[Bugs]

I think the same thing is going to happen in Santaluz this time that happened in Fairbanks Ranch last time. They got caught with a ton of high-dollar inventory in varying stages of development going in and took some really big losses by the time it was over. I’d guess that 90% of the homes in construction over there are spec homes, not owner-builders.

[Bugs]

The most pessimistic prediction (Jim’s) came true. Good call, BTW. I think this could be the shape of things to come. You almost can’t get too pessimistic about the pricing in a declining market.

I’m sure the sellers are motivated to get out. I can’t understand why they didn’t have a Plan B and a Plan C in place to deal with the possibility that the bids were going to start off coming in a little shy. It seems like they almost would have been better off selling the lowest price home first to it’s highest bidder no matter what just to set the psychology in motion. Starting off with the big house and the big price, only to come up a little shy and then refuse to sell at all established a we’re-not-that-serious attitude that probably hardened the resolve of the remaining bidders.

I mean, if there were only 8 active bidders then they didn’t have enough buyers to go around in the first place.

I wonder how much the advertising and auction costs were?

[Bugs]

My point was in relation to the flip trade – they’re not that interested in 6% YOY increases. Getting 3% over CPI is not part of their fabulous wealth building system. You can argue that 6% YOY for 2006 isn’t going to get you to an overextended market.

I agree about Reno – it looks a lot better to me than Texas. Heck, I’d take Las Vegas (once it settles down) over Texas.

[Bugs]

LA-Y was absolutely right about the 2% loss – for the months of January and February of this year.

[Bugs]

They’re already having problems. The investor clubs had identified Austin and (I think) Amarillo as being among the next stops on the triumphant New Paradigm world tour. Both of those runups have reportedly fizzled and are already on the rocks. Their upswing was measured in months, not years.

[Bugs]

I wonder if the makeup of the audience had any influence on the bidding?

I don’t think the sellers need to take $200k losses. They’ll probably just go back to marketing the homes in the MLS, probably at the current list prices -10% discount. Maybe throw in a car as an incentive to keep the recorded price up. Those prices probably would drum up some impatient suckers.

One thing’s for sure – this group basically has to sell and get ou, and sooner is going to be better for them than later. These properties have nothing to do with providing shelter for the owners group. It’s strictly about the money and I’m pretty sure they’ve figured out that the longer they wait the more they’re going to lose. They wouldn’t have owner-occupancy financing terms on these homes as they were not purchased for owner-occupancy. For all we know their loan terms may have a short term call date on them.

The rents they were getting from Lennar were probably enough to cover the payments going in, but there is no rental income coming in right now, so how ever many partners there are would be covering the entire mortgage payment out of pocket between them. If they try to rent the homes out alls that does is reduce their out of pocket losses. Of course, those payments would all represent permanent losses once they’re paid out.

Just wait until 16 fully-decked out homes in Bressi Ranch do end up selling for 15% or more off their 02/2005 sale prices. I’ll betcha anything that prompts a few other flippers in the project who are already upside-down to walk, too.

[Bugs]

As for holding your breath I suppose it depends where a person is in the buy-hold-sell decision. The only people who should be sweating are the people who have exposure to losses. At the moment that includes thousands of 2004 and 2005 buyers and anyone who has maxed out their mortgage ATM in the last couple years. Of these people, some are actually smart enough to see how precarious their situations are (hence are sweating); while the others are too dumb to realize how bad their situation already is.

People who currently have no skin in the game have no rational reason to not continue to wait. The market is going down, and the decline isn’t that slow. There is no 3-year financial upside to getting in at the moment. If you want to preach the emotional benefits of owning the right to win or lose in the property ladder game then feel free. However, I think your message would be better received on one of the investor/flipper boards out there. Those guys love soft-landing predictions.

[Bugs]

The “Glamor City” argument has been put forth more than once, and I wouldn’t necessarily discount it as a whole. However, what exactly is it we’re saying when we say that people will always pay a lot more to live here? That’s basically saying that the demand outstrips the supply and that scarcity and competition between buyers is driving the prices. Meanwhile, we have net outmigration as people leave town, and they’re doing this at the same time that we have an ultra-high standing inventory of listings, with more in the pipeline. Some people may perceive there to be some scarcity but these wage/population trends appear to be demonstrating otherwise.

A true glamor city holds its ranking (if not its pricing) no matter what. How do they do that? Well, there are only so many ways to pay for that expensive housing. One way is to grow their buyers for these price ranges in the local economy. Jobs, businesses and wages. San Diego has done some of that, but only at a small fraction of what it would take to service the types of increases that have occurred. New York and San Francicso have much stronger employment situations to support their price levels.

The other way is to import your buyers, who have made their money elsewhere and are looking for their destination. No doubt some of the money used for housing purchases in the last few years has been money earned or inherited from outside the local economy. Again, it doesn’t look like the number of imports coming in would even be equal to the numbers that are leaving.

These prices will seek their own equilibrium, and maybe that equilibrium won’t be as low as the long term trendline. Maybe the average buyer will buy into the notion that in order to live in this “paradise” it’s worth it to them to spend 50%+ of their annual income. Even though they can buy the same house in Riverside County for about 35% less. Even though they can rent the same house in San Diego County for 50% less.

I do know that two of the main “fundamentals” driving the runup were speculation and fear, and that the departure from the market of those buyers have already been big factors in our recent declines. Glamor may be in there somewhere, too; but the money to pay for the glamor has to come from somewhere. So far, the sources of that money are proving to be very weak.

[Bugs]

Gotta wonder if he’s tapped that ATM and if he even can afford to sell the home for less than $415k.

[Bugs]

Now we’re getting into different property types that to a certain extent compete with each other.

I would characterize any use of rental factors to sale prices for SFRs to be an indirect indicator. It’s interesting as a point of analysis, but hardly anyone who’s buying or selling pay any attention to them when they make their decisions.

With the exception of short term flipping activity, the typical buyer for most homes is an owner-user. The economic proceeds are always a motivation but the fulfillment of emotional needs and the shelter aspect of SFRs will always be the main thing. Rental factors are useful to the extent that rental occupancy is an alternative to occupying it themself, but since that alternative is not often considered seriously it’s kind of a sideline.

Comparing SFR rental factors to those from other types of real property gets real tricky real quickly. For one thing, the rental terms vary a lot between these different types of property. For instance, because of what’s typically included with the rents for these different property types we could be looking at a rental market where expenses will eat up to 40%+ of the gross income (apartments and some types of office rentals), or it can be below 5% (for many of the retail leases).

Then there’s vacancy. Between owner-users and rental tenants, vacancy for SFRs normally runs very low. Flippers have apparently changed this vacancy rate in the last couple years, but prior to that homes just didn’t sit vacant for 6 months at a time. On the other hand, many of the office markets have vacancy rates that have been varying between 5% to as high as 30% depending on what and where. That’s a huge spread.

By the time you get to considering all these different variables, it’s easy to see why rent multipliers and capitalization rates vary by property type regardless of when in the cycle you’re looking at them. Heck, even among the same property types they tend to vary somewhat by size ranges because of the different motivations and criteria used by buyers at different pricing levels.

That’s why using gross income multipliers as a measure of value is sometimes like trying to use a spoon to make surgical incisions. They’re often used by lay people because they’re quick and easy, and to the extent they’re used on properties that are that quick and easy to compare they work okay. But many of the property types are not so simple, which is why the appraisers and investors use other tools and measure the income after taking out vacancy (Effective Gross Income Multipliers) or after all expenses (Net income Multipliers or Cap rates) or even after all debt service and tax liability is taken out of the income stream. As a general rule of thumb, the more of these variables we can reconcile out of the income stream, the easier it is to compare the apples to apples.

At this point we’re getting far away from how this discussion started, which was comparing GRMs for houses to their respective sale prices. I hereby declare this an official tangent. Discussing and comparing GRMs for SFRs is complicated enough without making it more so by dragging in disparate property types for comparison.

[Bugs]

The point you bring up about different areas having different multipliers is well worth pointing out. Among other things, an income multiplier is a (rough) measure of a number of factors in an investment. One of those factors is the risk involved with the property type, location, condition, etc. Another factor is the amount of competition at those prices in the sales market and the rental market, which don’t always move at the same pace or even in the same direction.

So yeah, you would expect GRM/GIM indicators (which are factors) to be higher in the more desirable locations and lower in the less desirable locations. You would expect them to be higher for the newer and better condition properties and a bit lower in the inferior condition properties because of maintenance and replacement costs as well as the lower rents. Bigger risks require bigger returns, which in turn reduce the rent multipliers.

Finally, it bears repeating (again) that rents are tied to local wages, not investment income; there are definite limits to how much people will spend on rents. People who retire from Phoenix don’t bring their nest egg to rent; they buy. Percentage-wise, the difference in rents between otherwise similar 2bd/2ba homes in La Jolla (93137) vs. Barrio Logan (92113) is nowhere near the difference in sale prices.

[Bugs]

SDR,

The 9.7 GIM occurred in 1995 based off of rents applicable at that time. As we already said, those prices were undervalued relative to the long term trendline by 20% or more. Your 1998 purchase price would have been at or even slightly above the long term trend line depending on what time of the year you bought and how well you did on your price. At that point, a taller GIM of 12.0 or higher would have already been in order. In 1998, a 10.0 GIM would have represented a 20% decrease if that had been what the rental and sales markets were doing at the time.

Obviously, rents have increased since 1998 and the sales market has far more than doubled. I think it’s safe to say we are in uncharted territory with these gains and the truth is we can’t know for certain whether this current correction will stop halfway to the trendline, go all the way, or as in busts of the past, overcorrect below the trendline.

We have yet to see a correction that didn’t overshoot, so from a past-predicts-the-future standpoint there’s no evidence to say it won’t happen that way again this time. But if we have only the past to explain that it might happen again, we have absolutely nothing that we could point to that would explain why it won’t.

—————–

The interest rate spike in the early 80s was just that – a temporary spike. It can be argued that the subsequent return to more normal rates helped to initiate and fuel the boom of the mid-late 1980s. Anyways, that interest rate spike evened back out after a couple years. If people are making a lot of money off of CDs it only begets more competition among depositers, thus resulting in lower yields. I see this as another example of what happens when there is an extreme – the forces of gravity will eventually bring it back into line.

Here’s something to consider, though. If the interest rates do go up, so too will inflation; and a loss of equity value through price inflation is just as much a loss as an outright price correction. So no, I don’t think we can justify overpriced @6% (based on the long term trendline) as being better than underpriced @12%.

[Bugs]

I’ve seen sub-8.0x gross on certain property types other than residential. I have one lending client that bases the value upon which they’ll lend at 7.0x gross. I think that’s being overly conservative and I know they’ve passed on a lot of profitable deals in this runup because of it, but I also know they don’t have problems with foreclosures or late payments.

I can think of a couple reasons why a single family residence or condo would routinely justify a higher income multiplier than commercial or industrial properties. For one thing, residential properties are subject to residential lending programs. This means they can qualify for 30-year mortgages with minimal downpayments and favorable interest rates; whereas a non-residential property (including 5+ apartment units) are subject to commercial lending programs. For comparison, most commercial loans are written at higher interest rates and get re-written every 5 years. The loan may be amortized on a 30-year rate but it comes due in 5, at which point it rolls over into a new loan at the prevailing interest rate, usually with additional origination fees. The increased demands on the mortgage side of the income stream result in lower returns on the equity side. Financing terms are one reason SFRs tend to show higher rent multipliers.

Another reason is that, just as they say, a house can always be used for shelter. Not so with a commercial property. A commercial property has no utility to a failed company, except as a disposable asset.

Yet another reason is that the price point for investors is much lower for a house than for an investment-grade commercial property. Simply put, more people can participate in that particular game because of the lower prices and the larger number of available opportunities.

For these reasons (and others) I’d be surprised to see housing and non-residential properties ever working off the same rent multipliers. There’ll always be some relation between the two, depending on the economy, but there’ll always be a spread.

[Bugs]

I would never say never to either increases of mortgage interest rates to 8.5% and/or the return of a 10x rent multiplier for housing. Just as this high entered previously uncharted territory, I think this backlash also has the potential to go where no backlash has gone before.

Depending on the losses suffered in the secondary market, I cannot rule out a standard 10% mortgage interest rate and 20% downpayment requirements at some point in the next few years.

[Bugs]

Appraisers normally use monthly rents and monthly factors when appraising SFRs, condos and 2-4s. The monthly factor is referred to as a “Gross Rent Multiplier”.

The use of annualized factors is generally reserved for apartment properties (5+ units) and non-residential properties like office and retail. The annualized factor is referred to as a “Gross Income Multiplier”, and we sometimes measure it as different points in the income stream, such as either before or after vacancy/collection losses, or after consideration of any rental concessions. For residential properties, appraisers just stick to the monthly rents.

A annualized gross income multiplier of 10.0 (sale price/ annual rent = 10.0) would equal a gross rent multiplier of 120 (sale price/monthly rent = 120).

The 1995 GIM average for houses of 9.7 would equal a GRM of 116.40, which would have actualy a little higher than what the apartment properties were selling with at the time.

The thing to remember about the 1995 prices is that they were undervalued relative to the long term trend, so I don’t think you should be using a GRM of 120 (= GIM of 10.0) as your baseline. It probably should be closer to 145 (GRM) or 12.0 (GIM), and vary off of that.

The GRMs we were seeing of 280-300 x monthly rents would equal an annualized GIM of about 24.0+, so you can see that off of the peak we would have had a long ways to go in order to get the rent/price ratios back down to the 145-165 (12-13) ranges.

Let’s give our bulls the benefit of the doubt and say that rents will continue to climb at a double digit pace. If we start from an average of $1,900/month for an existing 10+ year old 3bd/2ba home. How far up would the rents for that home have to go in order to meet a declining price structure (now at $550k) at the 150-165 GRM rate? Assuming the rents are increasing by 10% per year and the prices are decreasing by a similar amount, we can lay out the scenario.

Yr1: $550,000 Price / $1,900 Rent = 289.47 GRM (24.12 GIM)
yr2: $495,000 Price / $2,090 Rent = 236.84 GRM (19.73 GIM)
yr3: $445,500 Price / $2,299 Rent = 193.77 GRM (16.15 GIM)
yr4: $400,950 Price / $2,528 Rent = 158.60 GRM (13.21 GIM)

Under this scenario it would be 2009 before the rapidly decreasing price structure intersected with a rapidly increasing rental structure; assuming those opposing trends could occur simultaneously for any length of time.

The resulting $400k median price would represent a 27% decline in pricing, and the $2,528 rent would represent a 33% increase. Bear in mind, this what-if only corrects down close to long term trend line; it doesn’t overcorrect like every other downswing normally does – it would take at least 1 or 2 more years at these same rates to do that.

The other thing to remember is that the rental market for homes is not the only game in town for a rental tenant – houses compete for rental dollars with apartments and condos, so we’re not just talking about the one rental segment increasing by double digits during an RE downturn; we’re talking about all rentals increasing in varying degrees.

Speaking of which, am I the only person on this board who finds the idea of the rental market rapidly increasing during the same time frame the sales market is crashing to be…implausible?

[Author]

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