Investment Theory: Sample Capital Flow Analysis

Home Ownership

Supply and Demand for U.S. Residential Real Estate

The most popular investment in the U.S. is residential real estate. There is widespread home ownership — about two-thirds of Americans own the homes in which they live.

Residential housing (along with food) is a major tangible component of the Gross National Product that is still manufactured in the U.S., rather than being imported from abroad.

Because of easy financing, the supply or homes can be expected to rise to meet demand. The American mortgage finance system is the strongest and most sophisticated in the world.

The government promotes home ownership with tax deductibility for interest on mortgages and by encouraging expansion of mortgage financing.

Protection Against Inflation

In the long-term, residential real estate values are driven upwards by inflation, population growth, and high levels of employment.

Immigration policy has sustained demographic expansion and home prices.

Permissive immigration policy has sustained demographic expansion and home prices.

Residential real estate values have risen over the long-term, providing protection against inflation.

Home ownership is about the only investment in which inflationary gains are not taxed.

The combination of deductibility of mortgage interest and property taxes, and exemption from taxation on capital gains, makes home ownership the favored investment in an inflationary economy.

Political Support

Because home ownership is so popular, home owners have extraordinary political support, far more than, say, stockholders or investors in bonds.

Although property taxes have risen sharply in recent years, the political power of homeowners makes it unlikely that local taxes will be permitted to reach a level that could result in widespread evictions or foreclosures.

Homeowners enjoy greater political support than investors in securities.

A sharp rise in unemployment to the levels of the 1930s, although unlikely, would probably work more to the disadvantage of mortgage holders than politically powerful homeowners.

Most home mortgages are amortized in monthly payments over twenty or thirty years, often guaranteed by life insurance on the borrower.

On the average, Americans have about 55% equity (home value less mortgage debt) in their homes.

Financial Liquidity

Trade deficits provide easy financing for home ownership, because foreign investors prefer fixed income securities and mortgages and mortgage-backed securities make up a large part of the bond market.

Most Americans, as they grow older and pay down their mortgages, find that the inflated value of their equity has increased, allowing them, in their later years, to borrow against their home as a way to draw down on their savings.

Real estate financed with non-indexed loans protects against inflation.

Such equity financing is facilitated by an efficient mortgage market and the flow of funds from abroad from the trade deficit.

The Best Investment By Default

Although real estate values have risen with inflation, most mortgage payments are not indexed.

Over the years, this differential gives homeowners a real advantage, that is further enhanced by favorable tax laws.

Over-pricing of the stock markets and lack of serious inflation protection for fixed income securities have made residential real estate the preferred investment for the average American.

Whereas equity investment over the last fifty years have been generally profitable, over-pricing caused by buybacks and payroll-deduction investment plans, plus the impending retirement of baby boomers, raise serious questions as to whether the next fifty years will be as favorable for stocks.

Bonds, by there nature, usually do not offer protection against inflation. Consequently, by default, home ownership is the best investment for most Americans.

Is There A Real Estate Bubble?

Between 1976 and 2004, house prices in the U.S. increased an average of 5.9% a year (HPI: Office of Housing Enterprise Oversight).

Considering inflation (understated in the Consumer Price Index) and improvements in housing, this rate of increase does not suggest a speculative boom.

The graph shows that although the rate of change in home prices has varied from less than 1% to over 14%, the direction has always been positive.

The graph also shows that until 1992, there was a general long-term decrease in the rate of change of home prices as Jimmy Carter's inflation wore off.

Home prices have increased, on the average, 5.9% every year since 1976.

However, by the 1990s, the decline in long-term mortgage rates fueled by an ever-increasing trade deficit, helped to accelerate the increase in house prices.

The graph also suggests that although there are great swings in the rate of change of housing prices from year to year, the range is always positive.

In the long-run, as long as the population grows, stays employed, and there is fiat money, it seems that inflation will drive housing prices.

All Housing Is Not Equal

While real estate values may be uncertain in cities that are potential targets for terrorists and in regions suffering from long-term deindustrialization, home values in safer areas of the service economy should continue to rise with inflation as long as population grows and employment holds steady.

In some areas, a small percentage of Americans are over-extended on home mortgages, causing real estate values to fluctuate with local employment, natural disasters, and terrorist threats.

A favorable outlook for certain areas

It seems likely that most residential real estate values in the 'fly-over' areas of the United States will be higher in ten years than today.

In contrast to the equity and bond markets, most investors are not able to diversity risk in home ownership, which means that careful property selection, especially as to location, is essential. Financing with non-indexed loans is also important.

With this caveat, the outlook for residential real estate is positive.

August 2005

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