Real Estate: What's on the Horizon?

Includes: IYR, KBH, TOL
by: Jeffrey Dow Jones

This week we take a look at what might be in store for the real estate market. By this point, you all have probably read Some Straight Talk on Housing, so this piece will serve as an update to that one. Residential real estate has been a troubled sector, especially from an investment perspective.

But what might be on the horizon? Is the deflationary phase of great housing bubble finally over? What should homeowners and investors expect from this point forward?

We begin with a story that may sound familiar.

Original Sin, Housing Style

When did I know there were problems in the housing market? I'll tell you when. Most of my friends have heard this story before so you guys can scroll ahead.

The year was 2004 and I was in the process of buying my first house...

Under Construction...

If you were living under a rock and missed the inflation of the bubble, all you need to know is that it was a pretty crazy time. I was buying a new house and I distinctly remember that the realtor said that most people make between $15- and $25,000 between the day they contract to buy it and the day the house actually gets built. I had just emerged from three years of sorting out the wreckage of the dot-com disaster. That kind of easy money sounded strange to me.

Still, I was pretty excited. Home ownership was the American Dream. My mom was proud.

Eventually I found a floorplan I liked. Then the banks got involved.

My builder suggested I talk to Wells Fargo (NYSE:WFC) who said, "Sure, we'll give you a loan. No problem." But a day before escrow was supposed to open they called back and said, "Sorry, we can't give you a loan." Something about loan-to-value or income ratio. In retrospect, I really had no business getting a home loan in the first place. My income was indeed too low.

Then I called E*Trade (NASDAQ:ETFC) Mortgage. We had the following exchange. It's pretty much verbatim.

E*Trade: Thank you for calling E*Trade Mortgage. How can we help you?
Me: I'd like to get a home loan.
E*Trade: No problem. How much do you need?
I told them. It was $258,500. I was able to put 10% down which was probably way more than they were used to.

E*Trade: OK, that's no problem. What's your income?
Me: $50,000. (I had just received my first raise at my new job. It seemed like a ton of money at the time, and perhaps it was for a guy who was living in his buddy's spare bedroom with only a handful of assets to his name.)

E*Trade: Hmm. That's not going to work.
Me: What does that mean?

E*Trade: Well, the system won't let me do it. It says your income is too low to support this loan. But with this type of loan that doesn't matter. Your income is what you say it is.

Me: That's interesting. How much does it need to be?
E*Trade: I can't tell you that, but if you give me a number, I can tell you if it works or not.

Me: OK. How about $60,000?

I heard her typing on her keyboard. A click click followed by a "hmmm" and then a "no."

Me: OK. How about $70,000?

I heard more typing, another "hmmm" and another "no."

Me: OK. How about $80,000?
E*Trade: Yes! That works!

She sounded very happy for me. Happy, I guess, because I was getting a loan. But it might have been because she was about to get a commission.

Immediately after hanging up the phone I went back into Mike's office and told him the story. I was shocked. He was shocked. Right then and there the two of us sat down and tried to think of all the ways that we could short the housing market. Things were clearly heading for disaster. Some day I would actually make enough to honestly support my mortgage payments, but what about the guy who never would or told an even bigger lie about his income? What about the guy who wanted to buy it just to resell it? There were a lot of those in Nevada, you know.

But there were two problems with Mike and I trying to get short the housing market. The first was that it was 2004 and we were about a year and a half too early -- house prices were still going up. The second problem was that neither one of us were smart enough to figure out a way to actually execute that trade. Later that year the two of us went to visit one of the hedge funds our firm had invested in. Those guys were trying to get short the housing market too. But they weren't sure how to do it either. And those guys were really smart. One of them co-founded PayPal and sits on the board of Facebook.

So I guess that's when I knew there was something wrong with the housing market. Obvious fundamental problems and no obvious way to short it.

Oh. I almost forgot. This story has an epilogue.

The Epilogue

I didn't make a single payment to E*Trade Mortgage.

In less than two weeks after closing escrow my loan had been sold, packaged up, and shipped downriver to... wait for it... can you guess who it is... is the suspense killing you... Countrywide Financial.

Apparently they had appetite for garbage loans like mine. That appetite got them killed. Or technically, got them eaten by Bank of America (NYSE:BAC). Go ahead and fill in your own joke about Bank of America's appetite.

The problem with real estate, as a market.

The real estate is a market that works a little differently than the stock, bond, and commodities markets. For one, it isn't very liquid and pricing isn't always clear. This is what happens with assets that don't trade on a centralized exchange. It's difficult to convey decisive information about value, especially in real-time.

On top of that there isn't really a good way to short housing, and this is troublesome for the market. A few weeks ago I was watching a CNBC interview with the legendary short-seller/cult-hero, Bill Ackman. He made this same point, that one of the (many) reasons that home prices got so out of hand and took so long to come back down was that because it's nearly impossible to sell the housing market short.

Short sellers get a bad name in the press but one legitimate function they perform is keeping market prices honest. When an asset is obviously expensive, short-sellers typically step in to take the other side of the crowded trade, acting as a catalyst to send the asset's price back towards fair value. Short-selling carries some extra danger and these guys only do it if the potential profits are worth the higher risk. As a result, short-sellers like Bill Ackman are very, very diligent about making sure both their analysis and execution are correct. The costs of being wrong can be catastrophic. Nine times out of ten, it's the short sellers that first identify fraudulent companies, and it's the result of very thorough investigation.

But in markets where nobody can go short -- markets where it's only possible to buy the asset or choose not to own it -- bubbles can easily develop and remain artificially inflated for a long time. This is an important thing to keep in mind when assessing the worth of real estate as an investment.

A second leg down in housing?

A couple of weeks ago I heard Meredith Whitney on one of my Bloomberg podcasts. She was one of the earliest, loudest critics of the major banks before the crisis. If you've never listened to her speak before, she talks really fast so transcripts of her interviews aren't always so elegant. I emphasized the important points.

What has kept home prices stable - and make note that politicians and banks are eating their own cooking because they really believe home prices are stable - they're stable because there's been a ton of inventory kept from the market. So if you control the supply, you can control the price without controlling the demand.

Here's a statistic that I find fascinating. This is just for the top four banks. If you look at nonperforming assets - that's loans that haven't paid over 120 days - the size of that is 1.5 times all of the chargeoffs that banks have incurred since 2005. So you think credit has stabilized, mortgages have stabilized? Non-performs have ballooned so they've more than doubled since the beginning of 2009, and that's just stuff that has to start going on to the market, and interestingly, this quarter you're starting to see housing supply reach the market. That to me triggers another down leg in housing, so to me, I'm steadfast in my belief that there's going to be another double-dip in housing

There's huge growth in non-performing assets. These are numbers, apples-to-apples, on the four big banks. The issue is when does that stuff that's not paying come to market, and when do banks recognize the chargeoffs? I think you're going to see more of that in the second quarter and the third quarter. Does the supply move in the second quarter and then you report it in the third quarter? The timing may be weighted more to the third quarter. I just don't know. I think you see a huge leg down in asset prices when you see the supply reach the market. So no, it's not factored into valuations. No, it's not factored into bank guidance. And yes, I think it's going to be a big problem for the banks.

That statistic about loans that are 120 days past due is staggering. 1.5 times all the charge-offs that banks have incurred since the very start of the housing collapse. If you're 120 days past due on your loan, you're either in big financial trouble or you've chosen to default, both scenarios which are really bad news for the bank that holds your loan. In normal markets, banks would have foreclosed already on a lot of these homes. But by electing to just do nothing, the banks are in effect able to control the supply of houses, the price of them, and protect their balance sheets in the process.

Thank goodness we did away with mark-to-market accounting! Many savvy folks say that was the proverbial straw that broke the camel's back, catalyzing the disintegration of all those junky securities. Those rules were re-jiggered on -- conspiracy alert! -- March 16th, 2009, almost the exact bottom of the financial crisis. Banks no longer have to mark this stuff at what it would fetch in the market right now. They get to mark it at what they think it's worth, at what their models say it would be worth in anormal market. Actually, Bank of America defines it as "the most advantageous market ... in an orderly transaction."

How far 'till bottom

First let's take a look at the most widely-used measure of home prices, the Case-Shiller Index:


You can see that the homebuyer’s tax credit gave the market a shot in the arm last summer, but since that’s over, a second dip has clearly begun.

Now let’s have a look at an updated version my favorite housing chart:


I think one of the most helpful things to do when assessing real estate is to relate home prices to income. That’s the red line in the chart above, the median home price divided by the median family income. Today we’re back in a more normal range, but there’s still some room to overshoot on the downside, especially with structural economic headwinds like we’re currently facing.

With these chart as our guide, it’s reasonable to be concerned about another 5-15% drop in price depending on how severe the economic headwinds and how low mortgage rates stay.

In addition to a simple analysis of price behavior, we can look at fundamental factors like supply and demand. Let's put that Econ 101 knowledge to use.

Here's a chart of supply, courtesy of our friends at Calculated Risk:

There's still a ton of supply out there relative to historical norms, by a factor of about two. What's more concerning is a recent spike in inventory. That could translate into more months' supply later in the year and could be real hindrance for home prices. That's exactly what Meredith Whitney was talking about.

Keep in mind that none of this includes the "shadow housing market," houses that are bank-owned and not on the market, severely delinquent borrowers whose banks are willfully looking the other way, or "sideline sellers" who are just waiting for better times to put their house up for sale. In a normal market, homes like that would already have a "For Sale" sign in the front yard, and as things slowly sort themselves out these properties will trickle back on the market. This side of the market is being tightly controlled right now.

The supply side is better than it was and moving in the right direction. But it's still pretty grim (if you're a seller), and there's still a long way to go before it gets back to normal again. We'll continue to monitor this carefully.

What about the demand side?

On the demand side, prices are driven primarily by two things:

  1. Income - how much current and future income the buyer has available to allocate to a house.
  2. Interest rates & lending standards - how accommodative the environment is to enabling them to pay more for a house.

I think you guys have a pretty good idea how that's going to go. Real incomes haven't gone anywhere in 12 years and it seems unlikely they'll increase any time soon. Shoddy lending standards are also gone for good -- loans like the one I got back in 2004 aren't being written anymore. Lenders have to, like, actually verify stuff now.

The best bit of news is that interest rates are still ridiculously low. They've actually gone down in the last month or so while the global equity markets panicked on an EU-driven wave of economic concerns. I'm now seeing 30yr mortgage quotes at almost 4.5%. A one percent increase in interest rates reduces purchasing power of buyers by about 10% and a corresponding drop in price. The Fed knows how important the housing market is to an economic recovery and they know how important a factor interest rates are in home prices.

You can do the math: rates will stay low for a while a while.

Jobs, Jobs, Jobs

Here's another interesting chart that relates the level of unemployment to mortgage delinquencies:

No surprise that those two data points correlate strongly. If you lose your job you're more likely to stop making your mortgage payments. The housing market won't firm up until the job situation improves substantially.

What is surprising is how bad things are in Nevada. Over 20% U-6 unemployment and nearly one fourth of all mortgages are delinquent.

Negative Equity by State Q1 2010

On top of that, 70% of all the mortgages in Nevada have negative equity. 70%. The national average is about 20%. No wonder that basically every listing in Reno is a short sale or foreclosure. I did a quick survey around town and found that for the most part, the sensible listings are priced around what these houses were worth back around 1999-2002.

The right way to look at housing

We've always said that unless you really know what you're doing, residential real estate is a lousy investment. It always has been and the average person should not think of it as such. You should think of your house simply as a place to live.

Beyond offering basic shelter and comfort, a house has always acted more effectively as a mechanism for forced savings. I know that changed for a brief window when lenders stopped requiring down payments and handed out HELOCs to anyone that asked, but things are now back to the way they always were. Owning a home forces you to send a little bit every month towards reducing the principal of the mortgage and increasing your equity in the home. Theoretically, that equity comes back to you if you ever sell your house.

I know that didn't happen if you bought in the last decade, especially in hard-hit states like Nevada. A lot of piggy banks got wiped out as prices collapsed. But if you buy a house in the next decade, there’s a much better chance that your savings will be protected.

In a perverse sense, I think this could actually be a good thing if you're a buyer who still has a healthy balance sheet. If you were prudent enough to protect your cash over the last several years, there could be opportunity out there. I think there are a lot of families who can handle a $1,500 monthly payment but don't have anywhere close to the $50-75,000 down payment that would be required with that kind mortgage. Not everybody is in a position to benefit from these low mortgage rates and reduced prices, and if you are, you probably won't be hurt too badly should you choose to take advantage of them.

I suppose that's a lukewarm endorsement of the market as a whole.

What are the big boys doing?

It's clear I'm not the only one with a long-term perspective on real estate. Most of the major homebuilders like KB Home (NYSE:KBH) and Toll Brothers (NYSE:TOL) have been busy scooping up land in the last few months. They've been quite public about this, which makes me wonder. Why are they being so noisy about their land acquisitions? They're probably being noisy about it to reshape their public image, but that's not the only reason. Toll Brothers' inventory has declined for three straight years now, from $6.1 billion to $3.2 billion and at some point down the road they will need more land to build more houses. That is their business, after all. May as well buy at distressed prices.

I recently heard about a local developer who just purchased 40 undeveloped lots in one of Reno's luxury gated communities. They picked these lots up for a song, about 75% less than what existing lots up there are listed at. Their plan is to just sit on these things for at least five years and then see where the market is at. This isn't the only incident of something like this happening around town, either. My guess is that the large homebuilders are getting similar deals on the land they're buying.

So it sounds like the big money is thinking long term, like ten years out. It sounds like they might see some upside way out there and that the downside is manageable enough to take action right now.

When I add it all up, I don't see a lot of positives for the market, but I see much less chance of getting hurt. I still think there's another 5-15% of downside in home prices. In tough markets like Nevada, I think the probability of seeing further declines is very high. So many people here have lost their savings or their jobs and there are so many houses for sale out there. In healthier markets, I wouldn't be surprised if the bottom is already behind us. States like North Dakota didn't really have a collapse in prices because they didn't really have a bubble in the first place.

I don’t hear the question “will housing get back to where it was?” much anymore. The answer to that one, of course, is “no.” But the fact that people have stopped asking, stopped hoping, and started realigning their expectations is a positive step on the journey towards normalcy.

Another lukewarm endorsement of the market, I suppose.

Disclosure: No positions