Minnesota Real Estate, the S&P 500, Treasury Bonds, and You

Stocks are partying like it's 1999. Bonds are selling off, well...like it's 1999. And yeah, real estate in the US is having a good run too, finally showing some signs of life after a long period of something between ok-ish and abysmal returns.

What’s really going on? This is anecdotal evidence--but let’s take a look at the anatomy of a real estate deal from the depths of the financial crisis and cashed out in today's feeding frenzy.

This dandy townhome just sold a few months ago in a neighborhood a few miles from my house. It is a beautiful place...1700 square feet, three bedrooms and three baths, enough space for a small family with great schools. You see the list price above….after a little bit of haggling it sold for $263,000.

In early 2012, the same place sold in foreclosure for $193,000. The buyer bought it with cash and rented it out for an average of $1750 per month over the last (roughly) five years.

I ran the costs and revenues through a real estate spreadsheet I built and got this:

An unlevered compounded return of nearly 12%. Not bad for what is really a fixed income asset.

But what was our benchmark? I ran a similar calculation through a calculator I found online for the S&P 500, which considered the total return of the index with reinvested dividends. Here was the result:

Over the same time period, that money would have returned 14.26% in a simple S&P index fund with reinvested dividends. Equities outperformed….

Not so fast, you say. You’re comparing a fixed income asset to an equity asset. Yep, apples to oranges. Real estate, especially if unlevered, has certain equity and fixed income characteristics. I took a look at the total return on a JP Morgan credit index over the same time period. It was right around 4%.

So if I were to have some mix of stocks and bonds and maybe some REITs that had high single digit returns, the return over the last five years looked a lot like the return on a chunk of Minnesota real estate.

Then I think about the implicit returns built into the price of the assets when they were purchased. Five years later, those prices should be able to tell us something about the returns we can expect (or have realized) in the future.

For the townhouse, the implicit return, or the cap rate, at the time of the purchase was about 7.25%. That’s a pretty spicy return in these parts--this townhome is in a tony neighborhood, and one that has only gotten more exclusive in the last five years as more high-end condos have been built in the area and the city has become a destination for fancy restaurants and brew pubs. In short, more rich people want to live there now than did five years ago.  

Today, the cap rate on the same property is about 5.7%. So the future cash flow you can expect from the property at current valuations is roughly 150bps less than it was five years ago. That represents the confidence in current values as well as the relative attractiveness of the asset---people are willing to pay more for the same thing today versus five years ago, when the US was at the nadir of a the credit cycle.

Now look at stocks. In 2012 the S&P sold at a price/book ratio of roughly 2.2. Today that ratio stands just above 3. To put it another way, not unlike our chunk of Minnesota real estate, buyers of stocks today are putting much more weight on the future profits on their assets relative to the book value where they could be sold on the open market.  

S&P 500 Price/Book Ratio.

Ok, so maybe I’m not telling you anything you don’t know already--assets in the US are worth much more than they were five years ago. But what struck me about this analysis was just how close the returns were. This is a piece of real estate that was clipped in foreclosure at the bottom of the market, and then punted into a red-hot market five years later, in a neighborhood that was a good one in 2012, but now is one of the most exclusive you’ll find anywhere in flyover country. You could hardly ask for anything more as a real estate investor.

And you compare that to stocks--where the same argument applies! US stocks in 2012 weren’t exactly dogs...now they are the a red hot, multiple offer property that brokers salivate over because they know people are tripping over themselves to buy them.

Throw in a few high-yield USD bonds, which have benefited from the same lust for yield, and you can see a pattern: there is no small amount of financial engineering and monetary steroids that have led to a such a wide array of assets having such a similar rate of risk-adjusted return.

Then I look at a chart like this, follow the path of appreciation of those assets, and wonder what the future might hold as the slope of the line turns negative:

I agree with the camp that argues that the global economy is coming out of a long period of dormancy--one not uncorrelated with the chart above. I think the recession in the US didn’t really end in late 2009 simply because the economy started growing again--it lasted well into 2012 as capital writedowns and a Schumpeterian creative destruction slogged through the American landscape.  

Where does that leave investors today? Many would argue the implicit returns baked into metrics like the real estate cap rate or the equity price/book ratio cited above will be pathetic. That may well be. But as investors we have to consider where there could still be some upside.

I’ll put my two cents in for emerging markets. Last week, Jeremy Grantham made a great case for EM equities. I’ll throw in my two cents for EMFX and local fixed income at large, which are driven by very similar dynamics around the global manufacturing cycle and commodity prices.

I think it comes down to this: the benefits of the crash in oil prices combined with increased domestic energy production was a positive supply shock for the US. This caused a huge re-pricing and redirection of flows out of EM and into the US, despite continued massive quantities of global monetary accommodation.

US assets, real, fixed income and equities, were winners throughout  the past ten years, but especially since 2015 as this positive supply shock spread throughout the economy.   But EM  assets hit a huge wall during the same time. Now, with a pro-growth, deregulatory environment in the US and Chinese demand still positive, there is plenty of space, from "macro" as well as valuation influences, for EM to continue to outperform--while much of that positive tail wind is already priced into US equity values.

You can argue that something will change to cause that theme to crack (China slowdown, US grinds to a halt, quanatative tightening, some black swan, etc.) but I think that's the environment we're in for the foreseeable future. The returns from the past five years have been predicated on a monetary sugar high--and one could make money by simply chasing that ball from one jurisdiction to another.

Today, investors are getting back to fundamentals: relative rates of growth and productivity rather than the potential, or reality of artificial stimulus.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista