Sep292008

Desire is not demand

The last line of defense for the housing bulls is the fallacy of pent-up demand. Belief in this fallacy relies on people’s inability to distinguish between desire and demand.give_it_back

Most people want a house. About 65% of Orange County residents own their homes, but probably 95% of residents wish they did. The desire for housing always exceeds the supply because there is always some segment of the market who is unable to obtain home ownership due to the cost of housing and a lack of available credit. True demand is the amount of money those with the desire for housing can raise to put toward the purchase of real estate. If those with the desire for real estate do not have savings and if they cannot qualify for a loan, they create no measurable demand. When realtors make the assertion that there is pent up demand, they are correctly surmising that there is an increasing number of people who want real estate who cannot obtain it, they are totally incorrect in their idea that this demand is merely sitting on the fence waiting to enter the market at a time of their choosing.

California’s residential real estate market is completely controlled by loan terms and the availability of credit. I first discussed this phenomenon in the posts Your Buyer’s Loan Terms and The Anatomy of a Credit Bubble. When credit terms are restrictive, when 30-year fixed-rate conventionally-amortized mortgages are the only available financing product, prices reflect the amounts of money people’s incomes can finance under those terms (as they were before the bubble). When credit terms are loose, when stated-income, Option ARMs, low interest rates, high DTIs and other terms and conditions allow people the ability to borrow two or three times the amounts available under restrictive terms, prices in the residential real estate market will be reflective of those terms (as they were in the bubble). Local supply and demand issues may temporarily halt the rise and fall to a new equilibrium level, but supply analysis alone completely fails to predict this new equilibrium or explain how prices got there.

Analyzing supply and calculating the time on the market is one method of trying to predict future price movements. The theory is that when inventory is low and sales volumes are high that prices must rise, and visa versa. This market snapshot of the balance between supply and demand can be useful, but it is notoriously unreliable because it does not examine the cause of the demand and it falsely assumes that demand is ever increasing. When you look at the chart below showing months of inventory from 2002-2007, you see a false spike in 2004. This signal would ordinarily foretell the collapse of market pricing, but since demand was stimulated in 2004 through the widespread sales of Option ARMs and the near elimination of lending standards, the inventory was quickly absorbed and prices continued higher. Similarly, right now in our market, inventory is down from the peak, and months on the market has fallen below 6 months. This would ordinarily be a signal of a price stabilization or future price increases. However, since credit is continuing to tighten and loan terms are becoming more restrictive, demand, as properly measured by dollars, will continue to weaken, and prices will continue to fall.

oc inventory

California has had a chronic housing shortage for many years. The mechanisms for bringing supply to the market are slow and cumbersome, and many local municipalities restrict the ability of developers to bring new supply to the market or outright forbid it. It is not uncommon in California for price points to favor the construction of new dwelling units and for municipalities to forbid its construction. In these circumstances, the normal mechanism for rebalancing supply and demand do not function. In most states, when there is a demand for housing, homebuilders will go to work and provide dwelling units to meet this demand. The increase in supply blunts the price impact greater demand has on market prices. This is why many states where there are fewer land-use controls, they experience much less volatility in their housing markets.

Of course, this is one other factor that contributes to the wild volatility in California’s residential real estate market: irrational exuberance (kool aid intoxication). In California’s markets, when prices start to rise, fear and greed creates a positive feedback loop that compels people to buy more (if credit is available) and drive prices even higher. In other markets rising prices creates a negative feedback loop that causes people to shun higher prices and not buy real estate. This psychological reaction to market price fluctuations is different for each market. Because supply delivery mechanisms are dysfunctional in California, it is easier for Californian’s to drive prices higher quicker than it is in other markets. This feeds the local psychology and creates even more volatility.davidlereah

Prices have already dropped 20%-25% in Irvine from their peak in 2006. This initial price drop did not occur because of foreclosures or supply issues. It occurred because tightening credit has stopped market participants, those desirous of real estate, from bidding prices as high as they could in the past. The rate of decline is certainly impacted by foreclosures and inventory problems, but the overall price levels are determined by incomes and the amount of money people can borrow based upon it. Credit will continue to tighten, and the amounts people will be able to borrow will continue to decline. We have already witnessed a spike in jumbo interest rates as risk premiums are being priced in to the loans that are not backed by the GSEs. As the repricing of risk continues, interest rates will continue to rise. This phenomenon will be most noticeable for jumbo loans (the high end is doomed). Also, as the recession begins to impact incomes, the borrowing power of potential buyers will be reduced even further. Currently, there are still many 5-year and 10-year ARMs being used to purchase real estate with very high DTIs. As these products become less common (they are just dragging out the foreclosure problem,) and as DTIs continue to decrease, bids will decline, and prices will decline with them.

Some of the people I know that purchased in this market did so because they saw the tightening credit as something that was going to take away their ability to finance the sums large enough to buy real estate. In short, they thought they would be priced out forever. This reasoning puts the cart before the horse. The tightening of credit terms is going to cause prices to fall because it directly determines the market bids. Right now, the high end market is characterized by very large bid/ask spreads. Sellers are holding out for wishing prices while buyers are seeing their bids get smaller and smaller due to tightening credit. Transaction volumes are very low, and while sellers hold to their fantasies, there will be very few transactions. This will not change until the Alt-A and Prime ARM resets force asking prices lower. We have seen this phenomenon before. The low end of the market in the areas most decimated by subprime ARMs is already at rental parity, and there may be overshoot in these areas. The bid/ask spreads in these submarkets are tight because there are few sellers bothering with wishing prices, and sales are dominated by REOs.

In the post Houses Should Not Be a Commodity, I went into some detail on the stages of market psychology and buyer behavior. In this first stage of the decline, there are still people who are willing to extend themselves to the maximum to obtain real estate because they believe they must. The bubble psychology has not really changed, but the technical factors of credit availability and terms have begun to limit bids. This is why prices have only corrected about half way to date. In the next stage, people will start voluntarily reducing their debt-to-income ratios because they don’t want to stretch themselves to buy what is obviously a depreciating asset. The next phase in the drop is going to be characterized by a reluctance to purchase exacerbated by even more stringent financing terms.

If you really want to understand the real estate cycle in California, you need to understand the credit cycle. The changing availability of credit and the fluctuations in the amounts of money financed with people’s incomes are the key determinants to price levels in our residential real estate markets. Right now, we are in a tightening cycle, and this will cause prices to continue to drop. Someday, long after our current credit crisis has passed and the credit markets recover, we will see a loosening of credit, and we may build another residential real estate bubble. Perhaps lenders and borrowers alike have learned the painful lessons of the Great Housing Bubble, or perhaps not. Greed springs eternal.