Residential Real Estate: How Much More Pain?

This piece completes a series that I started RealMoney, and continued at my blog.  For those with access to RealMoney, I did an article called The Fundamentals of Market Tops, where I concluded in early 2004 that we weren’t at a top yet.  For those without access, Barry Ritholtz put a large portion of it at his blog.  I then wrote another piece at RM applying the framework to residential housing in mid-2005, and I came to a different conclusion: yes, residential real estate [RRE] was near its top.  Recently, I posted a piece a number of readers asked me to write: The Fundamentals of Market Bottoms, where I concluded we weren’t yet at a bottom for the equity markets.

This piece asks whether we are at the bottom for RRE prices. If not, when, and how much more pain?

Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are different.  The signals for a bottom are not automatically the inverse of those for a top. Tops and bottoms for RRE are different primarily because of debt investors.  At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.  There is a sense of invincibility for the RRE market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.

As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.”  The same is true of RRE, and that is what differentiates tops from bottoms.  At tops, no one cares about the level of debt or financing terms.  The rare insolvencies that happen then are often due to fraud.  But at bottoms, the only thing that investors care about is the level of debt or financing terms.

Why Do RRE Defaults Happen?

It costs money to sell a home – around 5-10% of the sales price. In a RRE bear market, those costs fall entirely on the seller. That’s why economic incentives for the owners of RRE decline once their equity on a mark-to-market basis declines below that threshold. They no longer have equity so much as an option on the equity of the home, should they continue to pay on their mortgage and prices rise.

As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 12%. It may go as high as 20% by the time we reach bottom.

Defaults occur in RRE when there would be negative equity in a sale, and a negative life event occurs:

• Unemployment
• Death
• Disability
• Disaster
• Divorce
• Large mortgage payment rise from a reset or a recast.

The negative life events, which, aside from changes in mortgage payments, can’t be expected, cause the borrower to give up and default. During a RRE bear market, most people in a negative equity on sale position don’t have a lot of extra assets to fall back on, so anything that interrupts the normal flow of income raises the odds of default. So long as there are a large number of homes in a negative equity on sale position, a certain percentage will keep sliding into foreclosure when negative life events hit. For any individual, it is random, but for the US as a whole, a predictable flow of foreclosures occur.

Examining Economic Actors as We Near the Bottom

Starting at the bottom of the housing “food chain,” I’m going to consider how various parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve policy is loose, and the yield curve is very steep. Financial companies, if they are in good shape, can profit from lending against their inexpensive deposit bases.

This presumes that the remaining banks are in good shape, with adequate capacity to lend. That’s not true at present. Regulation has moved into triage mode, where the regulators divide the institutions into healthy, questionable, and dead. The bottom typically is not reached until the number of questionable institutions starts to shrink. Right now that figure is growing for banks, thrifts, and credit unions.

The Fed’s monetary policy can only stimulate the healthy institutions. Over time, many of the questionable will slow growth, and build up enough free assets to write off bad debts. Those free assets will come through capital raises and modest profitability. Others will fail, and their assets will be taken over by stronger institutions, and losses realized by the FDIC, etc. The FDIC, and other insurance funds, will have their own balancing act, as they will need to raise premiums, but not so much that it harms borderline institutions.

Another tricky issue is the Treasury-Eurodollar [TED] Spread. Near the bottom, there should be significant uncertainty about the banking system, and the willingness of banks to lend to each other. Spreads on corporate and trust preferreds should be relatively high as well. Past the bottom, all of these spreads should be rallying for surviving institutions.

Financing for purchasing a house in a RRE bear market is expensive to nonexistent, but the underwriting is strong. At the bottom, volumes increase as enough buyers have built up sufficient earning power and savings to put a decent amount down, and be able to comfortably finance the balance at the new reduced housing prices, even with relatively high mortgage rates relative to where the government borrows.

Many other players in RRE financing will find themselves stretched, and some will be broken. Consider these players:

1) Home equity lenders will be greatly reduced, and won’t return in size until well after the bottom is passed.

2) Many unregulated and liberally regulated lenders are out of business. The virtue of a strong balance sheet and a deposit franchise speaks for itself.

3) Buyers of subordinated RMBS have been destroyed; same for many leveraged players in “high quality” paper. Don’t even mention subprime; that game is over, and may even be turning up now as vultures pick through the rubble. This has implications for MBIA (MBI), Ambac (ABK), and other financial guarantors, since they guaranteed similar business. How big will their losses be?

4) Mortgage insurers are impaired. In earlier RRE bear markets, that meant earnings went negative for a while. In this case, one has failed, and some more might fail as well.

5) Do the GSEs continue to exist in their present form? That question never came up in prior bear markets, but it will have to be answered before the bottom comes. Will the FHLB take losses from their mortgage holdings? Will it be severe enough that it affects their creditworthiness? I doubt it, but anything is possible in this down cycle, and the FHLBs have absorbed a lot of RRE mortgage financing.

6) Securitization gets done limitedly, if at all.This is already true for non-GSE-insured loans; the question is how much Fannie and Freddie will do. My suspicion is near the bottom, as loan volumes increase, banks will be looking for ways to move mortgages off of their balance sheets, and securitization should increase.

7) The losses have to go somewhere, which brings up one more player, the US Government. Through the institutions the US sponsors, and through whatever mélange of programs the US uses to directly bail out financially broken individuals and institutions, a lot of the pain will get directed back to taxpayers, and those who lend to the US government in its own currency. It is possible that foreign lenders to the US may rebel at some point, but if the OPEC nations in the Middle East or China haven’t blinked by now, I’m not sure what level of current account deficit would make them change their policy.

That said, the recent housing bill wasn’t that amazing. Look for the US Government to try again after the election.

A Few More Economic Actors to Consider

Now let’s consider the likely actions of parties that are closer to the building and buying of houses.

1) Toward the bottom, or shortly after that, we should see an increase in speculative buying from investors. These will be smarter speculators than the ones buying in 2005; they will not only not rely on capital gains in order to survive, but they require a risk premium. Renting the property will have to generate a very attractive return in order to get them to buy the properties.

2) Renters will be doing the same math and will begin buying in volume when they can finance it prudently, and save money over renting.

3) At the bottom, only the best realtors are left. It’s no longer a seemingly “easy money” profession.

 

4) At the bottom, only the best builders survive, and typically they trade for 50-125% of their written-down book value. Leverage declines significantly. Land gets written down. JVs get rationalized. Fewer homes get built, so that inventories of unsold homes finally decline.

As for current homeowners, the mortgage resets and recasts have to be past the peak at the bottom, with the end in sight. (In my piece on real estate market tops, I suggested that after the bubble popped “Short rates would have to rally significantly to bail these borrowers out. We would need the fed funds target at around 2%.” Well, we are there, but I didn’t expect the TED spread to be so high.)

5) Defaults begin burning out, because the number of the number of properties in a negative equity on sale position begins to decline.

6) Places that had the biggest booms have the biggest busts, even if open property is scarce. Remember, a piece of land is not priceless, but is only worth the subjective present value of future services that can be derived from the land to the marginal buyer. When the marginal buyers are nonexistent, and lenders are skittish, prices can fall a long way, even in supply-constrained markets.

For a parallel, consider pricing in the art market. Many pieces of art are priceless, but the market as a whole tends to follow the liquidity of the rich marginal art buyer. When liquidity is scarce, prices tend to fall, though it is often masked by a lack of trading in an illiquid market.

When financing expands dramatically in any sector, there is a tendency for the assets being financed to appreciate in value in the short run. This was true of the Nasdaq in the late ’90s, commercial real estate in the mid-to-late 1980s, lesser-developed-country lending in the late ’70s, etc. Financing injects liquidity, and liquidity creates confidence in the short run, which can become self-reinforcing, until the cash flows can’t support the assets in question, and then the markets become self-reinforcing on the downside, as buying power collapses.

The Bottom Is Coming, But I Wouldn’t Get Too Happy Yet

There are reasons to think that we are at or near the bottom now:

• Sales are increasing in a number of areas where foreclosures are significant.
• What little lending is being done is being done on relatively sound terms.
• Securitization has slowed dramatically.
• The major homebuilders do trade for 50-125% of book value, generally. The question is how much remains to be written down.
• New home sales have slowed dramatically.Homebuilder confidence is low and construction has slowed.

But I don’t think we are there yet, and here is why:

• Foreclosures are still increasing.
• Mortgage stress seems to be increasing in prime and prime jumbo loans.
• The inventory of unsold homes continues to rise. At the bottom, inventories will have started to shrink, but are not yet to normal inventory levels. (There is also significant dark supply, or shadow inventory as well.)
• The inventory of depository financial institutions in trouble continues to rise. Regulatory triage is only beginning.
• We still have a lot of payment resets and recasts to go through. (My, but the option ARMs are ugly now.
• FOMC policy is not providing a lot of liquidity to the economy as a whole, but only to a few lending markets.
• The future of the GSEs, mortgage insurers, and financial guarantors are still up in the air.
• The US Government will try some more policy ideas after the election.
• We aren’t seeing a lot of speculative buying yet.
• The biggest booms have had the biggest busts, but affordability is yet to be restored in what were the hottest markets.

My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is projecting a 25% decline.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and keep me in the game today. Avoiding the banks, homebuilders, and many related companies has helped my performance over the last three years. I hope that I — and you — can do well once the bottom nears. There will be bargains to be had in housing-related and financial stocks.

Full disclosure: no positions in companies mentioned

Comments

[chtrplyr:]

I think this article does not apply a very good fundamental predictive valuation analysis of real property (considering rising rising rents and U.S. population) nor look at the long term appreciation trend in limited resources (land and water resources) nor the increase in amenities in today's housing. (You would pay more for 1.25 Ounces of Gold than 1 Ounce of Gold wouldn't you?)

I bet the 20 state composite case-shiller currently at 167 or so never gets below 160 - about 5% further to the bottom and that the author's 10%-15% further reductions nationwide is an exaggeration.

2008 Sep 02 03:59 PM

[22thoroughbred:]

Something very interesting and possibly gamechanging has happened in the Inland Empire in So Cal and I thought i'de share. It is now a law nationwide that municipalities must build new houses and apts. to make up the ratio of low-income housing to regular priced homes, so nationwide eventhough there is a glut of empty homes. builders must continue to build new to satisfy the law. Well in the Tuesday LA Times, there is an article that in the Inland Empire they are now buying foreclosed homes to use as low-income housing, buying, fixing, selling. If this takes hold nationwide, that adds a very large buyer of foreclosed properties, municipalities. If cities can but foreclosures and resell them as low-income, that takes inventory off the market and stops building of add'l. properties. It is amazing it has taken this long for that common sense approach to materialize.

2008 Sep 02 04:24 PM

[specks:]

Wonderful...all we need is more acquisition of assets by the state to dole out to a select group. Boy...we sure have come a long way away from communism, haven't we?

2008 Sep 02 04:36 PM

[22thoroughbred:]

it's something that is already being done, it's not a new program, all they do now is use existing property rather than building new.

2008 Sep 02 05:41 PM

[Umm, yeah:]

Ugh, the municipalities had better know what they're doing, otherwise the losses could start spreading to municipal bonds.

2008 Sep 02 05:41 PM

[B smith:]

Thorougbred: Please state what law, maybe its CA, but I am not aware of any U.S. law requiring municipalities to provide affordable housing.

2008 Sep 02 07:06 PM

[22thoroughbred:]

All cities must provide affordable housing, usually when a developer gets a permit to build a 20 unit condo project 2-3 of those units MUST be priced as affordable housing to keep the ratio of affordable housing in that city in proportion. But now instead of having to build 2-3 new units and pricing that way, they can now buy 2-3 existing units that are in foreclosure and price as "affordable" I see what I wrote was unclear and made it sound as if the city had to buy the properties, I should have been more clear and said the cities are mandating the builder's buy the properties as a requirement to receiving the bldg. permit. Sorry for the lack of clarity

2008 Sep 02 07:43 PM

[Matt Blackman:]

Unless I have missed something, David has neglected to discuss a key component of bear markets: they are littered with bear market rallies in which the asset class (index, future, currency etc) experiences a dramatic rally only to end and subsequently put in a lower low.

The best example I've seen is the Japanese Nikkei 225 that has put in at least 5 bear market rallies of 50% of more since it peaked in 1990 ( see tradesystemguru.com/co... ).

The Philadelphia Housing Sector Index is another great example. After peaking in Aug-Sept 2005 near 600, the index has continued to fall and rallied more than 25% from July 2006 through Feb 2007. Since, it has fallen to around 130... www.quotemedia.com/res...=^HGX

So is it at a bottom? Maybe, maybe not. But they equate bottom picking to trying to catch a falling knife for good reason....

2008 Sep 02 08:39 PM

[Matt Blackman:]

Dr. H, I'll take that bet! The rate of change (negative) may have declined month to month but it is still accelerating year-over-year. Unless the bubble is done breaking, which would be an historic miracle, the Case-Shiller home price index should see values well below 150 before the declines are finally over. Take a look at the chart.. tradesystemguru.com/co...

History tells us that bubble aftermaths generally see prices return to well below their historic trendlines. The dashed orange line is a linear regression line so weighted for the later data. The longterm trendline sits around 130 for the 20-city composite...

2008 Sep 02 08:47 PM

[Just The Facts:]

I'd have to think really hard to grasp all that was said in the original post, but I suspect that my own real personal "real-life" situation probably reinforces the author's point.


I'm looking to move from north Alabama to central Alabama, to get closer to family. I currently rent (for a long list of reasons which would justify a whole different article and discussion), and had hoped to continue doing the same. But upon searching, I discovered that it would cost me as much or more to rent in my new location than it would to buy --- my own land and a mobile home!


Home prices haven't yet dropped to the point that I would consider it prudent to buy, but rental rates have gone up so much that it no longer makes sense to rent either.


For 12 months' rent, I could buy my own land and plant a used mobile home on it, thereby providing a roof over my head and protection from the elements. Bought and paid for, with no future payments required (other than minimal maintenance and upkeep). And be perfectly good to go for the next 10 years or more, as long as "keeping up with the Jones's" wasn't an ambition of mine.


Real money and basic necessities, where 12 months = 10 years? We're living in a bubble, my friends. And the only reason it hasn't yet totally popped is because local communities are inclined to pass "zoning laws" to protect the bubble.


I wouldn't want to be a home owner in a "protected" area when the bubble finally bursts. And that's all I'll say ....


:)

2008 Sep 03 12:34 AM

[Just The Facts:]

Heck, they're offering tiny little "McMansions" placed side-by-side with other "McMansion's" here in my current home town, for better than a quarter million dollars apiece. And people are buying them, even in today's market. Go figure.


It's like nobody any longer realizes exactly how much money a quarter million dollars is.


Or maybe a quarter million dollars isn't what it "used" to be. Can anyone say "bubble" ?!?!?! ....


/8^O

2008 Sep 03 12:45 AM

[Just The Facts:]

My parents paid $11,000 for their first home. And they're still alive. I don't have children, but I'm willing to bet that any child born today will also be able to buy their first home for $11,000 --- or thereabouts. Maybe I'm wrong. I hope I am, for all of "your" sakes ....


;)

2008 Sep 03 12:56 AM

[Go US:]

I am understanding more now that Banks are relying on the Bond insurers to support the falling/ increasing bank debt on real estate loans

We are looking at drastic shift in financial policy that is heading towards the Insurance companies (highly liquid) to bail out this whole mess. PMI and ABK are looking really good at this time as I see it.

What we have here is a failure to communicate!!!!! The Banks have not revealed their real losses on real estate loans but this is old news lets talk about the losses in banks gambling to shore up their losses I think they call it derivitives.

Real Estate Investors are looking at Cost of Build as a measuring stick to the value of a home relative to materials cost etc. Value in the land is not measurable, but neither is debt and the accountability of the borrowers to pay back the debt. In Poker we call this "You Got Nothing!!!. Banks are in trouble as they race to figure out a way to hold the barrowers accountable for losses and fruadulent loan documentation trumped up by the Mortga Brokers. No one wants to talk about it, IT being the consumer that says they were cheated when they caused the problem in the first place by misstating income and assets etc. to the Lenders. Oh I know the Lenders should have figured this out long ago. A Mortgage Broker I know said he couldn't believe the Lenders let these Loans go out for as long as they did, this was 3 years prior to the Real Estate Bust.... Yes 2004!!!!

I hope someone understands what I wrote????

2008 Sep 03 03:04 AM

[investor88:]

David's article is thorough and insightful. Can't argue with the logic and conclusion of the article. The day [may be as long as 2 years from now?] RRE and the bank recover, but not any sooner, it will be time to invest for the next cycle.

2008 Sep 03 10:10 AM

[Steven Hansen:]

david,

your article took a lot of work and is well documented. this is the type of article which makes seekingalpha great. doesn't matter if i agree with it or not because you have given enough info for me to make up my own mind.

2008 Sep 04 06:20 AM

[redriver:]

2007 - 2012 Renter Nation?

2008 Sep 04 01:52 PM

[redriver:]

2007 - 2012 Renter Nation?

2008 Sep 04 01:52 PM

[REITBull:]

This is one of the best written articles I have personally read on the housing decline. Well done David. I would love to hear your take on the short term valuation of commercial RE.

2008 Sep 04 08:49 PM

[chtrplyr:]

so far it is at 165 or so we shall see...

2008 Oct 29 12:44 PM