Buffett is Too Optimistic on Housing
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Warren Buffett doubled down on residential real estate this week, announcing on Monday that his Berkshire Hathaway (NYSE: BRK-B) was bidding to acquire the bankrupt mortgage originator Residential Capital LLC (ResCap), including its loan portfolio, for $3.85 billion. Buffett appears to be willing to pay up for the assets, as Berkshire's entry into the process is likely to start a bidding war with ResCap's favored buyer Nationstar, a subsidiary of Fortress Investment Group (NYSE: FIG). This is just the latest in a string of housing investments. Berkshire Hathaway owns a brick maker, a home builder, and has significant equity stakes in major mortgage originators like Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC). Buffett made the case for these big bets on homeownership in his most recent letter to shareholders, arguing that pent-up demand amongst young buyers would save the housing market:
"People may postpone hitching up during uncertain times, but eventually hormones take over. And while 'doubling-up' may be the initial reaction of some during a recession, living with in-laws can quickly lose its allure."
I don't relish putting my judgment up against the Oracle of Omaha, but the “hormone” argument just doesn't cut it. First, attitudes toward homeownership may be changing. A recent Pew study found that people aged 18 – 35 put a low priority on homeownership, with only 18% of those surveyed considering it an important goal.
Desire is ultimately irrelevant, however, as “demand” requires the consumer to actually be able to pay for the good they want. And the American middle class cannot afford more housing. One problem is that a major demographic for single-family home purchases – young, educated professionals – already has massive debts. Two thirds of college graduates had student loans in 2007 – 2008, compared to only 45% percent of 1992 – 1993 grads. And the size of the average loan is growing: $23,300 in 2011, with 10% owing more than $54,000.
A bigger problem is that middle class Americans of all ages simply don't have the incomes to support a housing recovery. In fact, they haven't had the incomes to afford their housing in a long time. For the home ownership market, the recession didn't suddenly cause a problem; it actually revealed a problem that had been festering for decades. The fact is that income gains haven't kept pace with home purchases, and the only reason that the housing market remained strong for so long was because people had access to cheap, easy, credit, often with no money down. Now, banks are requiring anywhere from 20 – 50% down payments, and are being much more rigorous in ensuring that a potential debtor has the income to service the loan. And what of this income? According to the Economic Policy Institute, incomes for the bottom 90% of earners were already falling even before the Great Recession, with the top 10% of earners therefore accounting for more than 100% of all income growth:
Regardless of whether you fall closer to the Occupy movement or the Tea Party, this pattern of income growth just can't sustain a housing recovery. The middle class cannot buy more housing with declining real incomes, and the top 10% are not likely to buy ten houses per person to offset the loss. Shifts in corporate culture as well as stronger regulation should prevent banks from returning to the disastrously shoddy standards of underwriting that lead to the sub-prime crisis. Therefore, any rebound in the housing market must necessarily be preceded by rising employment and income growth for the middle class: that's the only thing that can make homeownership possible for them. Such an economic renaissance would usher in a boom for all sectors. Housing, with its high up-front costs, would be slower to recover than other industries, and therefore even a strong housing recovery would still lag the market.
Now is not the time for ordinary investors to be bullish on homeownership. As we saw with his purchase of Bank of America preferred stock and special warrants, Warren Buffett has access to exclusive deals not available to you and me. Even if Buffett is right about his own bets on housing, the average investor would be wrong to mirror his optimism.
Daniel Ferry owns shares of Berkshire Hathaway. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, and Wells Fargo & Company and has the following options: short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $29.00 calls on Wells Fargo & Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Berkshire Hathaway and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.