Looking Beyond The Bubble: What's Next For Highly Appreciated Markets

(The original was posted March 31, 2006. This is an updated version)



Doing my workout this morning I asked myself what's next for the real estate market.



The state of the market here locally is that prices are and have been in decline. The Association of Realtors even finally admitted it last summer. They are still hiding how far that prices have declined, but that is to be expected, stupid as it may be.



What comes next? I originally said increased defaults, as short term loans come up for adjustment and people are unable to make the payments, as I had previously said any number of times, and unable to refinance because they owe more than the property is worth. Short sales also increase, as people try to just get out. More Notices of Default means more trustee sales, as well. If the property sells at auction, somebody probably got a bargain. If it doesn't, the lien holder owns it (subject to senior liens) and that may be even better if they are willing to admit reality, which some are and some are not. The phenomenon I've been encountering is that the servicer overseeing the foreclosure is often the original lender who approved this loan in the first place, then sold the right to receive payments. They take less than the amount of the loan, so that the company with the actual right to receive payments takes a loss, and they get sued. So they are playing the same game as the old joke with the punchline, "A lot may happen in a year. I may die, the king may die. And maybe the horse will learn to sing." A lot of the asset managers I've tried to deal with are freshly minted MBAs, twenty-three years old and no experience in the real estate market. Their entire adult lives, they have been hearing about how real estate appreciates twenty percent per year. They think if they stonewall hard enough, people will offer more than the property is worth. Not. Gonna. Happen.



All of these are happening already. When I wrote the original, daily foreclosure lists had more than doubled locally from a year prior, and the levels have continued to build. Trustee Sales are up, and so are REO's (Real Estate Owned by those who were originally lien holders). Check, check, and check. All about as surprising as gravity. What I'm trying for here is at least one prediction that has not already come true.



Rates have been rising of late, but there is a limit as to how far they are likely to go, if only because Bernanke and company are very shortly going to have irrefutable evidence of all of the above stuff nationwide (What did I tell you? They stopped raising rates in the summer). A nationwide economy has a lot of something analogous to inertia. Takes a while to move things in the direction you want them to go. More time, and more effort, than most folks, particularly bankers running our money supply, are likely to realize and sit still for without further pushing, which they have done a bit too much of, in my opinion, by about one full percent on the overnight funds rate. Once things get going in the direction that the Fed has been pushing them for the last two years, they are similarly going to have a lot of momentum built up. Bond investors are going to dry up at attractive rates, and Sarbanes Oxley or no, you're going to see private companies going public again because it's the only way they can raise capital at attractive prices, and the flow of public companies going private is likely to mostly stop. Hard to think of Sarbanes-Oxley as a brake upon economic activity, but in the short term, that's what it's likely to prove. CEOs and CFOs are still not used to the idea of personal responsibility for corporate activity, and while the cost of private capital is even vaguely competitive with public, private will be their choice. It's going to take a while for countervailing forces to come into play. This is still ongoing. The newer factor that's come into play is that the rest of the world may have finally woken up to how shaky the entire US economy is, with foreign investment in our debt keeping the cost of borrowing as low as it was (the law of supply and demand is always in force, even if it does take a while to work), and the dollar has slipped some in recent weeks, with the trailing expectation being that borrowing capital is going to become more expensive, and therefore, public offerings more lucrative.



When bond rates rise, so do mortgage rates, and mortgage consumers don't have the option of moving back to public offerings of stock. When mortgage rates rise, and people can only afford the same payments, prices fall, further exacerbating the price fall that's already happening. I actually think that my local market (San Diego) has seen most of the depreciation it is likely to, due to constricted supplies of housing and the fact that it is not the entire supply of housing, but only those intending to buy or sell who are influenced by the sales market. For those who don't want to buy, or those who don't want to or have sell, the market is not very relevant. They've got their property already. Furthermore, there is a large amount of pent up demand, for who want to buy, but are frustrated by market conditions or waiting for market conditions to improve. Let their perceptions of the market change, and they're going to be back in the market.



Lenders are already between a rock and a hard place to a much larger extent even than nine months ago, and it's going to get worse as those who were sold too much house, or took too much money out of their equity, continue to experience difficulty. Keep in mind also that aggregated mortgage bonds are an attractive investment because of their historical level of security, and even that's going to be compromised to a certain extent, and rates are going to rise further if for no other reason than that is what the money costs. Low supply and high demand. I expect rates on A paper thirty year fixed rate home loans to stabilize somewhere around seven percent, at least for a while. Shorter term fixed rates will be cheaper once the yield curve normalizes, and indeed, the 5/1 ARM is starting to be noticeably cheaper than the thirty year fixed rate loan again, if not nearly so wide as it usually is. Given the prices things have sold at in highly appreciated markets, this is likely to permanently popularize medium term hybrid ARMs, as saving one percent in interest on $500,000 is well worth the cost of refinancing every few years, and people are refinancing every two years on average anyway. Two and three years fixed is really too short for most folks, but five is probably more than fine.



Here's another newsflash. I'm not going out very far on a limb here, but a three bedroom single family residence in a reasonable neighborhood here locally is likely never to drop back into the sub $300,000 range again. I'd bet serious money it's not going below $250,000. That's what I said nine months ago, and the bet is looking more solid now than it was then. Yes, the market got badly overheated - but not that badly overheated. Furthermore, if past Southern California history is any guide, we'll lose about 30 percent of peak value, and then start going back up again. No fun if you're a semi-skilled worker trying to raise a family, but the most likely scenario nonetheless.



Now what's going to happen to the people who have bought highly appreciated properties who can actually make the payments? Well, if prices fall, they can't sell for what they bought for until they recover. They don't want to do that. But they don't want to be in a negative cash flow situation, where the rent they get from the property doesn't cover their expenses, if they can avoid it. They definitely don't want to be in that situation to a larger extent than they can avoid. A $500,000 purchase with a 6 percent first and 10 percent second yields principle and interest payments of $3276, plus property taxes of $520 and insurance costs of $120 per month, means that the owner is out $3916 per month without any repairs or management expense. A monthly rental of $1900 isn't going to cover that. A monthly rental of $2500 isn't going to cover that. This is starting to put more upwards pressure on rental rates. $2500 is the entire gross monthly income of someone making $14.75 per hour, by the way. But the people feeding the mortgage alligator don't really care, all they know is that they have to pay the bank so much per month, and set aside so much for the state and the insurance company. This is also going to put upwards pressure on wages, and therefore prices, as people have to make more to be able to afford living here, or anywhere else that got this highly appreciated. Inflation kicks into higher gear, which puts more upwards pressure on interest rates. Vicious cycle.



And this phenomenon is going to be part of what eventually helps prices make a comeback. If somebody is feeding the landlord $3000 per month, they're going to be more amenable to paying it to the bank instead. Especially since they get tax breaks, and most especially because when you buy the property you intend to live in, you take your monthly cost of housing out of the column that says "what the market will bear," which is subject to changes - and usually increases - and put it into the column that says "this is under my control." If you buy with a sustainable loan, your monthly payment may be higher right now, but you are putting it under your control forever.



(It is to be noted that even if that $500,000 property loses $150,000 in value the day after you buy it, historical 7 percent per year increases will have you back in the black in about five years, and ahead of a market return on the rent you would have saved in about ten. Thirty years down the line, your net benefit from the purchase as opposed to invest the extra money over the cost of renting and investing the excess in the stock market, will be somewhere between $800,000 to $1,000,000. An almost irrefutable argument in favor of buying a home, if you plan to live there a while. Yeah, it's no fun being upside down while it happens. But the eventual payoff isn't exactly chump change, even by the projected standards of thirty years from now.)



Caveat Emptor