The Real Estate comeback will be huge.

In a world obsessed with scarcity, investors are shunning one of the scarcest things out there: A safe and convenient place to live.

Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.

This article is entirely free to read.

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Remember how I told you about the embarrassment test for vetting an investment idea? Imagine yourself in a social setting with strangers or at least with people you are only loosely acquainted with. It could be a company event at your spouse’s firm or your friend’s birthday party. You find yourself in a group of 5-10 people who have started to discuss their latest investment ideas. It’s clear that your conversation partners are not newbies. They have invested for many years and have developed strong opinions that are reasonably well supported. Some may even do it professionally. What opinion of yours could you possibly throw in that you are hesitant about because you would be afraid to earn laughter and irritation? The answer to this question is often a strong indicator for something that you should probably investigate further because it is very promising. It’s important that you choose something where you can actually make a fundamental case. Don’t just be contrarian for the sake of it. ;)

You know what my response these day would likely be? Real estate. North American residential real estate to be precise, but some of my arguments pertain to real estate generally. What reactions do you think I would get? Probably something like “With this lack of affordability? With these prices and interest rates? Right into the lagging effects from ultratight monetary policy? Against the political current that is on a vendetta against landlords? Are you insane?”

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TLDR Summary

• Scarcity-based investing is en vogue because monetary authorities have lost credibility subsequent to their experiments in the 2010s and the subsequent worst inflation shock in decades. It’s why the global crypto market cap has swollen to $2tn.

• In such an environment, real estate should do well. After all, it’s the epitome of scarcity. The amount of living space in safe neighborhoods with amenities and access to job opportunities is limited, at least within reasonable time frames. It should provide attractive returns and protection from further monetary debasement.

• But has completely fallen out of favor. Investors hate this asset class as much as they did at the peak of the GFC. That’s obviously when a debt-fueled bubble burst and the economy drove over a demographic cliff. Incomparable to today. When Energy was equally hated in the fall of 2020, its US sector ETF tripled afterwards in two short years.

• Aside from simply fading the crowd, it’s hard to make sense of this hate from a fundamental perspective. When Bitcoin rises, it’s celebrated for its scarcity. When home prices rise, they are reprehended for their lack of affordability. Double-standards if you ask me.

• Real estate’s fall from grace has to be viewed in historical context. It caught a bid in the 2010s because interest rates were manipulated to zero. Income investors looked for alternatives and some found it in real estate. Others looked in dividend stocks or short volatility bets. The revival of rates have made them abandon these proxy assets.

• To many people, the risk return profile of real estate does not appear compelling. Even if lower rates lift valuations, they would likely come with economic weakening which would hurt rents. Bonds don’t have that problem which is why their portfolio allocations are going through the roof. And inflation is not deemed a positive for real estate because it would come with a corresponding increase in rates that would hurt valuations. It’s considered a lose-lose situation.

• There is opportunity in this one-sided assessment. In the US, economic growth will likely exceed expectations because private sector finances are very strong. This causes upside potential in rents. A hard landing favors bonds. A soft landing favors real estate.

• In addition to that, US and Canadian residential real estate markets exhibit a structural supply/demand imbalance which will have to be reflected in prices after a rate normalization revives transaction activity. Both countries have been building way less homes than they should given immigration flows and demographic conditions. This is particularly true as changed consumer preferences are rendering some of the existing housing supply inadequate.

• Canada in particular will be a special case for two reasons. Firstly, its interest rates will likely drop much faster than in the US because household balance sheets are more leveraged and leveraged with shorter duration which makes households more vulnerable to rate hikes. The BoC should have never followed the US to 5% and will have to walk back this mistake. Secondly, as a % of its population, Canada’s population is much stronger than the US and it doesn’t have a national infrastructure to distribute newcomers evenly throughout the country. This exacerbates the shortage issue.

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Current real estate sentiment and positioning

Half a year ago, I asked people why they disliked real estate and what would have to change for them to like it.

The post received one like and 10 comments. Most of these comments answered the first part of the question. None of them answered the second part.

Actual positioning data is backing this anecdote. Per the latest Bank of America Fund Manager Survey, REITs are the most hated asset class by a mile.

The last time I remember seeing a sector so hated was Energy in the fall of 2020. Needless to say that the sector ETF XLE 0.00%↑ tripled over the following two years.

Real estate isn’t just hated today. It has carried the lanterne rouge for an entire year, having placed last for the first time in August 2023. It is now as hated as it was during the height of the GFC!

What pushed real estate out of favor?

Disliking real estate might appear logical to you given current economic circumstances. But I have had a really hard time steelmanning the bear case for the purpose of this article. I have been pondering about it for several months and almost abandoned it before publication.

After all, we are living in times where large numbers of people have lost trust in the government’s ability and willingness to protect the value of money. It’s a result of more than a decade of ZIRP and QE followed by the worst inflation shock in 50 years.

This political failure has incited an obsession with scarcity-based investing which created a $2tn crypto industry. The entire raison d'être of that industry is monetary doomerism. Real estate should actually do well in such a zeitgeist because it is known to have inflation protection baked in.

Yes, high interest rates are problematic for real estate because a) investors (have to) employ leverage and b) unleveraged returns compete with cash returns. But I don’t think it’s that straight-forward. After all, many investors are actively betting on lower rates. Wouldn’t real estate be a suitable vehicle to do so just like bonds?

Real estate’s fall from grace has to be viewed in historical context. It’s firstly important to understand that there is considerable demand in the investor community for defensive income producing assets, especially in an ageing society. Such assets are attractive because you don’t have to worry much about price fluctuations as you simply collect your periodic income and reinvest or consume it. The natural go-to-asset for this purpose is a long dated treasury bond. It’s risk-free from a nominal perspective because it carries zero credit risk.

There is a problem however: A treasury bond is not risk-free from a real perspective. Its real value can fluctuate wildly when inflation volatility is high. And a bond becomes particularly unattractive when central banks artificially suppress interest rates so they become negative in real terms.

We have just had an extreme case of exactly that. During the ZIRP age from 2009 to 2021, the entire yield curve was suppressed, effectively filtering out bonds for many investors. Government bonds were mostly purchased by central banks and certain other private and public institutions that were incentivized to hold them for regulatory reasons or because paying a fee on their cash deposits was an even worse alternative. The needs of defensive income investors were however still there. So they had to find alternatives. They found those alternatives in dividend stocks, short volatility bets and in real estate.

The chart below plots the net flow into the six largest dividend and dividend growth ETFs in the US. Together, these ETFs have $227bn of assets under management, which is up from just $8bn at the end of 2006.

As you can see, inflows into these ETFs have been highly cyclical with major waves in 2009-11, 2018/19 and 2021/22. Some of these flows happened during periods of broad-based equity inflows. But I believe some of them were distinct flows originating from the bond market because rates were manipulated down, particularly in the early 2010s (when investors realized ZIRP is going to stick around for longer) and the early 2020s (when they thought ZIRP had been cemented forever).

Real estate was part of this equity income bid. Take a look into the positioning chart earlier. Its institutional portfolio weight rose all the way from post-GFC lows until the beginning of the last hiking cycle in early 2022.

The reoccurrence of interest rates worth their name has made investors abandon these proxy assets. Much of the real estate outflows have financed the bond bid that we have seen. It was a reversal of the paradigm in the 2010s. To what extent this process has been completed is anyone’s guess. It appears plausible however that such an extreme rotation will ultimately overshoot. And then mean revert.

Such a mean reversion would naturally begin at a moment of utter capitulation when the bear case is obvious. Real estate seems pretty close to such despair these days. To many people, its risk return profile is not compelling. Even if lower rates lift valuations, it would likely come with economic weakening which would hurt rents. Bonds don’t have that problem which is why their portfolio allocations are going through the roof. And inflation is not deemed a positive for real estate because it would come with a corresponding increase in rates that would hurt valuations. It’s considered a lose-lose situation.

Fundamentals: United States

I wrote the piece below on the US housing market below more than two years ago. In my opinion, it’s a still a good starting point to think about market dynamics.

9 reasons why we may not be in a housing bubble

I argued that housing supply is likely inadequate for the growing population because of underinvestment following the GFC.

But more importantly, I argued that people are most likely underestimating the demand for real estate for a couple of reasons.

Firstly, from a demographic perspective, there are two age groups that are most important for net housing demand. Ages 25 to 39 are forming households. They are typical first time buyers. And ages 80 and higher are usually selling their last home. The chart below illustrates that we are right in the middle of rising numbers in the first group while an acceleration in the second group will not start until later this decade.

In short, Millennials still need homes and Boomers are not selling them yet.

Secondly, from a consumer preference perspective, housing needs are always changing. Bigger rooms, more bathrooms, more square footage, smaller households and so on. A Millennial with his newly formed family often does not want to or is not able to move into the home is Boomer parents will be vacating soon.

Also, certain neighborhoods, cities or even entire states are falling out of favor or getting en vogue. This is particularly true during times of economic change and political division. A portion of the existing housing supply will therefore become inadequate for market purposes every year. Even more new housing must be built to compensate for that.

Some demand may have been pulled forward during the pandemic housing binge. But I really doubt that most Millennials have figured out their housing needs in those short few years. The problem is simply on pause. For reference, here is once more the existing home sales chart that I have shown a couple of times already. I find it profound.

Fundamentals: Canada

I have written in quite some detail about my expectation of an incoming Canadian real estate boom. It passes the embarrassment test even better than a general real estate bull case.

To not overburden this article, I am simply going to refer to my previous work below:

CAPREIT: Betting on the Canadian Century

Oh Canada...

I still stand by everything I have said in those articles.

I only want to add one anecdote that you might find interesting: I happen to know some real estate developers in Ontario. They are currently pausing development projects because interest rates and home prices can’t be aligned with production costs. Think for a moment about what this means. New homes in Ontario are barely selling for replacement cost. Does this sound to you like a market that is running hot? Isn’t it more likely that this is cyclically bombed out beyond imagination? And all of this happens while the population is rising at breakneck speed. The counter stands at 41.6m now. 1.6m people more than last summer when it hit 40m unexpectedly quickly.

Sincerely,

Your Fallacy Alarm