Canary in a Real Estate Cycle

By Damon Rhys January 20, 2019

Canary in a Real Estate Cycle

Canary in a Real Estate Cycle

Knowledge is Wealth!

So would be a canary in a real estate cycle. The proverbial canary in a coal mine was used to portend levels of noxious gases (usually methane or carbon monoxide) that would be harmful to humans as these birds were susceptible to passing out at much lower noxious gas concentrations. Once seeing your canary buddy unconscious the smart move would be to make like a roadrunner and hightail it out of the mine. What if you had your own “canary in a real estate cycle” that predicted when this cycle would peak? What would you do with that information? It is not like the stock market where if you could predict the exact tide changing between bull and bear markets, you could sell everything – perhaps even short the market. Real estate is not as elastic as the stock market because for most people their primary property is not just their shelter but also their “home sweet home.” Ultimately though, the canary in the real estate cycle would be different indicators for different people in various stages of their lives. For a first home buyer it might be a good idea to wait it out a couple of years, stay with mom and dad for a bit longer. Investors may want to liquidate some property investments and invest elsewhere (precious metals, stocks, bonds etc.) or just hoard their cash. However, most people would just stay at home and ride out the usually short bust phase of the cycle.

Many readers may find this topic a bit dry but please read on if you can. Please note the latest Oahu real estate statistics can be found in the last section of this newsletter and 60 Second Open Houses video thumbnails are located above this article. For general info on which way the weather vane could be pointing in this real estate cycle, please keep reading about the canary!:)

To continue, let’s quickly review the 4 basic phases of the real estate cycle noting that our last bust corresponding with the great recession happened in 2008 with the real estate market bottoming in 2011. Here is a simple graphic courtesy of Mueller, Real Estate Finance, 1995: (click to expand)

Real Estate Market Cycle Quadrants

In a typical 8 year cycle, Phase 1 (Recovery) and Phase 2 (Expansion) would last about 6 years while Phase 3 (Oversupply) and Phase 4 (Recession) would last about 2 years. The great recession in the US officially ended June 2009 but as it was financial (crisis) in nature (Lehman Brothers bankruptcy etc.), it was especially severe. Because of this many Economists including myself believe this current cycle may last quite a bit longer this time, perhaps 12 years or more. In Hawaii median prices of single family homes bottomed at the beginning of 2009 and flatlined thru 2011 (condos bottomed mid 2011) and then turned upwards from there. Here is a graph courtesy of the Honolulu Board of Realtors:

(click to expand)

Median Sales Price Change Oahu from 1987Given the already extended economic cycle this round (real estate cycle typically lags the general economic cycle by a year) and assuming this time we run for 12 years (instead of 8), we have at least 2 more years or more to go in Phase 3 (Expansion) as shown in the Market Cycle Quadrants graph above.  

Back to our canary, we have one here in Hawaii which at first may seem very surprising to you but I assure you it is the perfect bellwether taking into consideration the diverse real estate buyer market in Hawaii compared to the mainland US e.g. Japanese buyers especially at the upper end and for pure investment purposes etc. Our canary is none other that the Ala Moana Hotel with 1,100 units each of which are owned by individual investors. Because of this it is technically a “condotel” but is run like a hotel with each of the unit owners having the option of putting their units/rooms in the “hotel pool” and letting the hotel manage their nightly rentals for a % fee. Though not as liquid as buying stock, the residual income owners receive from renting their units out thru the hotel could be comparable to a stock dividend or compete with US Treasuries (bonds) as I will explain. Here are some of the pertinent facts about this real estate weatherbell condotel:

1) With units in the $200K range selling them can be fairly quick allowing for a certain level of liquidity.
2) As of this writing 9/7/2018 the 10 year treasury yield is 2.94% and the 2 year treasury is 2.71% (note the spread between these two has just started to flatten**)
3) The CAP (Capitalization) Rate on the units with the most consistent occupancy rates runs about 3% or just over (for a Buyer client I recently examined data on approximately 20 units carefully looking for the ones with the best CAP Rates and I found a pattern). For an explanation of CAP Rates please my Oct 2017 – What’s Your Investment CAP Rate?
4) The US Economy managed to stoke its inflation rate just reaching 2.9%.
5) Japanese investors also like to invest in old condo buildings. Why? In Japan they are allowed to depreciate (and deduct from their taxes) almost the entire purchase price of a condo in a building 47 years or older over a 9 year period. Ala Moana Hotel Condo was built in 1970 making it 48 years old.

How is all of this related? Assuming that you:

A) Invest in one of the good units in the Ala Moana Condotel at a good price (if interested please do not hesitate to call me, I know which ones they are!).
B) Get your annual 3% CAP Rate (basically the annual return on your money).
C) You cover your resell costs through natural real estate asset appreciation (tends to be higher in Hawaii – See my Investors’ Buying Guide article for details). You could possibly recover your resell costs after only holding a unit for 2 years (it would be helpful to negotiate the best price possible – feel free to ask me about that too!).
D) Understand buying an Ala Moana Condotel is a cash only proposition (normal mortgage financing is not an option for condotels).

The 3% CAP Rate (annual return on your money) is looking a lot like and a little better than 2 Year Treasury Yield of 2.71% with probably a bit more volatility but as long as you hold on to it for at least 2 years it would also provide some liquidity. You have the added benefit of actually staying in your own condotel the few times a year when you visit Hawaii (no free nights at the Treasury!:). In fact, even with 10 Year Treasuries at 2.94% you would still be beating those with your 3% CAP Rate (assumes you have a smart realtor who knows which are the best units)!

So what has happened in the last 3 months in the Ala Moana Condotel, our Hawaii Real Estate canary? For one, average days on market (on average how long it takes to sell one after putting on the market) has grown substantially to 76 days! In all of 2107 the average was less than 32 days. Why? It really has everything to do with interest rates. A year ago the 2 & 10 Yr Treasuries were 1.21% and 2.05% respectively. Compared to this a CAP rate of 3% and some free nights in the Ala Moana Condotel in Hawaii look fairly good. However, with the next couple of Fed Rate hikes even the 2 Yr Treasury will outperform a 3% CAP and we will only be left with those who really like free nights in Hawaii. I suspect at that point average days on market could reach 90 plus (still a very short time compared to the Hawaii Luxury Home market which is 14.7 months) and prices could soften a bit.

Also, our Japanese investors described in 5) above should greatly offset the general yield chasing investors who now decide to pass on buying in this building – since even a 2 Yr treasury may outperform the 3% CAP rate. Using round numbers, say a Japanese investor bought a unit with a really nice ocean view for $270,000. He or she would be able to depreciate almost this whole amount over 9 years or approximately $30,000 year which they can deduct from their yearly tax bill. On top of that our Japanese investor could sell after 9 years and realize some capital gains. On top of that they would have been earning a yearly 2% – 3% CAP rate per year (units with better views usually have lower CAP rates – if you want to know why please do not hesitate to call me, too much to explain in this already lengthy newsletter!)

In summary, with this recent development we are definitely past the halfway point on the Phase 2 (Expansion) part of the Real Estate Cycle in the diagram above. Interest rates are still somewhat low though increasing at a steady pace now along with inflation. Although the spread between the 2 Yr and 10 Yr treasuries is flattening, it could take a few (3?) more years to completely flatten**. I predict we get at least 3 more years out of this expansion*. 

Lastly, for reasons explained above, prices in condos can make a bit of a leap when they reach 47 years old*. Though our canary may start to look a little wobbly in the legs right now, it seems there is a Japanese canary paramedic standing by with some fresh oxygen:)! If you are interested in some of these buildings that are 47 years or older, please contact me.

I will leave you with an excerpt of the cover letter I recently wrote to the listing agent of the unit for which I put in an offer for my buyer client. In it I am justifying the somewhat lower offer:

Dear XYZ,

After careful consideration my client is hereby submitting the following offer for the purchase of your Ala Moana Hotel Condo. With all due respect, we kindly ask you to consider the following:

1) Average days on market for units in this building in the last 3 months has been 76 days. This is more than double all of 2017 which had an average of 32 days on the market. Significantly rising days on market means there is a surplus of units on the market which results in a decrease in prices.

2) Interest Rates are also increasing leading to a softening of prices in general which also has an effect on the condotel market. It is also partly responsible for the rapidly increasing days on the market as in 1) above.

3) I have also included a verification of cash funds with this offer so as to fortify the strength and reliability of this good offer.

With all of the above in mind we respectfully request your due consideration of my client’s fair offer.

Knowledge is Wealth!

Aloha!

Damon

*Disclaimer: Any opinions expressed in this newsletter are that of Damon Rhys only and do not necessarily reflect the views of his brokerage firm, Sachi Hawaii Pacific Century Properties. Though knowledgeable including Management Science / Quantitative Economic Decision Science & Master (MPIA) Degrees from the University of California, Damon Rhys is a licensed Realtor in the state of Hawaii. He is not a licensed Financial Advisor. For any specific investment decisions, it is advised that one consults with a licensed financial advisor. Sachi Hawaii legal counsel has advised Damon Rhys to include this disclaimer on his newsletters and blogs. Common sense should always prevail -fair advised and fair warned!

** This is called the Yield Curve and when it becomes flat it usually corresponds with an economic recession.

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