Aug032011

Irvine condo and SFR price trends by Global Decision and IHB

Many people are hunting for houses. Some are looking at the high end, and some are lookiing low. Which is the better way to go?

Over the last several weeks, the IHB has been proud to present a series of hedonic house price analyses by Jaysen Gillespie of Global Decision:

An accurate view of the Irvine housing market by Global Decision and IHB

A detailed look at Irvine Village premiums by Global Decision and IHB

The market value of Irvine home features by Global Decision and IHB, and

OC Housewife, Ponzi borrower, failed land baron.

This week Jaysen has taken on a comparison of the single family market with the condo market in Irvine to see the similarities and differences. Some of the conclusions may be surprising. Below is Jaysen’s writing. My comments pick up afterward.

A presentation by Jaysen Gillespie of Global Decision

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Global Decision is an analytics consulting firm.  While our methods are not industry-specific, our engagements are skewed towards specific industries in Southern California, such as real estate (along with online gaming and restaurant chains).  We specialize in applying both foundational and advanced analytics to better understand business and economic issues.

Today continues our series on using the Global Decision Hedonic Price Model to determine how homes values are trending and the underlying factors that create such value.

Up to this point, we’ve focused on single-family homes (SFRs).  In some parts of the country, SFRs represent the vast majority of the market.  Irvine is not one of them.  In fact, in the Irvine sales data from 2000-2011Q2, condos represent over 50% of all sales by quantity.  As a result, no understanding of the Irvine market is complete without an equally in-depth review of how condos sales are trending.  In expensive coastal California, condos serve as an entry-level market for those moving from rentership to ownership.  More importantly, condos *had* served as a source of equity for those wishing to move up the ownership ladder – into a single-family home.

In the above chart, we compare Irvine SFRs to Irvine condos over the last 11 years.  Not surprisingly, the lower-cost condos rose a bit higher (as a percentage of their Year-2000 starting point) than houses.  Said condos have also fallen farther from their peak.

Because Irvine condo values rose at a faster rate than the values of Irvine single family homes while the housing bubble was inflating, the above chart’s ratio of home-to-condo values initially shows a “negative premium” for single family residences.  However, as the bubble deflates the home-to-condo value ratio quickly reverts to 1:1 and then rises further as condo prices decline more rapidly than SFR prices.

An interesting chart results when we start the x-axis from peak pricing (2006) for both homes and condos.  Both series peaked in 2006 and have declined 18% (SFRs) and 30% (condos) in the last 5 years.  The magnitude of the decline is important to understand because it directly impacts the probability that a given homeowner is underwater.  At this point, a sizable percentage of 2006 Irvine condo buyers are likely underwater.  Those who purchased in 2006 are especially likely to be underwater as a down payment of 30% would have been required to keep that cohort in a positive equity position after an assumed 5% “get out” cost.

Irvine condo buyers who carefully saved a 20% down payment to buy a condo in 2006 (or even 2007) now find themselves with a paper loss of 100% of invested equity.  At peak median condo prices of around $580,000, such buyers have paper losses of $116,000.  Such losses do not have to be realized until a sale and some owners may not find the loss of said amounts to be particularly problematic.  However, the losses do have a few serious impacts in the market.  First, 2006-2007 condo buyers have no equity to fuel the purchase of more-costly SFRs.  This fact is reflected in the data showing that higher-end homes in Orange County take much longer to sell than lower-end homes.  Second, once buyers are underwater, each additional drop in home values makes them more likely to consider walking away from the debt.

http://faculty.chicagobooth.edu/luigi.zingales/papers/Determinants_of_Attitudes_towards_Strategic_Default_on_Mortgages.pdf

Page 30 of the linked .pdf file, shows that a shortfall of $100k induces 2.5X the propensity to strategically default vs a shortfall of $50k.  Page 49 shows that knowing someone who strategically defaulted also increases reported propensity to strategically default.  For a full read on attitudes regarding strategic default, please see the March 2011 paper at the University of Chicago’s Booth School of Business linked above.

Somewhat perversely, the 2006-2007 Irvine condo buyer who put down the bare minimum (0-3%) has a much smaller paper loss and has preserved the option of “walking away” with a smaller financial hit.  Using a zero-down program to purchase a home is essentially obtaining a free call option:  if home values rise, you pocket the gain.  If home values fall, you have the option of walking away from the debt (in exchange for a lowered credit rating).  Low-down payment programs thus create a feedback loop that exacerbates swings in the direction of the housing market.  When home values are rising, they induce people to over-invest in residential real estate.  When home values are falling, they exacerbate the drop by adding to inventory (shadow and real) and sap buyer demand for move-up housing.  It’s hard to argue that low down payment programs make sense from a stability standpoint.

With the Irvine condo dataset, we find that a large chunk (21%) of all condo sales occur in the Irvine village of Woodbridge.  As a result, we can also construct a valid hedonic price index for Woodbridge Condos.  Doing so allows us to not only see trends in an established high-quality area (see our previous analysis of Irvine neighborhood values to see why “high-quality” is not our opinion, but based on market valuations), but also allows us to remove the “area” as a variable in the underlying regression.

In the chart above, you can see that the value trend for Woodbridge condos (light blue) and the value trend for Irvine condos (light green) are similar.  Such results provide evidence that having an “area” variable in our underlying Irvine condo model is not skewing price trends and serve as a good gut check for each other.

Looking again at the post-bubble behavior of price trends in Irvine, Coto, and the region (as proxied by the Case-Shiller LAOC high tier index), we find that most indexes have fallen between 29% and 33% in value.  Irvine’s condos (in both Woodbridge and city-wide) have dropped 30-31% in value while the LAOC Case Shiller High-Tier is also down just under 30%.  Coto SFRs have slightly underperformed with a drop of 33%.

The Future:  Irvine SFRs vs. Irvine Condos

Interestingly, Irvine SFRs have declined only about 18% from peak pricing.  Even more interesting, it appears that temporary incentives (such as an $8,000 tax credit) lifted Irvine SFR prices more, as compared to a 2009-Q1 floor, than condo prices.  Irvine SFRs have retained some of their gains since the 2009-Q1 recent bottom, while Irvine condos have now reached new post-bubble lows.  Logic would have dictated an opposite result – a fixed $8,000 “incentive” should have more greatly swayed lower-priced markets.

A common theme in housing analysis is the (in)famous substitution effect.  We’ve discussed this effect when looking at Coto vs. Irvine, and now we can consider the Irvine-vs-Irvine substitution effect of SFRs vs Condos.  A frequently mentioned benefit of living in Irvine is access to excellent schools and proximity to employment.  Unless the Irvine Unified School District utilizes some highly gerrymandered attendance zones, owners of Irvine condos are entitled to receive and same quality of schools as Irvine SFR owners.  Rumor also has it that the IUSD allows children from SFRs, condos, and even apartments to sit in the same classrooms as each other.  We do indeed hope that SFR parents have that difficult talk with their children about what a “middle unit” is before kids learn the hard way.  Oh, the horror!

All Irvine residents enjoy the same overall crime rate, proximity to jobs, microclimate and so forth.  As a result, Irvine condos are a close substitute for Irvine SFRs, especially given that Irvine contains many larger 3-bedroom condos.  A long-term equilibrium will likely either have condo prices rebound, relative to SFR prices – or will have SFR prices decline, relative to condo prices.

IrvineRenter’s Commentary

Falling condo prices mean the move-up market is broken. It isn’t until condo prices bottom then come up a bit that buyers have equity to put 20% down on a different property. The move up market doesn’t happen by magic. People still need a raise in pay to afford better accommodations because houses all rise in price together in a healthy market. If the low end of the market is moving down, it is robbing the equity of prospective buyers looking to move upward.

Condo prices are more volatile than SFR prices because not all the equity from a condo sale is used to push up the next rung on the property ladder. There is always some diffusion as people endure transaction costs, and during the housing bubble, extracted and spent their equity. This makes condo prices rise quicker in a good market; however, since condos are less desirable than SFRs, they also tend to fall faster in a bad market.

Jaysen’s commentary on the effects of 100% financing are right on. Mortgages take on the characteristics of options, and what started as an affordability program, 100% financing ended up making houses very unaffordable as prices were driven up to the stratosphere.

Jaysen’s conclusion is a point I want to reitereate; “A long-term equilibrium will likely either have condo prices rebound, relative to SFR prices – or will have SFR prices decline, relative to condo prices.

Regardless of which path the market takes, if you are buying as an investment, it makes little sense to buy an Irvine SFR. If you believe in the Gospel of Irvine, and you want to make money purchasing Irvine real estate, you should be buying condos. When the equilibrium is restored — up or down — condos will move positively more than SFRs.