We Have Not Yet Hit Rock-bottom Prices in Real Estate (Updated 7/15/2011)

Take out private-property rights and wealth vanishes. We revert to the ravaging of the commons and to mutually assured destitution. That is what Obama and the market molesters are really about. They don't believe the fantasy that redistributing wealth brings equality of results. They want you to believe it! - Lorenz Kraus, The Fantasy of Wealth Redistribution, Ludwig von Mises Institute, November 12, 2010

Since the housing market peaked in 2006, some 6.5 million homes have been lost to foreclosure. There are likely another 4.3 million more homeowners who are “seriously delinquent,” meaning they are more than three months behind in their payments, according to data released by the Mortgage Bankers Association this week. Many of those homeowners will soon enter the foreclosure pipeline. - 4 Million American Foreclosures Yet to Come, MSNBC, May 21, 2011

For the first time in U.S. history, banks own a greater share of residential housing net worth in the United States than all individual Americans put together. - 50 Statistics About the U.S. Economy That Are Almost Too Crazy to Believe, End of the American Dream, June 2, 2010

20% Drop in Housing to Cause Recession in 2012, Says Gary Shilling

Daily Ticket
July 14, 2011

Stocks rallied Wednesday after Federal Reserve Chairman Ben Bernanke suggested the central bank would go ahead with another round of stimulus -- aka quantitative easing -- if the economy continues to slump. In this scenario, the Federal Reserve would once again purchase assets to keep interest rates low in an attempt to support the economy and prop up asset prices.

So far, the Fed's actions have done more good for asset prices like stocks (see: S&P 500 chart since 2009) while doing less to help the economy (see: June jobs report). U.S. gross domestic product grew just 1.9% in the first quarter of the year. For 2011 as a whole, the Fed forecasts U.S. GDP growing at 2.7% to 2.9%, which is lower than the plus 3% forecast they made in April.

Today's guest, Gary Shilling, President of A. Gary Shilling & Co. and author of the Age of Deleveraging says another recession is brewing -- no matter what action the Fed takes.

"Economic growth here and abroad is slipping, making a 2012 recession a distinct possibility," he writes in his July newsletter. And, "when you have slow growth it doesn't take much of a shock to throw you in negative territory."

Shilling says the shock to trigger the next recess is "another big leg-down in housing." (An asset class the Fed has not been able to reflate.) As those familiar with Shilling know, his forecasts are generally bearish. However, in his defense, Shilling was one of the few economists who correctly predicted the dangers of the subprime mortgage market and its impact on the broader economy.

The problem with the real estate market remains excess inventory. Based on Shilling's research, there are 2 million to 2.5 million excess homes in the country -- a supply that will take 4-5 years to work-off. The result: Housing prices will fall another 20% and underwater mortgages will balloon from 23% to 40%, he says.

With housing slumping again, Shilling says recession is coming to a town near you in 2012.

Housing Market Double Dip Surprises Economists — Just as Original Crash Did

Fund My Mutual Fund
May 9, 2011

The same economists shocked by the original housing crash (prices can’t go up forever?), now appear to be in the fetal position as the much too obvious second leg of the downturn has arrived.

While I do have an economist degree, living in the locale experiencing a 1 state Depression [Jan 27, 2011: Metro Detroit Home Prices Back to 1994 Levels...Before Accounting for Inflation] had me much more negative than those who live in the ivory towers of Manhattan or D.C..

I wrote a few years ago about a few articles that also opened my eyes to what was going on out there in the rest of the country. [May 30, 2005 - Fortune: Riding the Boom] [Sep 11, 2006: Option ARMs - Nightmare Mortgages] Hence in late 07, I showed with simple math why we were in for a doozy of a drop in the housing market. [Dec 6, 2007: What Should Median Housing Prices be Today?]

As you can see from the mid/late 1970s to 2001/2002 the ratio was consistent in a tight range between 2.6x to 3.0x. Essentially this means the median home price in this country was 2.6x — 3.0x median household income. And it’s been right around 2.8x for most of that time. That’s 30 years….

Then in 2002+, we had innovation…. great innovation… and 1% interest rates. Easy money. No mortgage regulation. Happy times. And crazy housing prices that detached from reality.

In 2006 at the height of ‘innovation’ (where were these politicians 1 year ago? seriously), the ratio went "off" the chart, it appears 4.0x. After the ‘correction’ we’ve had, that ratio has fallen all the way to…. 3.8x.

In July 2006 at the height of insanity the median price of a home was $230,200.

It has already fallen in less than a year (October 2006) to $207,800.

Pain over, correction done — time to party. Right? Wrong.

What are median incomes nowadays? As of 2006 the median household income was $48,201.

$48,201 x 2.8 ratio (historical average for past 30 years) = $134,962.

Folks that is still nearly $73K away…. or a drop of 35% from October 2007 levels. And a drop of 41% from peak levels in July 2006.

Correction over? Not by a long shot.

Now that’s assuming we return to historical norms. I am fully confidant that by the time this is all said and done NEW financial innovations will be introduced (along with bailouts) which will keep prices elevated above where they ‘should be’ without the ‘not so invisible hand’ propping things up.

Sure enough we’ve had bailouts, handouts, the type of Federal Reserve policy I never imagined, etc etc. Much of it just good money thrown down a rabbit hole to try to stop reality. [Mar 5, 2009: WSJ - Mortgage Bailout to Aid 1 in 9 Homeowners] [Dec 8, 2008: More than Half of Homeowners with Modified Loans are Back in Trouble]

So here we are 3.5 years later. With record affordability. And close to record mortgage rates. And still housing prices are dropping. I won’t go into the litany of reasons that we discussed ad nauseam in 2008-2009 on why this would be the type of housing downturn the likes we’ve never seen before.

But let’s be clear, despite the protestations of most on financial infotaintment TeeVee we have years more to go before prices clear.* And of course, this May, June, July we will see an uptick in housing activity — as we DO every spring/early summer — and the Kool Aid drinkers will be making their bottom call yet again. (3rd year running) One day these broken clocks will be correct.

*As always I am excluding places with bubble economics like Washington D.C. [Mar 11, 2010: [Video] America’s 3 Wealthiest Counties Now Ring Washington D.C.], areas where Federal Reserve handouts galore continue to the financial community like Manhattan, or "America’s Australia" aka the northern plains states.

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This morning’s Wall Street Journal cover piece is about the "shocking" downturn in the housing market, without the government paying people to buy homes as we did 12-24 months ago.

• Home values posted the largest decline in the first quarter since late 2008, prompting many economists to push back their estimates of when the housing market will hit a bottom. Home values fell 3% in the first quarter from the previous quarter and 1.1% in March from the previous month, pushed down by an abundance of foreclosed homes on the market, according to data to be released Monday by real-estate website Zillow.com. Prices have now fallen for 57 consecutive months, according to Zillow.


• Last year, the housing market showed signs of improving as price depreciation slowed in some markets and stabilized in others. In response, a number of economists began forecasting that housing would hit a bottom in late 2011, then begin to recover. But the improvements, spurred by federal programs that gave buyers up to $8,000 in tax credits, proved fleeting. (uhh, I believe the current parlance is "proved transitory") Sales collapsed when the credits expired last summer, and prices in many markets have been falling ever since.


• While most economists expected sales to decline after tax credits expired, the drag on the market has been greater than many anticipated. "We expected December and January to be bad" as the market reeled from the after-effects of the tax credit, said Stan Humphries, Zillow’s chief economist. But monthly declines for February and March were "really staggering," he said. They indicate "a reflection of the true underlying demand, which is now apparent because most of the tax credit is out of the system, and it’s being completely overwhelmed by supply."


• Prices are decelerating in large part because the many foreclosed properties that often sell at a discount force other sellers to lower their prices. Mortgage companies Fannie Mae and Freddie Mac have sold more than 94,000 foreclosed homes during the first quarter, a new high that represented a 23% increase from the previous quarter. More could be on the way: They held another 218,000 properties at the end of March, a 33% increase from a year ago.


• The companies are bracing for more bad news: On Friday, Fannie reported a $6.5 billion net loss, largely as it boosted loan-loss reserves in anticipation of falling home prices. (I used to post the Fannie Mae losses on the blog, but it appears no one cares anymore about Fannie coming to the taxpayer every quarter and asking for more handouts — it’s just the new American status quo I suppose. I do get a kick — they still do it on a Friday evening each quarter when everyone is headed home for the weekend.)


• Paul Dales, a senior U.S. economist with Capital Economics, says prices could fall by as much as 10%, down from his previous forecasts of around 5%. A March survey of more than 100 economists by MacroMarkets LLC forecasts a 1.4% drop in prices this year, down from the December estimate of a 0.2% decline.


• Other home-price indexes also show weakness. The widely followed Case-Shiller index published by Standard & Poor’s showed that prices climbed from April 2009 until last summer, when they started declining as tax credits expired. Today, prices are on the verge of reaching new lows, the index shows. The Case-Shiller index tracks repeat sales of previously owned homes using a three-month moving average.


• According to the Zillow index, a handful of California markets and Washington, D.C., saw price appreciation last year, but that has since reversed. Mr. Humphries attributes the "double dip" in those markets, which include Los Angeles, San Francisco and San Diego, to the way in which the tax credit stimulated demand from buyers. When the tax credit went away, markets were left with rising supply from foreclosures but with less demand from buyers.


• To be sure, steep declines in home prices along with mortgage rates near their lowest levels in decades have helped make housing more affordable than at any time in the past 30 years, according to Zillow. Markets that have lower levels of foreclosures, such as Dallas, and those with better job-growth prospects, such as Washington, are faring better.


• Buyers who qualify for mortgages are demanding bigger discounts as added insurance against further declines in values. Sellers, meanwhile, are balking. "More often, they don’t want to take the first offer," says Jeffrey Otteau, president of Otteau Valuation Group, an East Brunswick, N.J., appraisal firm. "What they don’t realize is, in an oversupplied market, the next offer is for less."


• While some analysts have argued that home prices need to fall to "clearing prices" that will attract more buyers, price declines could also complicate any recovery by pushing more borrowers under water. Zillow estimates that more than 28% of borrowers owe more than their homes are worth nationally. Those numbers are much higher in hard-hit markets such as Phoenix, where more than two-thirds of borrowers owe more than their homes are worth.

Markewatch.com also weighs in today:

• Average home prices are down 8% from a year ago, 3% over the quarter, and are falling at about 1% every month, according to Zillow.


• Zillow now predicts prices will fall about 8% this year and says it no longer expects the market to bottom before 2012. “There’s no way we can get to flat, from these depreciation levels, in the last nine months of the year,” says Zillow economist Stan Humphries. “Demand is a lot more anemic than we had previously thought.”


• Falling real-estate prices mean spiraling hidden losses throughout the economy, from banks to homeowners. Remember Japan’s “zombie banks”? Here in America we have “zombie homeowners.”

The Allure of Real Estate

By Fred Buzzeo, Ludwig von Mises Institute
January 12, 2011

These days everyone is sitting at the edge of their seats waiting for a real-estate recovery. Indeed, during the past ten years, everyone has become a real-estate addict. It is hard for me to walk down the street without someone telling me that the market has "hit bottom" or that the market is on the "rebound."

Do I know anyone interested in this piece of property, they ask? Is the timing right? Can I put together a deal? These are the questions that I am constantly bombarded with by the real-estate "junkies" that I encounter while making my rounds trying to find the next deal — and my next paycheck.

Most people are attracted to real estate because they perceive it to be a high-powered game. They envision building empires the way that most of us have done on the Monopoly board. People like real estate because it is a sexy investment. And unlike stocks and bonds, it can actually be touched and admired. You can even live in it. It is part of the American dream.

As a developer, I can tell you from personal experience that completing a project, no matter how small, gives one a great sense of accomplishment. I have colleagues in the business that have transformed entire city skylines. Wow! It gives me a rush just thinking about it.

These attributes, however, are what makes real estate so volatile and, therefore, dangerous. Fortunes have been made and lost — sometimes within the course of the same business cycle. And the fact of the matter is that most of the real-estate-development process is not even under your control. You can be stymied in all of your efforts by some government planner who has never risked a dollar of his own money and who has never even added a single unit to the real-estate inventory. A notable mention should also be given to the roller-coaster ride that most developers are given by the erratic monetary policy of the Federal Reserve.

Because the real-estate market constitutes a large portion of GDP, the government closely watches over real-estate activity. Housing inventory and vacancy rates are studied. Even the number of building permits filed is monitored along with a dozen of other statistics that relate to real-estate activity.

There is no denying that real estate is an important component of the economy. In fact, the world economy is currently in a tailspin caused by the malinvestment that found its way into the real-estate development process.

Therefore, the government is focused on stabilizing the market. Each day that you read the paper, you will find some new government concoction aimed at reversing the real-estate meltdown. In fact, you read about all sorts of ideas aimed at stabilizing the real-estate market so that economic growth can be stimulated.

Nevertheless, all the "support" that the government has given to the real-estate market in the last few years has done very little. Even the S&P/Case-Shiller Index has indicated that the real-estate market has weakened further. According to the recently released numbers, six cities have hit new bottoms. This is not good news for the government whiz kids working on the real-estate recovery.

Therefore, the real question to ask is, can you spur economic activity by getting the real-estate market moving upward again? It seems to me that this is like putting the proverbial cart before the horse. Let me explain:

In order to get the housing market moving again, there must be willing and able buyers. People are usually willing and able to buy when they have jobs. Without economic expansion, there is no job creation. Without jobs, people do not have the confidence or the purchasing power to consider buying or investing in real estate.

Once again, we can turn to Say's law for guidance here. An increase in productive activity, and hence job growth, will create the demand for products in general, including the demand for homes and other real-estate assets.

With an unemployment rate above 9 percent, not to mention the current rate of underemployment, the US economy is not positioned to create significant job growth. The small business man, the main engine of job growth, is still financially strapped and unable to expand and create value. Unless this situation is altered, there will be no significant growth in real-estate assets. This is not rocket science.

So it seems to me that the main focus should be aimed at increasing US productive capacity. As a free-market operative, I may be biased. My prescription is therefore simple — let the free market operate and we will reach a new equilibrium in the shortest amount of time possible. The Depression of 1920–21 proves this conclusively. It was over in one year and has been labeled "our last natural recovery to full employment." This short duration and the minimal amount of government interference are the reasons that this economic downturn is conveniently "forgotten" by the mainstream.

My next suggestion is going to shock many nonbelievers: stop trying to stabilize the market. Let the market deflate. Real-estate prices are still too high in many areas. Therefore, seasoned investors — at least those who still have some money left — are not buying. The risk–return ratio is still not positive, or at least still not acceptable.

Prices must drop to a point where mortgage payments are not consuming an entire paycheck. After all, there is still milk and bread to buy, not to mention little Johnny's tuition payments. And let's not focus simply on the Housing Affordability Index, a statistic that just before the meltdown was telling us how cheap it was to own.

The proper way to look at this is to compare the cost of buying a house to the cost of renting a similar unit. If after you factor in the tax expenditure and any possible appreciation, it still makes more sense to rent than to buy, then the price is too high. When I am marketing a unit, this is the first analysis that I perform to determine value. Obviously, valuation is more complicated with larger investment properties where we must employ discounted-cash-flow analysis and other financial modeling. But the crux of the problems that we are experiencing today is in the primary and secondary home markets.

A deflation in the market will also restore the confidence of prospective buyers. No one is going to buy a home that is underwater on the date of closing. Everyone wants to feel that there is some value in the asset that they buy. We have not reached that point yet.

From a personal perspective — I look at real-estate assets nearly every day — I am still not finding any deals that make sense. Short sales are the only game in town and many of them are still not reasonable given the amount of work necessary to bring the unit to a marketable state. In addition, most short sales wind up not closing. To protect against this, title companies that I deal with want the title-search fee up-front when they realize that they are working on a short sale.

It is only when prices drop to the point where the deal makes sense that housing inventory will drop to normal levels — a sign that the "bottom" has been reached. Even today, inventory in many markets is too high. As of December 2010, the national inventory level is at 10.5 months. It is much higher in specific markets. For example, it will take over 20 months to absorb the roughly several thousand units priced over 500K that are currently for sale in Miami-Dade County. A healthy inventory of homes is somewhere between 4 and 6 months. Therefore, prices are still too high.

I am all for workouts for buyers who put down a substantial down payment and have equity in their homes but simply cannot make the mortgage payment due to a reduction in personal income. This is a free-market approach that many smart bankers are employing. However, those homes that are underwater and cannot be saved should be heading straight to foreclosure. The quicker that this happens, the quicker the market will reach bottom and the quicker that the homeowner will be free of a heavy financial burden. This deflation, a condition that is simply an economic adjustment, is a necessary requirement to subdue an overheated market.

The same scenario is applicable to the commercial real-estate market. Everywhere you look you can see vacant commercial spaces that were occupied for years by the same tenant. If small businessmen experience a loss, they will eventually shut down and vacate the spaces they once occupied. Unless small business begins to grow, the spaces will remain empty. There is, therefore, no way to help the commercial real-estate market unless you can generate a healthy rate of small-business formation.

Finally, I should like to point out that all of the TARP money given to banks did absolutely nothing to help the ordinary consumer. All it did was positively adjust the balance sheets of the "too-big-to-fail" institutions. Most banks are sitting on cash and simply not lending unless they are in an extremely favorable position. This sounds ironic because it was their unhampered lending that created the mess in the first place.

Contrary to the thinking of the government economists, banks are not going to lend money, even if it rightfully belongs to the taxpayer, simply to increase the number of nonperforming loans on their balance sheets. Why aggravate the situation? Anyhow, does anyone really think that the bailouts were aimed at helping the consumer?

Fred Buzzeo is a real-estate developer and a consultant to small property owners in the New York City area. He resides with his wife and two sons in the Town of Oyster Bay, (Long Island), NY. During the 1990s, he held executive positions in city municipal government. It is during this employment that he saw firsthand the pitfalls of government intervention and regulation. Send him mail. See Fred Buzzeo's article archives.

Housing Bubble Correction

iTulip.com
Originally Published on January 20, 2005

Fifteen Years to Revert to the Mean

"If there is a real shift downward in housing demand, it would have a dramatic impact across the entire economy," said John Benjamin, a professor of finance and real estate at American University.

Millions of Americans have become dependent upon rising home values to support home-equity loans and mortgage refinancings, which can be used to pay for cars, remodeling projects, clothes and more.

"We live in a consumption economy that is financed by debt," which in turn largely rests upon our home foundations, Benjamin said.

Since the beginning of the economic recovery in November 2001, employment in housing and housing-related industries has accounted for 43% of the increase in private-sector payrolls, according to Asha Bangalore, an economist for Northern Trust Corp.



Chart 1: Correlation of Housing Prices to Employment

Chart 1 above shows that housing prices are strongly correlated to the unemployment rate. Housing prices fall as unemployment rises, and vice versa. Given that 43% of all jobs created since 2001 are housing (bubble)-related, a decline in housing-related payrolls can be expected to reinforce housing price declines in the bust part of the cycle. The rate of home equity extraction is a good proxy for the housing market itself. Home equity extraction tends to rise in line with property values and declines on the way down; no home owner wants to borrow against a deflating asset, and no bank wants to secure a loan against one either.



Chart 2: Home Equity Extraction - Past and Predicted

We'll use home equity extraction as our yardstick to project the bust. Thanks to my friend Paul Kasriel at Northern Trust for the original of Chart 2, which shows home equity extraction from 1950 until 2005. I have modified it to show a possible trajectory of home equity extraction decline in seven steps, A through G, from now until 2020. While I'm fairly confident in the length of the entire process, the length and timing of each step is subject to a wide range of error.

Step A: You are here. Whether the rate of home equity extraction implodes from here (as shown) or decreases more gradually is a matter of debate, although in past boom-bust cycles, the bust rate of decline has been significantly more rapid than the boom rate of growth. What is not debatable is whether the rate of home equity extraction will revert to the mean rate of about zero, from the current rate of more than $250 billion annually. It will.

In fact, the rate of home equity extraction will tend to overshoot the mean to reach an extreme negative rate of equity extraction (building equity) that's twice the rate of positive extraction that occurred during the boom phase. This relationship occurred in the previous two cycles, which bottomed in 1982 and 1995, respectively. This implies negative equity extraction of minus $500 billion per year at the cycle trough. Chart 2 shows a more optimistic prediction of negative $250 billion occurring between 2015 and 2020. This more prosaic estimate accounts for government efforts to mitigate the impact and minimize the overshoot, by offering specialized loans, making direct purchases of securitized mortgage debt, and so on.

Step B: As housing prices begin to decline, sales will continue, though more slowly and less frequently. Old habits die slowly. One year into the decline, housing speculators will have left the market, but home owners will generally still believe that prices will either resume their rise or at least flatten out, not continue to decline. Remember the first year of the stock market bubble decline, when most people hung in there until they'd lost all of their money? The first lesson of behavioral finance is that the most common mistake made by market participants is to hang on too long and fail to cut losses.

While home owners at this stage will borrow less against their houses, and loans will be more difficult to come by, the average home owner will still make frequent trips to Home Depot or hire contractors to make home repairs and improvements, believing they'll "get their money back" in an increase in the value of their home at least equal to the cost of fixing it. Some home owners will put their home up for sale—if they purchased early enough in the boom so that they can still realize a profit, even selling at five to twenty percent below the peak price.

Step C: After prices have declined for two years, large numbers of buyers who purchased near the top of the market will begin to feel the psychological effects of being underwater on their mortgage. They will be less inclined to borrow money, or to spend money fixing up their home, as home improvement value increases will be swallowed up by general market price declines. There will still be profits to be made by those who bought very early in the previous boom cycle, but fewer people will have this option.

As transaction volumes continue to fall, demand for housing-related employment will decline too. The first signs of labor market distress will start to show up, as more and more of that 43% of the private sector who found jobs in the housing industry are no longer needed. Coincidentally, major employers—such as the U.S. auto industry—will be going through major restructuring, adding to pressures on housing prices in some areas. Some home owners will need to sell at a loss in order to move to regions of the country where the labor picture is better, and will do this if they have enough equity and are not paying cash out of pocket to cover their remaining mortgage obligations. These sales will further depress home prices.

Step D: Three years into the decline, marginal home buyers will learn what owning a home really costs, versus renting when housing prices are declining and jobs are more scarce. Rent is a fixed cost, whereas home ownership presents many variable costs, including increased interest payments on ARMs, and rising tax, insurance, and energy costs. Also, upkeep for the average home typically costs five to ten percent of the price of the home, annually. As prices fall, homeowners will have less access to home equity loans. Many will not be able to afford repair and maintenance expenses. Homes in some neighborhoods—and in some cases, entire neighborhoods—will begin to look neglected, further depressing prices.

Step E: Five years into the downturn, rising unemployment will begin to more seriously affect the market, as indicated in Chart 1. As unemployment rises, homeowners will leave housing bust regions to move to areas where there are more jobs. Many houses will be sold at a loss, or even abandoned, as the market price falls below the loan value. Given the choice between paying cash out of pocket to sell their home or leaving the keys with the bank, many home owners will make the latter choice.

Step F: Ten years into the downturn, real estate will be widely regarded as a terrible, "can't win" investment. McMansions will be subdivided for rental as multi-family homes.

Step G: Ten to fifteen years after the start of the decline in housing values, prices will bottom out, setting the stage for the next boom. Time to buy.

Housing Bubble Correction Update: Geographic Regions Cascade (March 29, 2006)