enough supply for everyone who wants to live here, especially again, in the single family home category, and especially in the A rated cities, towns, and neighborhoods.  

2. Hyperinflation and the Federal Reserve Pivot

There are some who feel that as the US enters recession here, the Federal Reserve will pivot and lower borrowing costs again.  The political powers that be certainly do not want to be in a bad recession when the next election cycle comes around in Fall 2024.  If a pivot occurs before unemployment has really taken over (bad unemployment is a hallmark of bad recession) then people will still have cash flow to service debt, and also the ability to borrow again at low rates.  This would no doubt reverse the recent trend of destroying demand.  Housing demand and prices could turn on a dime.  Anyone who had purchased recently without competition could find themselves in a position where their price now looked really good and they could also refinance to a lower rate, whereas the crazy bidding wars could return as quickly as they went away.  I would personally not bank on this scenario but it is certainly possible.  I intend to explore the idea of this “pivot” in a future post in the near future, but I believe any pivot would only occur once the economic conditions were moderately bad, and therefore any bounce in demand would not be enough to counteract the damage already done (i.e. layoffs).  

3.  Obtaining and Controlling Something that may be hard to buy, or scarce, in the future

Recently there has been an interesting dynamic of natural and also manipulated scarcity.  An example of natural scarcity is that our population growth far exceeds even the normal ability to create more units in fully functioning market.  Or that we have effectively run out of easily developable land.  Or that the earth is out of a certain raw material or there is a dwindling supply of that material.  

Artificial or even manipulated scarcity, e.g. lockdowns in 2020 that broke the supply chain.  The globe produced less of everything for a period of time.  Building Materials, semi-conductor microchips, raw materials, etc. were all in short supply which means they will cost more to the manufacturer, which means the manufacturer has to charge more, which means wages have to go up for consumers to be able to afford the products at the new prices.  Additionally people had more money in their pockets since they weren’t spending as much, plus in many cases, Americans of all economic strata were just handed extra money to further spend and bid up prices, and create more scarcity.  It’s a snowball effect.  

And at the same time, rules, regulations, and laws are being instituted for incredible and sweeping changes that are also very inflationary.  I’m thinking of the push into the electrification of everything which is changing how we move around, but also how we live (dwellings).  Transportation and shelter are everyone’s two biggest expenses.  I’m not saying these changes are all bad, but they are highly inflationary and expensive.  

Some people looking to rebuild after the Colorado fires are now realizing that there are new green regulations to the building code.  They may be required to add solar panels (if you haven’t priced those out, they are $$$ with pretty much $0 ROI), electric car chargers (price out with an electrician to add a 220/240v circuit and outlet to your garage), upgraded insulation and high efficiency features, in some cases rules what Hvac (heat pump or geothermal, not cheaper nat gas) must be spec’d out.  In aggregate, all of these things can add tremendous cost to building a house, not even to mention the labor costs.  Whereas, the older house that was already built, had none of those things, since it was built at a time when they were not required, is “grandfathered-in.”  

It’s similar to your car if you have a gas car, which the vast majority of people still do.  Maybe you don’t want to be forced to buy a $60,000 or $80,000 electric car at 8-10%apr financing rate and have a $1000+/mo payment (plus pay an electrician $2000+) to wire a charging station.  

Much has been written that starter homes are impossible to build for a builder.  There is no profit at all in them.  So they build bigger more luxurious homes.  

You can still obtain such homes through the resale market and they are “grandfathered-in.”  In the city of Denver, 1950-1960s mid century ranch homes, or pre-war bungalows, you literally could not build these anymore for what they cost to buy.  The replacement cost exceeds the purchase cost by a lot and even if you, as an experiment decided to build the exact same house as your neighbor’s 1950 house, it would have to meet the latest Denver building code.  There is far more reading on this topic here, a recent article in the Denver Gazette.  

In essence, older buildings are far less expensive to buy and run/operate.  

Additionally, anyone who has looked at new and newer construction homes in Denver is aware the lot sizes are miniscule.  This is not mandated by code, but the builders/developers are typically large corporations and they need to squeeze as many homes in as possible.  This means your starter home in that old neighborhood, with that 6,000′ or 9,000′ lot, in my opinion, will only become more scarce over time, and thus more expensive.  

Conclusion

In concluding, there is still a very good case for considering purchasing or investing in Real Estate now, even with the prices and cost to ownership being what it is.  However, I encourage all prospective buyers to be very pragmatic about their goals, their financial situation, their investment strategy etc.  We are in unpredictable times.  More to come on some of the ideas contained herein as I flesh out some of these topics into separate posts.  As always, thanks for stopping by.