Getting the Real Estate Crisis Right

30%, 40%, 50% drops sound a bit chicken littleish to me, but I do think that real estate is primed for more fall - particularly if the economy softens.

You posted some very startling numbers there, though they're numbers I think most of us are at least vaguely aware of. I'm buying Cleveland is all I have to say. My family is actually from Ohio, so even those numbers I was sort of aware of. I guess it's one thing to think of selected overheated markets (think New York 1970's) dropping 30%, but the real estate market overall - that's hard to imagine.

Why? Because real estate is a little different than most other investments. We actually have to live in our houses, and the decision to buy and sell them takes the odd investor behaviors we see otherwise and cranks them up a notch. So when someone really wants a house, they're more likely to outbid the offer, and when they've got to sell, they're very reluctant to take a loss. So the upside can be amplified and the downside is definitely dampened by the fact that these are our houses we're buying and selling.

Essentially the price of a house comes out to just about what people can pay, monthly. The NY Times did a great story 3 or 4 years ago that showed that real estate prices corresponded almost exactly to median income per month, with housing prices moving up as interest rates moved down to set that monthly payment for a house, which is what people can afford and then buy.

It's a little different than in a country like Spain (and much of the rest of the world) where almost all mortgages are based on variable rates. In that case, if rates really move up, there can be a huge squeeze, though again, the underlying dynamic of average wage buying an average house do not disappear, but there's more likely to be more shor-term repo pain. In the U.S., with fixed rates, as long as you keep your job and don't suffer a financial catastrophe, you should be OK.

All of this is just to say that if the real estate market collapses, at or beyond the sorts of levels that Matt describes, we'll have a lot more serious issues to worry about than how much our house is worth.

Comments

[Malkiel:]

I came to the same conclusions about income as your report--common sense says that selling prices of homes in an area must basically be within a range reachable by the median income. While people can stretch the safe limits in order to sacrifice for a nicer place, the limits are finite. A person with an income of $50,000, the current national median for a single wage earner, can reach to 250,000 instead of the theoretical safe limit of $125,000 and a couple can reach to 350,000; after that, only mortgage magic can put them into a $500,000 or $700,000 house, and we now know how shaky magic can be. Given those numbers I would expect massive depreciation of McMansions built on speculation, and a re-adjustment of mid-range prices down to the mean. If owners who are upside-down on mortgages think the market will recover they tend to stay in the house and stick it out, which slows down market depreciation, but if the loss is too high they may voluntarily walk away, helping knock prices back to the mean. We'll see how that plays out...

2007 Aug 21 11:05 AM

[Christian:]

We all know real estate is cyclical, and most know that this cycle is nothing anyone has seen before. I'll agree with Malkiel - magic has been rampant (I'm here in SoCal), and right now (and always has been), it is governed by simple SUPPLY AND DEMAND.

Fundamentally, what changed to cause the big run up? I don't think there was a massive "religous revolution" that 5-6% of the population all decided within a few years time that being in a house was the place to be. Something that this nominal percentage (4 million households?) hasn't even devoted a passing thought to in the last several decades. Low interest rates, and the classic: I gotta buy - housing's going nowhere but up. Supply was ramping up, but demand was enormous, the "next big thing."

In its nascent stages, it was quite fun. But as the prices ascended out of reach of pretty much everyone, more people had to resort to adjustables, so-called "liar loans", and (gasp!) option loans. I'm not sure why the comment was made about the U.S. being "different" with regards to adjustables. Many of my relatives still can't fathom why I'm planning to put 20% down (on a 30yr fixed) on my next home purchase (it won't be anytime soon).

Now the party's over, foreclosures are up, interest rates are up, and lending has pretty much ground to a standstill. Add to this mix people who we expect HAVE to sell their home (relocation, job loss, illness, etc.), we've got a very different supply/demand relationship.

What I submit is that we do have a correction, and this is in absence of an outright recession. Home values are coming down, and yup, it'll take some time. I don't think we'll reach huge levels of depreciation (maybe in some of the "bubble" markets), but there needs to be a reckoning between what's available, and what people want or can buy.

One more thing: a house shouldn't be considered an investment - maybe a commercial building is. In the past several years, yes - plunking down several thousand a month on a vacant place for 10-20% annual growth may be a nice "investment." But in the "norm" of recent decades past, a couple of thousand a month for an ROI that keeps in line with inflation ain't an investment - it a place you call "home."

2007 Aug 21 12:40 PM

[Carl leason:]

Christian,...You are the first in a long time to really get it right !!! I see so much BS about the housing market that it's mind boggeling ! But You have it right on all points ! Makes me wonder what the other "experts" have been reading. All the talk about "corrections" and median prices as compared to incomes is simply analyzing and not looking at facts ! I have been in the R.E. Business for over 25 years and you wouldn't believe how many times I have been asked by people to "get them out of a contract" that they signed and put down a good deposit ! I keep telling investors to "Do the math".
but it seems that most Investors have a Herd mentality,...follow the friends actions , even if it's a dumb idea ! Thanks, LC
Thanks for writing ! LC

2007 Aug 21 03:36 PM

[Dabbio:]

I still see single sector thinking dominant. Look, consumption and employment are critically tied into housing. It was housing, cheap Chinese imports, and easy consumer credit that fueled the consumption binge. Now, we are going to see it work in reverse. (Except, let's hope the Chinese don't raise prices.) Even if people don't sell their houses, they are going to HAVE to cut back on consumption to make the higher payments. This is going to seriously impact profits and employment. And then people are going to HAVE to sell their houses. See where this leads?

2007 Aug 21 01:55 PM

[Tony Rand:]

Maybe you should call me Chicken Little. Example: The affordability index in 27 major metropolitan counties shows that borrowers left without the ability to lie about their income/assets nor the ability to accept a high risk negative amortizing mortgage cannot afford to own residential real estate. Realistically, all home price gains from 2003 will most likely be wiped out. So in many areas we will see home value declines as high as 50% to 60%. Most areas will be in the 20% to 30% range. Any area in which normal home price appreciation has been realized from 2000 will maintain a great degree of normalcy with a 1% to 7% reduction in values. This is my fifth market cycle, but for myself (and everyone else who has been in this business a long time), the characteristics of this perfect storm will bring more damage than ever expected...compare this fiasco to the S&L scandals of the 1980's and then add appropriate inflation factors for your region. At the end of the day, the recent inverted Treasury yield curve guarantees our recession. How the legislature, GSE's, HUD and all of the mortgage servicing entities handle recasting adjustable rate mortgages and loss mitigation of repayment impairment will only soften the overall blow to the existing market...not eliminate it altogether.

2007 Aug 21 02:09 PM