“If it can happen in the stock market, it can certainly happen in real estate.”
This was a comment somebody posted on my blog last week that I didn’t approve because it was preceded by a couple of very obnoxious statements.
Some people assume that if the stock market is volatile, so too is the real estate market. Well I’m here to tell you that just isn’t the case…
Last night, somebody posted the following comment on a post I had written last year:
“The ‘crash’ (10-20% by the end of 2009) has now begun. Surely there is not any doubt about that?”
This comment really got me thinking; not about the statement itself, but rather people’s perceptions of markets in general.
I’m not an eternal optimistic, and I’m not an overzealous salesperson. I own a few pieces of real estate, and if I truly thought the market was going to “crash” 20% in the next 16 months like one of my readers, then I’d be renting a small one-bedroom apartment right now.
My opinions are based on my expertise and my knowledge of the real estate market, and I did study economics in business school for four years.
It just bothers me when people make outlandish statements such as “the market is going to crash 20% in 16 months,” to paraphrase my reader.
I think that because of what happens in the stock market, some people assume that could happen in the real estate market.
It’s not uncommon to turn on CNBC and see a report on a biotechnology company that dropped 38% that day because of a terrible earnings report or a failed clinical trial.
But a house on Jones Avenue is not the same as a the shares of a publicly traded company based in San Jose, California, and yet people continue to draw comparisons between the two markets.
Sure, there is no doubt that the stock market and the real estate market help fuel, and are fueled by the economy. But there are tremendous differences that in my opinion, make the real estate market significantly less volatile.
And it is volatilitythat makes for these huge gains in bull markets, and much-publicized drops in stock prices when the economy is lagging. The poing I’m trying to make here is that the price of a house is NEVER going to drop $100,000 overnight unless a war breaks out during those dark hours.
I’m not saying that the real estate market doesn’t fluctuate up and down, but it’s not nearly as volatile as the real estate market.
Let’s look at a few differences that contribute to reasons for the presence or lack of volatility:
1. Volume of Sales. Last Friday, there were 15,295,100 shares of American Express that changed hands on the New York Stock Exchange. How many condominiums were sold in downtown Toronto? How many pieces of real estate were sold in all of Canada?
2. Cost of Asset. Other than Berkshire Hathaway, can you think of a single publicly traded company that costs anywhere near the price of a piece of real estate? Shares of stock range in price from “penny stocks” to a few hundred dollars, and for argument’s sake, let’s say “most” shares are between the $10 – $50 range. If you buy 100 shares, it’s going to cost you a few thousand dollars. But if you buy a condominium or house, you could be looking at $300,000 or over $1,000,000.
3. Cost of Disposition. This isn’t 1958 anymore, we don’t have to physically hand over pieces of paper that show our ownership of company shares. We can log on to E-Trade and rid ourselves of those pesky Iscope Incorporatedshares in less than ten seconds. What does it cost us? How about $9.99 per trade. Selling a house costs 5.0% in real estate commissions, and land transfer tax applies wherever you move to. There are lawyers fees, moving vans, and the dreaded “miscellaneous costs” as well.
4. Difference in Nature. Break it down: residential real estate is a house or a home; stocks are shares of ownership in a business enterprise. A company can go bankrupt or shut down and close it’s doors overnight; a house is the same house the very next morning, unless that overnight war breaks out. How can you compare a house to an invisible share of stock?
These are just a few differences, since the list could go on and on, and I’m sure some of my astute readers could either add to my list or find fault with the way I’ve described some of the ideas above.
But this all comes back to that statement:
“The ‘crash’ (10-20% by the end of 2009) has now begun. Surely there is not any doubt about that?”
First of all, there is doubt. There is tons of doubt. A client of mine on the weekend told me he heard that “the market had dropped,” and I explained to him that the average price in the GTA as a whole has actually risen a modest 5% since this time last year, but sales are down double-digit figures. There is a difference.
Misinformation is the ultimate buzz-kill, isn’t it?
For our real estate market to drop a whopping 20% inside of 16 months, something absolutely catastrophic would have to happen. Think for a moment: what is the most catastrophic event in the last decade? Well that’s easy: 9/11 in New York City. That one day changed the world forever.
Markets fluctuate up and down in the short, medium, and long term, but in order for an absolute “crash” to occur, we would need a catalyst.
Not just an external catalyst such as 9/11, but perhaps also an economic one. Could a crash in the stock market produce a crash in the real estate market? Well, now we’re getting into one large circular argument…
But the differences between the stock market and the real estate market simply must be understood.
Look at it the other way around: the gainsinstead of the losses. Real estate “booms” are far smaller than the booms in the stock market, since the last seven years in the real estate market might have seen a house in Riverdale increase in value 60%. But a share of stock can increase exponentially overnight! Think of a gold company that strikes it big in one of their African mines—the stock jumps 53% the very next DAY!
Nobody day-trades in the real estate market! It’s impossible! But you can move shares of stock that rose 11% since the opening bell or follow a stock on the up-cycle as it gains 27% inside of eight weeks.
You can’t make these kinds of gains in real estate unless you’re talking about sub-dividing a piece of land and increasing the value of it “overnight” once you get the go-ahead from the City.
Volatility is what provides such massive short-term gains in the stock market, but it’s also what causes such monumental losses.
The stock market is far more volatile than the real estate market, and thus if my reader had posted “The Dow Jones is going to crash 10-20% by the end of 2009,” surely I’d be free to disagree that it would happen, but not that it could. No way.
The real estate market WILL decrease at some point, or every economics professor I had at business school was wrong. When that will occur is anybody’s guess, but I’m going to go ahead and predict that we’re not in for any 20% drops anytime soon.
20% in 16 months is a “crash” alright. But I just don’t see it happening…
Franky B
at 12:32 pm
Very good post, and I generally agree with the conclusion.
I’d also add that:
1) you cannot short real estate (at least not individual properties)
2) the inherent leverage in real estate is very high (10% downpayment is 10:1, 5% is 20:1, and so on). When you buy a stock on margin, and the value of the stock drops below a certain point, you have to put up additional collateral, even if you are not behind in your interest payments or otherwise ‘in default’. No such ‘readjustment’ mechanism exists in the real estate world, partly because of how loans are structured, and partly because any drop in value is not always immediately observable.
3) the US experience seems to prove that at least some organizations are willing to lend well beyond most ‘common sense’ creditworthiness would suggest. This was largely driven by up-front fees the mortgage originators were able to charge. Banks and brokerages seem less willing to do this with their counterparty investors (hedge funds, etc.). They have been willing to do so in leveraged buyouts, and have suffered similar issues as they did in real estate, with a corresponding drop in prices.
WB
at 5:36 pm
You quoted a 5% rise in the average price in the GTA since the same time last year. The TREB numbers for July show a 1% rise year-over-year. in Toronto, it was only 0.1%. So….in real terms (inflation-adjusted) real estate prices are DOWN year-over-year in the GTA and Toronto. And, I bet that if someone made the calculation, real estate prices in nominal terms would show a decline over the past few months (if you could calculate a seasonally-adjusted average value.)
I watch one specific area – of Toronto very closely (one of the hottest areas in the past 10 years), and there is no doubt that average prices are down in the past 3 months. I also know someone who follows another area very closely, and average prices there clearly are coming down (again, another very well regarded neighbourhood that has increased in value substantially over the past decade.)
I agree that real estate prices are less volatile that stock prices, especially on a day-to-day basis. But on a longer term basis (i.e. how much can an index like the S&P 500 change vs. the average house price) I think that the difference is less so. I still think stocks are more volatile, but not by a significant margin. As an analyst, I follow both markets quite closely and have studied prices on a long-term basis quite closely.
By the way, did you know that in the Great Depression, real estate prices dropped by 90%? I know it is very very unlikely that we will ever see anything like that again, but it is an interesting piece of information. Imagine taking a zero away from the value of your house…..unimaginable, but it actually happened!
simon
at 11:13 pm
Hi,
I’m the aforementioned cynic that was quoted in your essay.
I point out that Toronto home prices have previously dropped by 10%+ in 16 months on two occasions in the past 30 years.
http://cuer.sauder.ubc.ca/cma/data/ResidentialRealEstate/HousingPrices/housing-pri-toronto.pdf
I appreciate the consideration you have given to the issue, and I don’t think you are necessarily wrong. Rather, I think that you are correct is suggesting that an economic catalyst could initiate a substantial drop. There is a global credit crisis, and indeed many major markets (not just the US) have seen substantial drops in housing prices. I suggest that Canada has delayed our own down cycle with the introduction of 40/0 mortgages in 2006. However, the retraction of the 40/0 option in October will initiate a catch-up phase in our downswing.
Similarly, the our present historically low mortgage rates have served to increase purchasing power. When rates eventually rise this will exacerbate the downswing.
In fairness, I will concede that it was cheap of me to say “Surely there is no doubt…”. Of course it is not a slam dunk. Economics never is, and maybe I’m completely wrong. By the same token I suggest you shouldn’t have focused your essay on the “20%” figure as it was the high end of my range. 🙂
Nonetheless, because I am impressed that you wrote an essay in response to my post I give you my word that if I am proven wrong I will come back in 16 months and give you a 750ml bottle of Dom Perignon (if the decrease is not 10%+).
regards
Simon
J.
at 9:45 pm
It should also be mentioned that the carrying cost of owning the property is higher. Property taxes, interest expense, condo fee and general maintenance of the place can also add up compared to stocks.
I agree with your assessment that real estate fluctuates less then stock and is a good long term investment, but I would like to see your view of renting versus purchasing.
dave
at 8:41 am
Howdy,
Just popping in to say that even though June is off to a good start I’m still confident in my original prediction. and if we don’t see the 10% drop Aug08 to Dec 09 then I’ll honour my promise and be buying you some booze!
regards
David Fleming
at 12:09 pm
Dave – should you be keeping track, or should I?
My numbers might read differently than yours…. 🙂