Move Away From Real Estate Stocks

 | Aug 30, 2017 | 1:00 PM EDT
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In last week's column, "Repeal of Mortgage Interest Deduction Is Way Past Due," I discussed the potential for the mortgage interest deduction (MID) on owner-occupied properties to be reduced and the dichotomy between the perceived negative impact, which is pervasive within the financial industry, vs. the logically marginal positive impact it would have in real terms.

I'm going to expound further on that here as both the Trump administration and the House of Representatives have indicated that restructuring the MID is being considered.

Politicians openly discussing this is similar to a company being put "in play." Once that happens, a process is begun that rarely results in the company's status returning to what prevailed prior to being put "in play."

The principal issue for the MID now is not whether it will be changed but what that change will be.

Every time I've brought up this issue, subscribers have told me it will never happen because the real estate lobby and support for the MID by most politically aware and active individuals is too great, and that talk of doing so is really just a red herring or bargaining chip to leverage concessions from other areas.

That was true for generations prior to the last housing crisis, but it has not been the case since.

The last crisis largely extinguished the political clout of the real estate and mortgage banking industries.

The best empirical evidence of that is that there's been no legislative attempt by either the president or Congress to provide stimulus for the housing sector since that crisis, other than the feeble attempts at providing mortgage restructuring options.

That's left the MID vulnerable for a restructuring and just waiting for the political necessity to make it happen.

That necessity was not caused by the election of Donald Trump and his ideological preference for a more financially efficient federal government. It was going to be faced by any president.

His desire to substantively restructure both the tax code and federal spending, however, causes the MID to become a prime target simply because of how much capital it makes available to be reallocated.

As the reality that the MID will be altered this time begins to resonate with investors -- which is imminent because it will be a part of the process of raising the debt ceiling, negotiating a new tax plan and creating the 2018 federal budget -- the logical and prudent initial response by investors will be to move capital away from everything associated with the real estate industry.

Even though reducing the MID is positive, or at least neutral for housing, moving money away from sectors affected by the change is prudent and rational because it's a big change.

The MID has been in place since regimented personal income taxes were concurrently introduced as part of the passage of the 16th Amendment to the Constitution in 1913. It's survived every legislative attempt at reducing it since then, with the last time being the 1986 tax reform act, the last major U.S. tax overhaul.

So, there's nothing wrong with moving money out of the real estate sector until the impact of the change can be witnessed.

However, investors should not mistake that prudent move as an affirmation by investors that the real estate industry will be harmed by the MID's restructuring.

There will be excellent long-term buying opportunities presented by that short-term withdrawal of capital, and that's what investors need to watch for.

Those opportunities are going to be made across multiple areas because real estate's direct and indirect impact accounts for about a quarter of GDP.

The direct impact will be felt by homebuilders, and to a lesser extent by mortgage lenders, mortgage servicers and mortgage insurance companies.

But, because most of the financial expense associated with real estate is concentrated in the maintenance, servicing and ownership transferring of existing improved properties, the immediate negative impact on share prices may be even greater on the appliance manufacturers, residential mortgage REITs and Zillow Group (Z) .

There are far too many individual companies involved in the sector broadly to list here, but investors should simply make a watch list of them all and monitor the performance of the stocks as the tax and federal budget debates heat up.

The immediate potential negative impact on stock prices could be exaggerated by the simultaneous potential for the Federal Reserve to begin balance-sheet reductions.

But that too is actually positive for the industry.

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