Home prices fall in dollars not percentages

[sdrealtor]

Deadzone,
I live on the coast and it went up slowly between 1997 and 2001. The real appreciation started in 2001 contrary to what you said.

As for the base year, it doesnt really matter and I dont understand why everyone is so hung up on that. if there were good comparables starting then I would use them, unfortunately most of the nice homes around here were built starting in 1998 and didnt begin hitting the resale market in earnest until 2001.

[sdrealtor]

PS,
When i get some time I’ll look back at 1998 to satisfy the masses here. It may take a day or two but I suspect I’ll find the same thing.

[Bugs]

The numbers I used may seem arbitrary but I can promise I didn’t pull them out of thin air. I saw lots of examples of pricing compression while it was occurring, and we did actual market analyses covering the easier zip areas to confirm. The bottom end held better than the middle and upper ends. The upper end held a little better than the middle, which took it the worst.

And if you think about it this would make some sense. The bottom end holds a bit better because those buyers are coming from both directions – buyers entering the market and buyers moving down after struggling with the move ups. The upper end holds a little better because rich people are not as affected by employment trends. The middle gets nailed because those buyers include the merchant class and the middle manager types that are always very susceptible to employment trends. That’s also why the middle markets exploded in number during this run-up.

[Anonymous]

sdr, the only reason we’re hung up on the base period is because 98 is when the appreciation started. But it brings up an interesting point that the appreciation peaked at different times for different areas and types of homes.

Prices on the coast most certainly appreciated more from 98-01, at least in PB and La Jolla areas. In fact, my condo in PB gained 130% during that time period before I sold in late 01. Of course it continued going up since then but not nearly as sharply. Prime La Jolla real estate also made most of its gains by 2001. You can check the mls if you don’t believe me.

[sdrealtor]

DZ,
I’ll check and will let you know. I suspect you might be looking at percentage increase and not dollars. A $100K condo going to $230K is a 130% increase. A $230K condo going to $460K is only a 100% increase. Personally I rather make 230K with a 100% increase than $130K with a 130% increase.

As for the prime LJ real estate that is an animal unto itself and along with RSF certainly not a playground for us lowly pawns. The ultra high end market is driven by the economy and stock market gains. When the stock market soared there was lots of funny money floating around so it wouldnt surprise me to see those markets soaring then. Thats more the exception than the rule and certainly not the domain of those of us around here.

I’ll check and will let you know.

[docteur]

So, is the consensus on this forum that housing prices, assuming they drop 35% – 50%, will fall far below replacement value?

Most builders work on 10%-15% margins (in good markets and a lot less in bad ones). A 50% drop puts a new home (or a resale) at a price way below the cost to build that home (including the land).

Is that what is being predicted here? Not only will land values have to fall a long way but also the cost of all construction materials and labor. With commodity prices increasing I certanly don’t see that with materials and the cost of labor can’t fall too much either.

Honestly, if homes values fall 50% on a mass scale, the entire building industry, not to mention all those related businesses, at least those which pertain to residential construction, will collapse and disappear from the landscape.

[FormerOwner]

Just because something cost X dollars to build doesn’t mean it has X dollars of economic value. Look at cars: you buy a car for 40K and a couple of years later it’s only worth 30K even if you don’t put any miles on it. There’s such an oversupply of houses now (many of which are not near any job centers) that no new ones need to be built for quite a while. They just don’t have much economic value.

[PerryChase]

docteur, profit margin on construction is a lot more than 10-15%. In Texas builders sell 1500+ sf houses for $150k. including the land and still make a healthy profit. The cost of material should be the same everywhere. Labor in California is only slightly more.

I wanted to build a 3-wall 300sf addition to my house and the contractor wanted $100k. For that price, I’d rather go to school and find out how be be my own contractor. Builders would like us to think that it cost $200/sf to build a house. $80 to $100 is more like it.

Builders make a lot of money. If they overpaid for the land, well too bad.

[Daniel]

Docteur,

That’s an interesting comment. Although my personal bet is that prices won’t drop that much (35%-50%), I don’t think that there is “replacement value” support 10%-15% under current prices either. Let me explain.

The cost of the housing structures in SD (materials, labor) is not much higher than elsewhere in the country. It is the implicit cost of land that makes housing very expensive. But the implicit cost of land is extremely volatile, and it includes a very high speculative “lot premium”. In a downturn the cost of land and the lot premium will likely go down.

Let me give an example of lot premiums: say you have a 10,000 sq ft lot with one house on it (large back yard). You can compute the “implicit cost of land” by substracting the construction costs from the market value of the house. Then let’s say you divide the 10,000 sqt ft lot into two 5,000 sq ft lots, and put two houses on them (identical houses, but with small yards now). You repeat the calculation: the implicit cost of the land equals the market value of the houses minus construction costs for the two houses.

If you do this calculation (and I read a report that did just that, I’ll try to see if I can post a link later), you will be surprised to find out that the single 10,000 sq ft lot is worth much less than the two 5,000 sq ft lots. Actually, a 10,000 sq ft lot is worth just a bit more than a SINGLE 5,000 sq ft lot.

This is the very definition of land speculation and speculative lot premium. Land is not valuable per se, in $/sq ft. It is valuable as long as a house can be built on the parcel. As I said, I would be surprised if the lot premium held up during a downturn.

[sdrealtor]

PerryChase,
Building is not as simple as you make it out to be in CA. All you are considering is building materials and labor. There is ALOT MORE THAN THAT! How about the roads and utility infrastructure that have to be built? How about all permits, governmental fees, affordable housing fees and environmental mitigation fees to name a few? A good rule of thumb I have heard is that land costs around here are typically at 1/3rd of the price of a home. I believe a buildable lot for a tract home in SD runs between 250K and 400K whereas land in TX is almost worthless in comparison. I’m sure someone on this forum has the expertise to step up with insight regarding this. Hopefully they will.

[docteur]

PerryChase – Thanks for your comments but I have to disagree with them. SDRealtor has a better handle on what’s involved in building a house.

I have been subidviding and selling land to builders for 30 years. I see their proformas and know how much they earn.

Builders make a lot LESS than you think. Booking profit is done through large volume and quick turnover in dollars, not high margins. Building is an extremely competitive business and builders keep one another in line in their efforts to bring buyers into their subdivisions.

$ 100 per foot for a new home (cost) is high. With the economies of scale, you can build a very nice tract home for $ 80-$ 85 per foot in today’s market (upper end and possibly more for less expensive homes — at basically the same spec level, a larger tract built home can oftentimes be cheaper per foot than a smaller one).

A custom or spec built home is a whole different analysis and in some areas can be as much as $ 300 per foot, depending on the level of spec. The cost to remodel a home can easily reach $ 400 per foot, depending on the improvments (my brother is a contractor and just finished an addition on a home on a flat lot that was $ 425 per foot because the home was older, demolition cost and matching of materials was difficult, etc.)

In the old days the rule of thumb for merchant builders was 1/3 for the land (finished lots, ready to go vertical), 1/3 for construction and 1/3 for overhead and profit.

Those ratios disappeared at the start of the last boom as land prices began to soar, in part due to the fact that entitlement processing took longer and longer because of the massive increases in environmental restrictions. (The last land deal I did took 15 years to bring to market – long lead times add to higher home prices because of the huge processing and holding costs of land).

Today, land can be as much as 50% of the cost of the new home (and higher with single built spec homes), and if construction is as much as 40%, it doesn’t leave a whole lot for the builder for profit and overhead. Again, merchant homebuilding is very risky because of long lead times.

An actual case in point from a recent transaction I participated in: Land $ 500,000 for a finished lot (all costs and fees); Construction $ 82 per foot (including financing), with the average size home being 3,800 SF. Projected sales price (homes are still being built and will hit the market in late fall): $ 900,000. Gross profit margin to the builder before taxes: 9.8%

The above analysis is fairly typical in today’s market. And margins are falling as prices are falling and the market is softening. At the height of the building craze on this last go around I saw margins as high as 20%, but those builders had bought the land years ago and entitled it themselves (they did not purchase “retail” lots).

But to say prices across the board will fall far below replacement cost, just doesn’t sit square with me. Again, the entire construction and building industry would disappear and we would be in deep caa caa. We better pray it doesn’t get to that.

So, although retail pricing may reflect $ 200 -$ 300 per foot or more, depending on the market area (my current home in Carmel Valley was purchased new at $ 308 per foot (with about $ 150,000 in builder upgrades) in 2003 and was recently appraised at $ 588 per foot, but I also put in about $ 300,000 in landscaping and other improvements. Will my home fall to a value of $ 294 per foot (50% drop) to a resale value of just under $ 1 Million?

I seriously doubt it. Again, I just don’t see prices falling across the board to a level that is far below replacemnet cost. There would be no incentive to build anymore and then existing housing stock would start to increase in value until an equilibrium was reached in pricing that caused builders to come back into the market.

Quite frankly, I am amazed at some of the predictions made on this forum. Just because someone says it doesn’t mean it is so. As I have said time and time again, nobody knows what is going to happen and the best we can do is simply observe, without emotion, the trends and then follow them.

Additional comment:

Daniel – Thanks for your perspective but again, long lead times are what keep land prices and indirectly, home prices high.

One recent deal I did went down as follows: Land Cost in 1988 dollars – $ 1.2 million; Processing Costs $ 5.3 Million (including carry). Sales price to give investors a reasonable return on capital: $ 30 Million. Time to bring to market (start home construction): 18 years.

There was tremendous risk in this deal and we didn’t get our approvals until 2003 (so for 15 years we didn’t even know if we would recapture our $ 6.5 Million, let alone make any profit). For nine years I negotiated with the Resource Agencies and almost got my land turned into a park. For that kind of risk, you want a decent return or you will move into other kinds of investments (which I have now done. It’s just way to risky at this point in the game to subdivide land in California, especially San Diego).

Again, long lead times (in California anyway) just kills you. In Texas you can get entitlements in some areas in 90 days. By the way, San Diego is one of the most environmentally restricted areas to build in the nation. We have huge bio-diversity here due to the climate and extremely aggressive environmental agencies and laws. Only Kauai Hawaii is worse as far as I know.

Believe me, these things keep land prices and indirectly building cost artificially high. The stuff you see going up now, especially in master planned communities, was designed and planned in the early 80’s and in some cases took twenty years to bring to market. Land prices are holding up remarkably well and I don’t expect to see any dramatic adjustments anytime soon. Most land guys I know would rather hold through a downturn than sell out at a hugely reduced price.

[sdrealtor]

Docteur,
Good to have you back on board and I hope you are having a great Summer.

SDR

[docteur]

Thanks. I hope everyone on this forum is having fun this summer and not worrying too much about the impending “correction.”

I am having a great summer…so much fun in fact, I have not had a lot of time to keep up on this forum. Surfing, sailing and swimming this time of year are activities that can oftentimes take all day because of our beautiful weather!

Lots of good stuff being posted though and I will do my best to stay on top of it! Sometimes it takes me hours just to catch up but it is definitely worth it.

[powayseller]

Welcome back, docteur. I fractured my leg/hip from running, so the pain and the summer school for the kids is keeping me home more than ever. I had looked foward to a nice vacation, but it won’t happen this summer.

Daniel, you are right. My 5.3 acres in rural Poway were worth $350K last summer, because only one house could be built on it. If the zoning were changed to 1 house/acre, that land would have multiplied in value. Real estate researchers, such as John Talbott, found the same result as you did, in studies of land value.

docteur, the high cost of housing is due to the high cost of land. The high cost of labor/materials is due to the short supply during the construction boom. As this cools, both will fall in price. Even the commodities boom will fizzle out once consumer demand slows down. By next year, I bet copper will be back at before-runup prices. The material costs were artificially high due to the overconsumption. If housing can or cannot go below replacement cost, depends on how much the builder overpaid for the land. Could Lucent stock go below what someone paid for it a year before? An interesting thing about bubbles: they correct to baseline, so any overpricing will be corrected on the way down. As long as you are comfortable with the possibility of your house being worth $1 mil, who cares? You said you are a millionaire, and you love your house, so why do you care if it loses value? Someone in your situation has nothing to be worried about, except the possible loss of the cash that you stashed away (dollar falling, etc.)

sdrealtor, a rule of thumb in construction is that one should spend no more than 1/3 of the total price on the land. Builders who owned their lots for many years, are earning a huge premium on their homes just on the lot value.

[PerryChase]

docteur, like you said it costs about $80-$100 to build a home. Since land is the biggest portion of cost, I don’t see why land can’t drop dramatically. If landowners can afford to hold on during a sharp protracted downturn, then that means that they made a lot of money during the boom.

I don’t put much credence in profit margin figures. For example, car dealerships would have you believe that they are selling cars at invoice. I don’t think they they could really do that for long. Car dealers don’t go out of busines often. In RE, say a landowner buys a piece of land for $10k then sells it for $100k. That’s a profit margin of 1000%. The new owner (maybe a related, but legally separate partnership/corporation) then puts up a building that costs $10k to build. He then sells it for $120K. The profit margin on the 2nd transaction is 9%. The builder then uses the 9% figure to justify that he’s hardly making any money. Notice that the 2nd transaction also allows the first entity’s 1000% profit to be shielded from lawsuits (i.e. construction defects).

As everyone knows, RE is full of related entities that sell to one another ’round and ’round. We’d have to carefully follow the money to determine what the true profit margin of a building/home is.

Only time will tell how RE will turn out in the next 10 years. Personally, I’m biased and I think that we spend too much of our income in RE. A big crash will be the catalyst that causes us to rethink our priorities. For example if land is so expensive, why don’t we build up instead of out (with proportionately lower prices)?

Economically, I believe that the stutus quo proctect builders. If other industries found ways to build better quality products at lower and lower costs, I don’t see why, if forced, the RE industry can’t achieve the same results.

[Author]

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