Getting Real About Real Estate 18 comments
Money Morning
From Money Morning:
-
Font Size:
-
Print
- TweetThis
By Peter Schiff
Once again, real estate market watchers have pounced on a shred of seemingly positive news to proclaim that the long sought "bottom" is in sight. The routine is becoming extremely stale, but somehow the media never seems to tire of it. This time the "good" news was that the percentage declines in national home prices (according to Case Shiller) in July were not as large as they were in June.
Although the report contained many other negative data points, including increased inventories and a spike in foreclosure sales, it was the slowing declines that got the spotlight. Talk about grasping at straws. The truth is that real estate has been grossly overvalued for years, and the adjustment process back to realistic pricing has only just begun.
But the problem is this: Few "experts" seem to appreciate the magnitude of this adjustment and its implication for an economy dependant on inflated asset values.
By most accounts, the decade-long housing boom began in 1996 and finally went "poof" in mid-2006. In January 1996, the Case Shiller 10-city composite home price index stood at 76. By June 2006 it had tripled to 226 - by far, the largest increase in U.S. history. Since then, the index has pulled back by 20% to 180. For those who believed that home prices could never retreat nationally, this 20% correction is more than enough. In reality, it’s just the down payment.
When real estate prices were expected to rise in perpetuity, the price of a house had two components - one part representing shelter and the other investment. The shelter component was the actual utility and desirability of the house and the investment component was the expected future appreciation. My guess is that at the peak of the real estate mania, a $500,000 house might have consisted of $250,000 for the shelter component and $250,000 for the investment component.
In effect, the appreciation potential, and the ability of the homeowner to tap into it though refinancing and home equity loans, offset the real costs of home ownership, such as mortgage payments, taxes, insurance, and maintenance. So the main reason a buyer would commit to a mortgage that would soak up 50% of his disposable income was that he expected to recover most of that outlay through future appreciation. Absent the expectation of that windfall, buyers would not have been willing to pay such staggering prices for houses or commit to burdensome mortgage payments.
Lenders were caught up by the same delusion. Since they, too, believed prices could only rise, lending standards were thrown out the window. If the collateral (the house) were to always rise in value, what difference would it make if the buyer made the payments? In effect, instead of relying on the borrower’s ability to pay to mitigate its risk, lenders merely relied on the house’s ability to appreciate.
However, now that real estate prices are falling, this has all changed: Lenders are beginning to rely solely on the borrower’s ability to pay. As this trend continues, lending standards will tighten and mortgages will be brought back into line with the incomes of borrowers.
In addition, down payments will be larger to reflect the greater likelihood of losses should loans end up in foreclosure. When prices were rising the foreclosure risk was negligible. However, now that foreclosures are soaring and recovery rates are less than 50 cents on the dollar, those risks are enormous.
So, with falling real estate prices, mortgages are much less appealing to both borrowers and lenders. The only solution is for home prices to fall far enough to where they are cheap enough for buyers to afford the mortgage payments (both interest and principal), without relying on appreciation, teaser rates, or negative amortization, and save enough for a down payment that would protect a lender in the event of default.
In addition, the collapse of the mortgage securitization market means houses must be cheap enough for our limited pool of domestic savings to supply the funding, as we will likely lose access to much of the foreign funding that fueled the bubble.
Of course, we need to be honest about the winners and losers of this credit crunch. Just because mortgage money becomes scarce, and lending standards tighten, does not mean people will not be able to buy houses - it simply means they will pay a lot less for them and that fewer new houses will be built.
Therefore it is sellers, builders and those holding or insuring existing mortgages who lose, while buyers win big. There’s a reason for that: Despite higher interest rates and larger down payments, they end up borrowing a lot less money. In the end they will become true homeowners, rather than indentured servants. If home ownership is truly the American dream that so many realtors profess, then the ongoing collapse in home prices will actually be a dream come true.
Related Articles
|
Find People on SA
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largest
increase in followers
in the last 7 days-
1
David Fry
-
2
Philip Davis
-
3
Tyler Durden
-
4
Bill Gross
-
5
Peter Schiff
Fastest Climbers » -
1
-
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most activeSee all
Instabloggers.
Top Instabloggers » -
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 18 comments:
This is my take on the housing and mortgage issue. First, what began around 1996 is really the second experiment by the lending community with guideline flexibility...the first began in the mid 1980's. In the 1980’s, as rates settled down from the 20% range, the lending community issued their first “no doc…stated income…no peek” type loans. This generation of loans did require large (25%) down payments, at least initially. The effect of these guidelines was to create a huge imbalance is the basics of supply and demand. Values went up dramatically.
Around 1989-1990, lenders, realizing that 90% of the buyers had been less than “truthful”…they lied about their income… changed the guidelines and collapsed the market. This, along with “peace breaking out” with the fall of Russia, created that housing and real estate problem.
In his first term, Bill Clinton determined that housing opportunity in America needed to be expanded to a broader market. That is not a bad mission if it is done properly. Government mortgage programs are highly inflexible, and it literally take “an act of Congress” to change guidelines. Much of the FHA structure, for instance, is legislated and it takes legislation to change. So, Clinton turned to Fannie and Freddie. These quasi government for profit companies, had control of their own rules, and they did not require legislation to alter them.
In the mid-90’s, Fannie began to create its automated system. Desktop Underwriter, or DU, as it is called, was intended to deliver an unbiased, sterile underwriting determination, one where factors such as race, gender, zip code, etc., were not a part of the equation. Every borrower got the same opportunity and consideration based on Fannies criteria. This was the good part. As conceived, bias was out of the picture, and many, many foreclosures (from the past) would have been avoided, or so went the marketing and industry buzz.
The problem was that, as for profit companies, Fannie and Freddie had the keys to the henhouse…they could manipulate the underwriting model. And, they did. And, as they did, they altered the entire lending landscape.
Imagine if you could grow your business by simply making it easier for customers “buy” your services…that’s was Fannie and Freddie did. They simply “tweeked” the UW model, and made more money. And, as they “tweeked”, so did other alternative lenders. After all, Fannie and Freddie were the “Gold Standard” and if they could “tweek”, then all lenders could “tweek”. As Fannie and Freddie encroached into other markets…alt A lending…sub-prime…the lenders working these spaces were forced to shut down or expand elsewhere…so, they expanded. Can you see the pattern?
So a great idea, gone bad, is really at the heart of the housing and mortgage problem. That, along with some good old fashioned corporate greed. By-the-way, Congress ultimately has oversight over Fannie and Freddie. You have to love it when capitalism and government come together… what a mess!
The second issue with this post is the idea that anyone wins right now. The article references the “Shiller Index”… which, as an index, has its own personality and problems, and I would question its true accuracy beyond “up or down”. However, Robert Shiller (get the connection), wrote a white paper a few of years ago entitled “Household Reaction to Changes in Housing Wealth”. In the paper, he reported his conclusions resulting from a multi-national study relating the “wealth effect” on household attitudes and consumption from stock market growth versus housing appreciation. He found that a 10% gain in stock values has not correlation to any increase in consumption in the economy. He also found that a 10% gain in housing values resulted in a measurable increase in consumption of 1% in the general economy. What effect on the economy will a 10%, 20% or greater DECLINE in housing values do to consumption…we are taking about a real retraction in real income…and a very real employment problem developing.
Shiller concluded: “I conclude that although the “wealth effect” of national home prices on national
consumption may be hard to prove, there is a serious risk of the consequences of home price
declines at least regionally. The regional housing bubbles that appear to be going on in the
United States ought to be concerns of the Federal Reserve Board.”
As manipulated as the housing market was from the mid-1990’s to say 2006, the effects of the current “manipulation” may be far more disastrous. Until all lending becomes more standardized and codified, we will be subject to non-market driven manipulations. This is the history of the past 30 years.
This wasn't the main reason. The main reason a buyer would do this is because their desire for a home outweighed the expected pain of f committing that amount to a housing payment.
And, housing prices had exceeded reasonable parameters, so if you wanted to own a home, you had to pay the price. And "going without" has been a foreign concept for quite some time.
It's one thing to be told that you'll be paying "X" and actually doing it, and many people underestimated just how much that would hurt.
Furthermore, many people are naive enough to believe that if an "expert" (mortgage broker) tells them that they "qualify" for a loan of that size, that they're capable of performing.
The expectation of future appreciation may have sealed the deal, but it was not the main reason most people bought a home.
The homebuying process is not nearly as rational as we'd like to imagine.
Economics textbooks never tire of telling us the latter but rarely tell us the former.
Buy, Buy, Buy ....
I dealt with dozens of people who made more money in real estate appreciation than they did at their full time jobs. They borrowed against it and bought his and hers Escalades, Rolexes, etc. and flaunted their new "wealth" before the neighbors.
People made more on houses than stocks, bonds, or work. Real estate agents and mortgage brokers would tell people that they were going to miss out on the only way to become wealthy and would be priced out of the market if they didn't buy now. Buying "now" was the key to getting into what was touted as the never ending appreciation.
Schiller did a study in 2003 or 2004 and I think he found that the average homeowner expected 10 to 14% annual appreciation each year over the following ten years. In areas of California it was even worse with people expecting 14% or 15%.
People absolutely consider ROI when buying a house and the investment component is huge. If that wasn't a significant part of the purchase, then why don't home buyers spend more on cars? I mean you could out do the neighbors by buying a new Mercedes S550 (although some people living in modest suburbs did do such outrageous things with their HELOCs and second mortgages)?
All over the evening news, the newspapers, talk at barbecues, bars, family get togethers, it was all about how much money people were making in real estate. That's why people started buying second homes. Not just wealthy people, people who bought their first home in 2004, bought another one or two or three by 2007. I talked to an illegal immigrant who worked in construction and made about $55,000 a year and he had more than $1 million in real estate (three houses) in the Bay Area (all East Bay).
Absent the expectation of significant ongoing appreciation, people would not pay as much for houses period. All of the assumptions about being able to get out, refinance, etc. are based on rapid appreciation. If the payment seems hugely burdensome, ongoing rapid appreciation is what the buyer expects will allow him to sell at a profit if making such huge payments becomes really unpleasant after a few years.
I think some people saw it like taking a second job to make extra money. You tough it out paying a huge I/O mortgage on a house you can't afford for a couple of years and then sell, or at least you always have the option of selling and walking away with a lot of money - a lot more than you put in, which was often nothing. Zero down and make the payments and in two to three years, you have $200,000 or $300,000 in equity and you can sell and take that tax free. If you make $200,000 a year, you're lucky to keep $120,000, but the house price gains are 100% tax free up to $500,000 (for a married couple, and $250,000 for an individual). People were watching their incomes taxed heavily when considering state, federal, social security (much of which is stolen and siphoned off into the regular tax expenditures) -- these people saw others making real estate gains and paying ZERO tax, no state, no federal.
The average person probably still thinks that when this all blows over, we will get significant appreciation again. When reality sets in and the fact that this was a once in a 150 year phenomenon, prices will reflect the reduced expectation of appreciation. People are stupid, but they aren't that stupid. Expected appreciation was a huge factor in what a home buyer was willing to pay for a house and when people realize that isn't coming back, prices are going to have to reflect what people really think a house is worth, which I expect is going to be a lot less -- probably another 20% to 40% less.
Adding to the carnage will be the baby boomers getting older, downsizing, moving to rest homes, selling investment/vacation homes, dying, etc. Also adding to the carnage will be the doubling up phenomenon where the ridiculously low 2.3 person per household rate goes back to a more historically normal 2.7 or so. The Federal Reserve published a paper five or six years ago predicting that ultimately there would be 20 or 30 million too many homes by 2018 to 2020 or so and pondered how government would solve that problem -- they said immigration would probably be the only way.
Smart folks are ones who remember that America doesn't work with safety nets. If you are out of work for six months or a year or two, it doesn't matter if you used to make $300,000 a year, you are going to go to the same shelter and beg for the same food as everyone else. The only thing that offers some protection is the preservation of capital through savings and diversifying that wealth. I'm not talking about 401k money either, I'm talking about good old fashioned savings on which the saver paid all taxes. It is the only security available here.
hiloliving.blogspot.co...
With the mortgage industry going back to reality, home appreciation will stagnate dramatically in the next five years. Forcing most buyers to actually put down a real down payment and qualify them using their real income will do wonders for the housing market.
When someone wants to buy a home, they rarely truly run the numbers on taxes, insurance, maintenance, decorating and furnishing the home. If more people were educated to the true cost of ownership, I doubt very much if we would have the problem we have now.
I disagree. Savings is dramatically eroded by debasing the currency/inflation. In addition, banks are failing. Your "savings", if held in a bank, has already been lent out 10 times over. Plus, the government through the IRS knows where all assets are held and can change tax law as necessary to get at them. What makes you think an organization who is in charge of transferring wealth would stop at your doorstep because you already paid some tax? Then there's always the easiest way - accuse someone of a crime and simply confiscate property. I'd love to know how to find "security". I just don't trust "saving" is going to accomplish it.
If you want to make money on Real Estate, you should buy and hold for minimum of at least 2 or 3 economic cycle(6 or 7 years is one economic cycle). Therefore, Real Estate investment is a long term investment rather than investment in stock and bond. The old rule for Real Estate investment is to buy and hold rather than flip and sell.
www.brokerforyou.com/b.../