Pennsylvania Investment Observer

The Eleventh Hour or the Eighth Inning

by Daniel J. Nestlerode

Write down this date, "June 2005". A few years from now, we will look back at the level of real estate prices and marvel at the level they had attained and wonder why we didn't realize that we were at the end of a decades long rise (in prices). I suspect that we are closing a major chapter in U.S. economic history that began back in the 1930s. Real estate was really cheap in the 1930s. My direct experience arrived later when our family moved in the mid fifties from one six bedroom house to another for about $12,000. It was a nice brick two story home, with a detached garage, a paved driveway, close to schools and shopping. Somewhere about the same time the family bought a fifty acre tract of land in Lycoming country along Little Pine Creek, with a barn and four cabins for $12,000. We later added another cabin and three acres for $5,000. In those days, banks rarely made mortgage loans and never made automobile loans because they were much too risky. The experience of the depression of the 1930s drove the decision making in the 1950s. Don't do anything that might turn out badly. So bankers only made sure-fire loans and did nothing risky, like real estate loans.

Since those days, real estate prices have surged across the country. Some real estate markets have performed better than others. Markets along the coasts seem to have appreciated most rapidly. My nephew has a two bedroom, single bath house in Santa Barbara for which they paid $550,000. For now, they have an interest only mortgage because they cannot afford to pay down principal in their family budget. New York City real estate booms right along too. Yet my brother's daughter-in-law (chief financial officer at a California company) recently sold her California home and is renting an apartment because she feels prices have just gotten too high. Little Pine Creek real estate seems high too as a quarter acre lot (with no buildings) on the creek sold for $38,000. The wonderful real estate stories go on and on. I've even heard it said that this time the market is "different" and prices will just keep going up.

I heard the same conversations five years ago as the stock market surged to over 5,000 on the NASDAQ average and the Dow reached over 11,700. Technology had made the economy into a perpetual motion machine and the worst that could happen was that prices might "level out" for awhile. Well, they did level out, after a pronounced decline. The darling tech index, the NASDAQ, trades around 2,100, down nearly 3,000 points from the peak. That is still a 58% decline in the average. The Dow Jones Industrial Average has never surpassed the 11,700 of the year 2000 but it is at least in striking distance.

Finally, I heard a knowledgeable investor speak of real estate as having intrinsic value. One of my principles of market behavior is that nothing has intrinsic value, but is only worth what some other interested party is willing to bid for it. And while they aren't making any more real estate, it is certainly true that the demand for it fluctuates a great deal over time.

So why do I think the rise in real estate prices is coming to a close? First, real estate is often bought with borrowed funds. The ability of buyers to bid on real estate is directly related to the availability and prices for borrowing money. Alan Greenspan is trying mightly to increase the price of borrowing money by raising the Fed funds rates. And while he has thus far been unsuccessful to push up the interest rates on mortgages, I expect that he will persist in raising rates until he gets some results on the long end of the interest rate markets. That will likely dampen demand for real estate. Secondly, the demographics of the United States are beginning to change. The demand for housing is largely related to family rearing. As the baby boomers begin to become sixty somethings, their demand for large multi-bedroom homes will atrophy as they downsize and seek low maintenance houses on a single level. Old folks don't do stairs well, so I've heard.

So there you have it. Real estate prices will likely decline in years ahead as demand declines from higher interest rates and the decreased interest in the product from aging baby boomers. I might be wrong, but in my forty years on Wall Street, every flowing market has eventually ebbed. I don't think the real estate market is any exception.

Before you take any drastic action in your market area, because real estate is always a local market, check the historic price increases and the demographics of your local area. Also check with your local lending institutions to see how willing they are to lend money on real estate transactions. And remember, real estate is not easily or quickly convertible into cash. When the decline comes, getting out will be increasingly difficult and costly.

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