Apr302007

Appreciation is Dead

gone_with_the_windAppreciation is Dead. It is not merely delayed for a temporary housing price crash only to resume its historic 7+% rate. Appreciation is dead. We will never see high rates of house price appreciation again in California. Sacrilege! Yes, but there are reasons to believe this may be true.

In October of 2000, I attended a conference put on by TradingMarkets.com. The NASDAQ had experienced the spring collapse and summer bear rally. The huge fall sell-off (which was the first of many sell-offs before the bottom was reached in the spring of 2003) was just beginning. One of the speakers at this conference was a very successful hedge fund manager named Mark Boucher. Everyone gathered at the conference had just been through the wildest bull market in history. All were convinced that the market was going to come roaring back. We just needed to get past this painful correction. Does any of this sound familiar?

When Mark Boucher spoke he dropped a bomb on the audience — 20% annual gains in the stock market were not going to be seen again in the next 20 years and perhaps in lifetimes of those assembled… Silence… A pregnant pause… One of the most successful money managers on the planet just spoken the unspeakable; the audience had to think the unthinkable. Heresy! Blasphemy! Was this possible? For a few brief moments the audience was exposed to the naked truth; the veneer of denial was stripped from them. It was a paradigm shift with seismic repercussions. Those who heeded his words made wise investment decisions and survived the bear market. Those who failed to listen bought the bear rallies and were destroyed. Seven years after the peak, the NASDAQ is still down 50%, and none of the last seven years favorably compares to the seven that preceded it. Mark Boucher was right.

I am not as smart as Mark Boucher, and I am not a preeminent real estate investor (I didn’t buy the bubble rally.) My words do not carry the same weight. However, consider what I write here, and you may save yourself a lot of money and avoid a lot of stress as the bubble deflates and the post-bubble market emerges.

Have you ever wondered why California’s housing market bubbles so frequently and other markets do not? It stems from a combination of two factors: limited supply and high wage growth (and, of course, Southern California’s Cultural Pathology).

Supply is not limited in the way most people think. We are not running out of land. Supply is limited because the process for obtaining supply is cumbersome — which is good for me because that is my job. In other areas of the country, when supplies of housing are low and prices begin to rise, a large amount of supply is brought to market quickly to meet this demand. In California, this is not the case. The entitlement process as outlined in CEQA is both lengthy and costly; therefore, when supply runs low, new supply is slow to the market, and prices rally higher than they would in other areas of the country. The point is that supply shortages are a temporary phenomenon not the permanent result of “running out of land.” Have you noticed that during the crash there is excess inventory on the market, and the builders have overbuilt? This is why.

The fundamental value driving up home prices is the growth in wages — at least indirectly. Wage growth drives rental rates higher, and it is rental rates which determine the fundamental value of housing; therefore, wage growth determines the rate at which housing will increase in value. Irvine has experienced wage growth exceeding other areas of the country. This is why pay scales are currently double the national average. However, this trend cannot continue forever.

Factor Price Equalization

When the cost of a good or service rises, people seek out lower cost alternatives. When the same product is available in a different market, buyers will purchase in the lower cost market until prices equalize. This is most notable in labor markets. After NAFTA was signed, wages for unskilled labor declined in the United States and rose in Mexico. Of greater importance to the higher skilled labor of Irvine is the problem we know as “outsourcing.”

Outsourcing

Outsourcing is happening all around us. I have a relative who works in customer support for a major computer maker. They are working to outsource most of his department to Banglore, India. Nissan has relocated its North American headquarters from Southern California to Tennessee. These are examples of high-paying, high-skill jobs leaving our area. This is happening for two reasons: one, they can pay less in other markets, and two, they can’t get employees to move to Southern California because the cost of living is too high. The second problem will lessen as house prices crash, but the first problem is not going away. We are paid too much in Irvine, and businesses are moving where skilled labor can be found less expensively; therefore, we many not see a continuation of 3% wage growth in Irvine for the future.

Wage Growth vs. House Appreciation

House appreciation cannot exceed wage growth forever: trees cannot grow to the sky. People have to earn money to buy a home (unless of course we become a nation of the landed gentry in which real estate is only transferred through inheritance.) Over the last 25 years, house appreciation in Orange County has outpaced wage growth. Wage growth has averaged 3.4% while house price appreciation has averaged 6.9%. Notice the bubble years (1986-1989) where house prices outpaced income growth followed buy bust years (1990-1995) where wage growth made modest recoveries. What is in our future?

income and appreciation

There are only a couple of ways house prices can outpace wage growth: 1. interest rates must decline allowing people to finance larger sums with less money, and 2. debt-to-income ratios must rise as people put higher percentages of their income toward making payments. Both of these phenomenons have been occurring in Orange County over the last 25 years.

Interest Rates

Mortgage interest rates have been on a slow but steady decline since the early 1980’s. Interest rates were at historical highs in the early 80’s to curb inflation, and the decline from these peaks to the 7% to 9% range was to be expected. This initial decline in interest rates coupled with low inflation caused house prices to begin rising again in the late 80’s culminating in the bubble that burst in 1990 leading to 5 consecutive years of declining prices.

interest rates

During the early 90’s while prices were declining, notice the drop in interest rates from 10.6% in 1989 to 7.2% in 1996. This 30% decline in interest rates made housing more affordable and help limit the declines in the early 90’s. If interest rates had not declined, house prices certainly would have dropped further than they did. Does anyone think interest rates will decline 30% from the 6.3% they are today down to an unprecedented 4.4% to match the debt relief of the early 90’s? The FED is not going to save house prices. In fact, today’s mortgage interest rates are likely not sustainable. The 6.3% today is 20% below the historic 8% average of the last half century due to global capital markets being awash with liquidity from Japan and China among others. With the declining dollar, growing national debt and inflation pressures, it is more likely that interest rates will rise rather than fall.

Debt to Income

dti

One of the often overlooked phenomenons of real estate bubbles is the fluctuations in debt-to-income ratios. DTI ratios is an interesting measure of buyer psychology. In market rallies people act with greed and put larger and larger percentages of their income toward purchasing houses because they are appreciating assets. In market busts, people put smaller and smaller percentages of their income toward house purchases because the value is declining.

Some of the bulls speculate that we have reached a permanently high plateau. This is crazy. The only thing justifying a DTI of 62% is the belief in high rates of appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment? Once it is obvious that prices are not increasing and even begin to decrease, the party is over. Why would you buy under those circumstances, when it is more rational to wait and pay less? Why would you stretch yourself to buy a house when prices are dropping? This is why prices drop until house payments match their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. When the market debt-to-income ratio falls below 30%, the bottom is near.

Future Appreciation Rates

As you can see from the charts above, interest rates are at all-time lows, and debt-to-income ratios are at an all-time high. Prices are going to fall — make that crash. This post isn’t about the crash, it is about the lack of appreciation in the aftermath. House prices over the last 25 years have appreciated at a rate greater than wage growth because interest rates have been falling and debt-to-income ratios have been rising. Interest rates cannot continue to fall. As they rise in the future to rates nearer their historic norms, house price appreciation will be held in check. It is likely that house prices will appreciate at rates of less than 3% while interest rates rise, and it will only match the 3% rate of wage growth thereafter. It is also possible that Irvine and Orange County may not see 3% wage growth in the future due to factor price equalization and outsourcing. Sustained appreciation rates of 7% will not be seen in the next 25 years — assuming of course we don’t have another bubble.

Buying after the crash

So what implication does all of this have on a future buying decision? Don’t count on appreciation. If you need to factor in appreciation to make the math work on a home purchase, you will buy too early, and you will pay too much.

Then again, you wouldn’t be alone. Pros make this mistake too. Some of you may have heard the story about one of our major homebuilders in Southern California who had to close their San Diego office due to poor performance. The president of the division routinely used high rates of appreciation in his financial models when analyzing properties to purchase. As a result, the San Diego division overpaid for almost all of its projects and lost the company a great deal of money. Usually, when a major company has problems at a division, they rotate staff. The problems here were so severe it was judged more prudent to wipe the division out and start over. Amazing.

When the cost of ownership is equal to the cost of rental it is safe to buy. Even if prices drop further — which they might — you will not be hurt by it. If you are counting on increasing rents or house price appreciation to get you to breakeven sometime later, you will probably get burned. Remember, appreciation is dead. Rest in Peace.

housing_bubble_tombstone