Monday, 6 January 2014

Oil and Real Estate

There are some real differences between the workings of the stock market and those of real estate. At its core the housing market, like the stock market, is all about supply and demand. However, the difference is that stocks and bonds investors base their decisions to buy into stocks on future potential, whereas real estate investors base their decisions to buy into housing on inherent value. Thus, the type and quality of demand exercised buy a stock purchaser is very much different from the type and quality of demand of a real estate buyer. Because stock investors characteristically place their bets on future potential, Wall Street is an excellent - the best, in fact - gauge of things to come, a thermometer of the future.

Wall Street, these days, seems to be saying that the future holds unpleasant surprises.

When the economy as a whole is put under the double pressure of increasing interest rates and increasing oil prices, the escape of capital towards the payment of interests and the purchase of oil and related products is to be felt on general demand for goods and services, which include both the stock market and real estate. Wall Street is invariably more sensitive to economic imbalances and their repercussions, because stock trading is a faster market than real estate, by far.

Supply threats in major oil producing nations like Iran, Nigeria and Iraq have pushed US oil futures to USD $69 per bbl., within striking distance of the all-time high USD $70.85 per bbl. hit last August, after Hurricane Katrina leveled U.S. oil platforms and refineries. Iran is at odds with the West over its atomic program, rebels have knocked out nearly a quarter of Nigeria's output and Iraq's exports are at their lowest since the U.S.-led invasion. Moreover, continued growth and strong demand for oil in the United States and China - the world's two largest energy consumers - is also adding to concerns that the oil industry may struggle to match voracious consumption, thus pushing crude prices even higher.

As oil becomes scarcer and more expensive, there is a high probability that the economic shock waves will hit hard throughout the economy. Petroleum is a basic raw material used in the manufacturing of many products including chemicals, paints, plastics and synthetic textiles. Other industries - steel, aluminum, power generating plants - use large quantities of oil and oil derivatives in the course of their production. When petroleum supplies become pinched and prices push up, these industries may well be forced to restrict output and raise prices, thus putting even more inflationary pressure on the economy. These, in turn, may force central banks to adjust their monetary policies by raising interest rates higher and, what's worse, faster, thus not giving enough time to the economy to adjust. Scarcely any enterprise is immune to the oil squeeze, as the lessons of the '70's and the '80's have taught, and real estate is definitely no exception.

Obviously, it is hard for stocks to take off with oil going straight up to the US $70 a barrel, or when the Fed keeps saying interest rates are going to go higher. And every day, people putting more money towards maintenance of their debts and towards the purchase of ever expensive consumers goods means less people putting money into stocks and bonds or, for that matter, real capital assets. Besides, as interest rates increase, mortgage funds erogated by lenders dwindle, because they too become more expensive and out of reach or, otherwise, unaffordable. The real estate industry has been booming as housing prices have soared. But if interest rates continue to rise, new borrowing against home equity will drop, and may disappear. If all that borrowing - which freed up cash that was spent on new furniture, appliances, vacations, cars and the like - simply vanished, the effect could be large enough all by itself to send the economy into recession.

At stake there is what we economists refer to as "The Wealth Effect". Consumers tend to spend more when their net worth increases, and less when it decreases. When people feel rich, they spend - a psychological effect known in Economics as "The Wealth Effect". It doesn't matter whether their wealth is actual or merely on paper, whether the money they spend is their own or borrowed on the equity of their assets. Economists use this rule of thumb: a $1 change in household wealth leads to a roughly 5-cent change in consumer spending. Consumers have felt rich - very rich - these past few years. So rich, in fact, that real estate purchasers, for example, have lined up to buy properties always more and more overpriced.

Why did they do it? Afterall, everybody knew that the market was overpriced, that it was 'hot', that it was a Sellers' market. I can personally attest to the fact that several times last year, when I took people out shopping for houses and apartments, it was very common to hear comments the likes of "Oh my God!" or "That's too much!" or "It's not worth it!" And yet, the same people who were making those remarks ultimately ended up buying - at Sellers' prices, in fact, if not more. So, again, why did they do it?

The answer is to be found in the ratio of the perceived value of a capital asset vis-a-vis its intrinsic risk of acquisition, the so called 'worth'. Clearly the lower the risk, the higher the perceived value and its worth. It follows, therefore, that the perceived value - or simply 'value' - of a real capital asset is the total monetary worth obtained by reducing exposure to risk and liability. Put in elementary terms, 'value' is the total net benefit a buyer expects to receive from a purchase, measured in currency. And in times of expansion, like the ones we have seen in real estate, risk was perceived as minimized because of the appreciation of property values, coupled by the relatively low cost of borrowing. Now that the tide is changing direction, sellers must apply leverage on the perceived value of the interest in land they are offering in order to motivate buyers, and there is no better way to accomplish that than by lowering prices.

It all boils down to prove, therefore, that oil is so important for real estate, that the impact of an energy crunch may be felt and engulf the entire industry in addition, of course to spread to the entire economy. In fact, it may affect our very own way of living.

Luigi Frascati

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