Beware the Blue Sky–The Current Housing Market

[December 2007]

“Men go mad in herds, but only come to their senses one-by-one.” –Charles Mackay

Despite the obvious bursting of the housing bubble and the associated freezing up of credit markets, many (suspiciously self-serving?) forecasters and investors suggest that the housing slump is close to bottoming out–or soon will be!

Even now, TOFKAOOATT (The Organization Frequently Known As Overly Optimistic All the Time) aka the National Organization of Realtors (NAR) projects that existing home sales will gradually rise over the next year as “pent-up demand is unleashed.”??? This would be great news if it made any sense.

But it doesn’t! Aside from the growing problems in the financial system and credit markets, there is the massive problem of falling home prices.

Today’s housing market–a unique situation

In the 45 years prior to 1995, house prices (adjusted for inflation) barely rose at all. During the past decade, house prices nationally rose by 70% more than inflation.

Consequently, an estimated $8 Trillion in “bubble wealth” was created. That’s a lot of “Blue Sky” in the real estate markets right now!

In fact, in its most recent quarterly study, Global Insight (a leader in economic analysis, forecasting, and market intelligence) concludes that despite falling home prices, housing remains overvalued in 208 (63%) of the 330 U.S. metropolitan areas examined and is “extremely overvalued” in half of those.

The report points out a critical caveat for real estate and real estate note investors:

Housing markets tend to adjust very gradually, and price declines have historically averaged 18 quarters in duration.

Heaven can wait!

While the NAR waits for the “pent-up demand” to be unleashed, we’re more cognizant of the”pent-up supply” of housing that is growing relentlessly. It’s too early to tell how bad things will get before they start to get better; however, a “soft landing” isn’t likely.

The foreclosure problem has really just started. Subprime resets will peak in 2008; but “Pay Option ARM” and “Alt-A” loan problems will not peak until 2011. Perhaps we’ll see a “dead cat bounce” in 2009; maybe another in 2010–before the final collapse heading into 2012.

A harbinger of what’s to come

With about 14 quarters of probable price declines ahead of us, home prices are only down about 5% percent from their peak of late 2005-mid 2006.

Though the worst decline since The Great Depression, given the unprecedented price explosion and the fundamental detachment of housing costs from any affordability rationale, there is no question that this is but a harbinger of what’s to come.

The upshot? There is still a lot of “Blue Sky” out there.

Anyone who purchases housing for anywhere near these fantasy-based asking prices will suffer losses for years to come–UNLESS they apply critical AND sensible economic fundamentals to their valuation model and discount their purchase price accordingly. The same caveat also applies to note buying–perhaps even more so.

Truth or consequences?

The core problem is that millions of people bought homes in a marketplace not unlike that which fosteredTulipmania, the famous “commodities crash” that gripped Europe in the 1630s.

Like the tulip-crazed buyers back then, “house-crazed” buyers borrowed too much money over the past decade, buying into an every increasing price bubble, that had absolutely no basis in “utility value.”

Predatory mortgage lending worsened the present situation, but interest rates are not the problem and cannot fix the problem. The bottom line is that too many people bought too much house.

Since the housing market went completely insane in 2002, home prices in many areas are still seriously disconnected from fundamentals far beyond any historically known relationship to either rents or salaries.

Never before in our history has it been so cheap to rent relative to own. Rents are as low as 40% or 50% of monthly mortgage costs (vs. historical 10-year average of 92% rent-to-mortgage ratios) in various parts of the country; and yearly rents are as low as 3% of purchase price.

The harsh reality is that salaries cannot cover mortgages at existing prices. Home prices need to fall at least 20% to 30% to reach equilibrium in many markets, according to a recent report from Wachovia Corporation in December 2007.

In some areas 50% to 60% price declines are considered very possible! We are already seeing builder discounts in many areas of 30% or more on the same models as last year, not including increased concessions. Condos are down 40% or more at auctions. Prime buildable lots have dropped as much as 60%!

To put these price declines into perspective, both the S&P/Case-Shiller U.S. National Home Price Index and the OFHEO, Purchase Only, SA index show that a 15% nominal price decline would roll prices back to late 2004, for both indices.

At a 30% price decline, Case-Shiller moves prices back to mid-2003, and OFHEO, 30% drops prices to late 2002. And a 50% decline would carve home prices all the way back to 1997 levels!

Not all areas will see the same price declines of course, but these indices provide a gross estimate of the number of homeowners with no equity, based on price decline assumptions.

At the end of 2006, there were approximately 3.5 million U.S. homeowners with no equity or negative equity (7% of the 51 million household with mortgages). By the end of 2007, the number will have risen to about 5.6 million.

If prices decline an additional 10% in 2008, the number of homeowners with no equity will rise to 10.7 million. And that is more than likely, in light of how the market is shaking out of its chimerical folly today. Many areas in the country are just beginning to see prices plummet.

So, how do private note investors and creative real estate investors turn all this baloney into prime rib? By taking a hard look at reality, adapting to it–and perhaps even help reshape it!

Where’s the beef?

To paraphrase from a quiz that uberinvestor Warren Buffett presented to Berkshire-Hathaway shareholders at their annual meeting in 1998,

“When you are buying hamburgers, would you prefer that the price of hamburgers is going up or going down? Likewise, if you expect to be a net saver during the next five years, should you hope for a higher or lower [real estate] market during that period?

“Many investors get this one wrong. Even though they are going to be net buyers of [real estate] for many years to come, they are elated when [real estate] prices rise and depressed when they fall.

“In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying? This reaction makes no sense. Only those who will be sellers [of properties] in the near future should be happy at seeing [real estate prices] rise. Prospective purchasers should much prefer sinking prices.”

If we are to choose the advice of any investment “guru” out there, we can do a lot worse than the “Oracle of Omaha”. We can also see that these present times, as painful as they are, will prove to be an epochal time of wealth building, if we position ourselves correctly.

Discipline and patience rule the day! Creative real estate investors and note buyers will need a new way of looking at the marketplace.

This will require the ability to ignore the hyperbole of the marketplace generated by builders, real estate agents, mortgage lenders, and unscrupulous appraisers and maintaining an intense focus on the economic factors specific to that community.

Toss out the concept of “fair market value” for the most part, and focus on “economic value” based on”affordability.”

Much as Global Insight’s report, you’ll need to consider household income, population density, interest rates, current and former house prices, and historical data, to determine what house prices should be. Adding “rent costs” vs. “owning costs” metrics to the mix is a sound strategy as well (and a topic for a future article).

Though “Risk vs. Reward” is the rule of the game, “Keeping What You Have” is the name of the game. To that end–“Don’t Buy Blue Sky!”

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