Real Estate Fundamentals - the Key to Predicting Value

Just as I examine fundamentals to analyze commodities and stocks, I use the same fundamentals to look at the present and future of real estate. Residential real estate increased in value from 2001 through 2005-6 because of several factors: 1) Lower interest rates, which allowed folks to buy more expensive homes, 2) "hot" money that flowed in from stock market investors who were licking their wounds, and 3) Excessive speculation - especially in California, Arizona and Florida - that drove prices through the roof.

Interest rates (just like anything else) go up and down in cycles, and eventually 'revert to the mean,' or the average over a long period of time. Because interest rates have been low for the last few years, they're due to come back up. Residential real estate values are affected by location, size of house, and the condition, but the two main factors that affect real estate values (no matter the location) are: Income and interest rates.

Because most Americans rely on working as an employee for a company for their main source of income, and because of global competition for labor, I don't see incomes in the US going up significantly for years to come. This factor - combined with the eventual rise in interest rates - is the reason why I don't see real estate values 'bouncing back' in the short term.

You also see the purchasing power of the US Dollar declining, and this makes for a very strong headwind against American residential real estate. I know that over the past several decades real estate has been (emphasis on past tense) a good asset class to invest in, and that home prices have almost always increased.

However, there are always exceptions to every long-term trend, and I believe the next two or three years will probably be one of those exceptions. I know that realtors and mortgage brokers don't like to hear this type of analysis, and most of them don't believe real estate can decrease in price significantly.

Keep in mind that almost all realtors and mortgage brokers are salespeople - and not investors. They want to believe that the good times will keep on rolling. Residential real estate today looks like the NASDAQ in 2000: A bubble market coming off its peak, and correcting downward. I could be wrong, but looking at the financial and economic fundamentals, I doubt it.