Real Estate’s Crash Landing

[powayseller]

Peter Schiff, Euro Pacific Capital:

August 25, 2006

Real Estate’s Crash Landing

During the unprecedented run up in housing prices over the last decade, most economists and real estate professionals firmly declared that the market would always move higher. When the recent cooling dashed those hopes, many reluctantly fell back to the “soft landing” hypothesis, which predicts that price appreciation will return to historically average rates. However the latest housing data, particularly this week’s figures on new and existing home sales, have made these overly rosy assumptions untenable. The “hard landing” scenario, which envisions real estate prices moving sideways, or actually posting moderate declines, is finally gaining broader credence. But, even this forecast will prove overly optimistic. The real estate market will not land soft or hard, it will crash and burn. Those who did not have the foresight to bail out may be faced with a distinct shortage of parachutes.

The glut of homes on the market, the highest level since 1993, doesn’t even begin to tell the story. Homes were far more affordable back in 1993 than they are today, and there were significantly more renters (who had not yet entered the market) who could potentially buy them. Today, home affordability is at an all time low, and just about anybody who could buy one already has. For those who think the inventory of unsold homes is high now, you ain’t seen nothing yet.

Consider these factors. There are a record number of new homes currently under construction. Real estate speculators who bought solely on the anticipation of rising prices will likely try to unload their properties now that the market has turned. With higher short-term interest rates, those who financed with ARMs will also try to sell their homes to get out from under mortgage payments they can no longer afford to make. A record number of Americans who bought second homes, or vacation properties, will likely reassess the wisdom of those purchases, and put these properties back on the market as well. Finally, homeowners who watched the values of their homes rise for years, but were reluctant to sell them for fear of missing out on even bigger gains, will rush to cash in before all that paper profit disappears.

This raises two pertinent questions. First, where will all the buyers come from to absorb this supply and second, at what terms will lenders be willing to finance these purchases? When prices were rising everyone wanted to buy, no one wanted to sell, and lenders were willing to finance just about any transaction. As a result, there was a “shortage” of homes for sale, a surplus of buyers, and prices rose accordingly. As prices begin to decline, few will want to buy, many will want to sell, and gun-shy lenders will be reluctant to finance all but the most secure transaction. As a result, the “shortage” will become a glut, and prices will collapse.

The glut of homes on the market indicates just how overpriced real estate has become. By next year just about every house in America would be for sale if the owners thought they could sell at today’s prices. It is impossible to clear the market at current price levels. The only solution is for prices to plunge. Lower prices will result in fewer homeowners wanting to sell, more potential homebuyers able to buy, and lenders willing to finance the purchases.

[Anonymous]

But, it will take time. Even highly liquid assets, such as stocks, can take time to reset to rational levels: GM stock rose from $8 per share in ’22 to $92 per share in ’29 (CAGR of 32%), and while it plunged in Oct./Nov. ’29, it continued its downward drift to $10 per share in ’32. Only after it hit the rational price of $10-12 per share in ’32 did it then begin its meandering move upward, again (yielding a rational CAGR of 11% over ’32 to ’48). Thus, it was three years from peak down to rational price, for a highly-liquid, widely-held asset. As you know, real estate is much less liquid, and could be considered illiquid.

Moral of the story: calculate the real, underlying value of the asset (for real estate, the capitalized rental value), then buy when the price approaches such.

[Anonymous]

This is a brilliant summary of the situation. The aspect that I think is huge, that nobody in the mainstream press talks about is this simple fact:

“just about anybody who could buy one already has”

This is why I don’t believe there will be any significant dead cat bounce. I feel people are grossly overestimating the amount of money actually on the sidelines. In the macro scale of things, I think it is insignificant due to the simple fact above.

[no_such_reality]

Yes, but they miss something too…

Because of the soft rental market from 1990 to 1997 and then the subsequent home run, very little rental housing was built.

Occupancy in large scale rental developments are unsustainably high.

The question will be who gets busted out first: home owners or renters?

Keep in mind that from 1990 to 1996 bottom that the bulk of the decrease was inflation. The nominal prices only fell 10% or so.

[bob007]

there is some money on the sidelines.

i live in bay area. the houses (3-4 bdrm 30 year old) i want cost $1 million.

if they fall to 700k i will buy them (assuming i have a secure job and i can get a loan).

in san diego i would jump on a 450k home in ranchos penaquitos or povay.

[powayseller]

Statistics tell us that home ownership is saturated. That means, statistically, no buyers on the sidelines. We are at 69% homeownership,the highest in our history. As far back as this is tracked, we were at 62 or 65%, I can’t remember which. Loose lending has raised this to 69%. Who can still buy that hasn’t? Sure, you have a few bubblesitters, but we folk on piggington are not going to move the market. Even if 1,000 people in the US cashed out to rent, I would be surprised. I personally know of no other people who cashed out to rent, except this group here.

I think you’ll be hard pressed to come up with data supporting any notion of money on the sidelines. The fact is, everyone who wanted a house already bought one. Or two. Or three.

Once prices fall enough, investors and first time buyers will enter the market. But many people will lose their homes first. We will NOT have an increase in the percentage of homeowners. New buyers will be replacing retirees and NOD victims. It’s as simple as that.

A reversion to the mean requires that we return to the historic 65% (or 62%, ?) homeownership rate.

Schahrzad Berkland

[Anonymous]

I agree PS, I based on both the statistics and common sense, there is no reason to think there is a lot of money on the sidelines. We are the exception I believe. Most regular people who wanted to buy already have, thanks to loose lending. The specuvestors are finished. So who is left to buy all the houses?

[Anonymous]

Once the condo “reversion” process completes, plus all the thousands of empty downtown condos I don’t see any long term lack of rental housing in San Diego.

[powayseller]

deadzone, we don’t have any group waiting to buy houses at current prices. Sure, some people here rent, like one of my neighbors, because they think prices are too high. They can afford to buy, but won’t at today’s prices. I know nobody else in that situation, outside of piggington.

People are leaving at the rate of 44K – 50K/year, and maybe a lot more. What if the current exodus is 70K/year? I’ll start a survey on another thread about this.

Nationally, the home builders are saying overbuilding has caused the high inventory and falling prices, and it can take 2 years or more to absorb the houses.

Even if no new homes are built, it can take 2 years for today’s housing stock to be sold.

Anybody who thinks that lowering prices will draw in buyers and prop up prices doesn’t understand the real estate market at all.

I am flabbergasted by people who make a living in real estate, who have no clue about how pricing works, how real estate cycles play out, and who think prices will keep climbing.

[Anonymous]

Right, and the builders keep building… I wonder if prices dropped 20% across the board overnight on all listings in SD, how many buyers would there be??

[zk]

“I wonder if prices dropped 20% across the board overnight on all listings in SD, how many buyers would there be??”

Probably less than there are right now. If prices dropped 20% across the board overnight, there would be panic. Everyone would be convinced that buying a house would be the worst thing you could do. Who cares if you can get a house for 800k that used to cost a million if it might be worth 700k or less next year? The fear creates a cycle, just like the greed did on the way up. That’s why the mean overshoots.

[SD Realtor]

zk I agree with you. Right now IMO what is hurting the market is psychology, (on top of way overpriced property) Rates are low, the 10 year has been dripping more and more, yet sales are down. I do believe there are more people on the sidelines then we all think. I know several people who are simply biding their time right now. Also I do believe that once properties become profitable for investors, to rent, not to flip, I do think people will buy them. It does seem like some funky equilibrium is attainable though doesn’t it? Say we hit a spot where prices have depreciated say 30%. So at that point we may start to hit some positive cash flow spots for certain properties. However I think there will still be a slow market with alot of inventory. So the rental market may stay somewhat robust, due to alot of buyer on the sidelines but there also may be more investors looking to put money into the market. Again though, I think zk repeated what we all know, the psychology is going to drive the market to a certain point… my point is that at some point smart money will start to enter the market.

[powayseller]

Once rentals are cash flow positive, investors should be buying rental properties. That’s what I think.

As far as buyers on the sidelines, I have my doubts. Everyone who wanted to buy has done so, as low interest rates and loose lending pushed demand forward. This caused home ownership rates to go up from its historical rate of 50% in the 1950’s, and 64% since 1980. Today we are at almost 70%. Who can possibly be left to buy? Illegals? Babies? Below 500 FICO scores? The unemployed?

SD Realtor, can you share some anecdotes of the type of people waiting on the sidelines, and how many you think there are.

[Carlsbadliving]

I’m waiting on the sidelines. I’ve wanted to buy but resisted the urge and new things would start to come back to earth. There’s got to be a reasonable amount of people like me who have never owned, could have owned (but chose not to), and are waiting for prices to settle.

I don’t think you can say “everyone who wanted to buy has done so”.

[powayseller]

Carlsbadliving, I think the people in your category are so few, that I doubt they will move the market. I used “everyone who bought already did so”, as a figure of speech, a phrase that Ivy Feldman (analyst) used when talking about the effect of low interest rates, which shifted forward demand. She was asking the Toll Bros. “who still needs to buy?”

In my entire 6 years in San Diego, I only met one person outside of piggington who chose to rent not buy, and that is because she moved here in 2005 when prices were too high.

The people waiting on the sidelines are all on piggington. Maybe an exaggeration?

I think there is a group of people who are priced out forever, based on their career choices, so they may never be able to afford a house in San Diego. As harsh as it sounds, the premium on San Diego real estate and low wages means that many San Diegans will never be able to afford to buy a house. They call it the Sunshine Tax. Don’t confuse those people with people waiting on the sidelines.

Finally, people who are determined to own a house, have already left San Diego. The number of people who want to own in San Diego and haven’t bought yet, is very small in my opinion. Like I said, I am a big talker, and I know only one family in that category. The rest are young people who work at gas stations and restaurants such, and they say they would like to buy a house, but they never will. Their jobs don’t pay enough.

[Author]

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