Jan312013

Rising prices stoke fears of kool aid intoxication

Everyone wants to make money for doing nothing. Learning about investing takes time and effort, and the results are far too slow to satisfy most people. Plus, you have to sell the investment and pay taxes on the gains. It’s too much hassle.

Real estate is so much better. Everyone is already an expert on real estate (or so they think) because they live in a house or condo. No learning is required, and when people get lucky and catch a bubble, they get to pat themselves on the back for their great financial prowess. And best of all, they don’t have to sell a house to get the cash. Banks will give them all the money they want with a HELOC. If the house keeps going up in value — and it can never go down, right? — then the bank will give them more and more money. There is no other investment that takes so little intelligence, research, learning or effort and produces such large and consistent returns. It’s a wonder everyone doesn’t want to own a house.

Home price rise fuels fear of boom mentality

Sharp increases in some markets could lead to a short-term mind-set, leading buyers to overextend themselves, some economists warn. The 20-city composite price is up 5.5% from a year ago.

By Alejandro Lazo, Los Angeles Times — January 30, 2013, 6:00 a.m.

Sharp home price increases — particularly in once-decimated cities such as Phoenix and Las Vegas — are raising concern among some economists that speculation could return to certain markets if such double-digit gains continue.

Prices jumped 22.8% in Phoenix and 10% in Las Vegas in a year, according to November data released Tuesday from the S&P/Case-Shiller indexes.

When I first started writing about buying Las Vegas real estate, people thought I was crazy. My thesis was simple, prices were depressed below fundamental values and were due to rebound when the foreclosures dried up.

Of course, I didn’t think the foreclosures would dry up for another two or three years because there are still tens of thousands of delinquent mortgages in Las Vegas, but when the Nevada Legislature changed the foreclosure laws in November of 2011, they legisltatively dried up the foreclosure pipeline. What was going to happen after the foreclosures dried up was easily foreseeable.

With supply of must-sell inventory declining, prices would bottom, particularly due to the increased activity of investors. Once prices bottomed and began to rise, the relative increases in price would be large. For example a $300,000 house selling for $80,000 at the bottom would easily be expected to see a $10,000 increase in price. That does little to recover the peak value, but it represents a greater than 10% increase off the bottom. Once that happens for a year or two, then speculators hoping to capture appreciation would enter the market and drive prices even higher– which is where we are now. The final stage will be the reentry of owner-occupants who lost homes during the bubble who will take prices back up to the affordability barrier. This is a natural recovery cycle for an undervalued market.

Notice the double-digit price increases that accompany the recovery from an undervalued state is very different from the double-digit gains we saw during the housing bubble. Those gains were predicated on unstable affordability products that artificially boosted prices. The gains today in beaten down markets like Phoenix or Las Vegas are being built upon fixed-rate amortizing mortgages. Even if interest rates go up, those markets will continue to do well because they are very, very affordable.

Such increases could fuel a short-term mind-set, economists warned. California cities are also on the upswing, with San Diego rising 8%, Los Angeles up 7.7% and San Francisco increasing 12.7%.

Those gains are likely to grow when data for December are reported next month, economists said.

“It’s been a real roller-coaster,” said Karl E. Case, one of the creators of the index. “And there is a danger of igniting it again.”

There is no question kool-aid intoxication will become a problem again, particularly here in California. People take on completely unrealistic expectations for sustained appreciation. Over time, prices rise in tandem with wage inflation, not any faster. There are certainly periods when prices move up faster, but those are matched by periods when prices went to down to match wage inflation.

Some signs of consumer woe emerged Tuesday, even as major stock indexes flirted with new highs. Consumer confidence fell in January, reflecting concern over a hike in the payroll tax. And although home prices are rising, homeownership is slipping, an indication that well-heeled investors are playing a bigger part in fueling the market’s rebound than traditional buyers. The Census Bureau said Tuesday that national homeownership fell 0.6% to 65.4% in the fourth quarter compared with a year earlier.

The biggest concern people should have over the market is the potential for rising interest rates. The recent small uptick in interest rates caused a dramatic decline in both refinances and purchase originations. In most markets affordability is high, so a modest increase in interest rates won’t result in prices becoming out of reach, but in markets like Coastal California where the degree of undervaluation is less, rising interest rates will stall the advance of prices.

The census data point to a hard reality for many buyers these days: Getting a conventional home loan from a bank remains difficult because banks have tightened their standards since the bust.

And the new qualified mortgage rules ensure standards won’t be getting looser any time soon. Thankfully, the new mortgage regulations will prevent future housing bubbles. Plus, the complaining about tight standards is a bit ridiculous anyway. It’s largely promoted by realtors who want to eliminate all standards to get in the way of more transactions. The reality is that Some creditworthy families will always be denied mortgages.

Getting a property appraised at a negotiated sales price also remains difficult. Both factors have led sellers to turn to investors who have all-cash offers.

With the super low inventory right now, the only way to get a deal in the resale market is to put more than 20% down. An FHA buyer doesn’t have much of a chance. First, for an FHA buyer to be considered, they must be the highest bidder. Since today that means bidding well over recent comps, there is a very good chance the property won’t appraise. It makes no sense for a seller to accept the bid from an FHA buyer who won’t be able to close when the appraisal comes in low, so instead, they take the strongest offer with the buyer who demonstrates the most financial reserves, preferably all cash.

Although it may be hard to imagine another boom-town mentality taking off in the West, the sharp rise in prices makes the possibility ever more real, said Case, a professor at Wellesley College in Massachusetts.

Having lived in California and seen extreme kool aid intoxication first hand, it’s not hard at all to imagine kool-aid intoxication taking over again soon. People will convince themselves the crash was an anomaly — despite the fact it’s the third crash in forty years — and that 10%+ appreciation rates are normal and to be expected. Pretty soon we’ll see Gary Watts explain how 15% appreciation is “in the bag.”  Or perhaps we’ll see other local realtors explain California had no real estate bubble. Idiocy returns quickly among those who believe because they want to believe.

One concern, he said, is that limited inventory will drive prices up and lead buyers to overextend themselves while competing with other buyers for a property. Then if prices declined again, people would be left with homes that could be worth far less than they paid.

Shevy and I have consistently told people over the last five years — and probably forever — not to buy unless you plan to stay in the property long term. If you need to sell in the next three to five years, you could easily find yourself losing equity or needing to short sell.

The scenario outlined above could easily come to pass. If any of the prevailing market conditions from today changes, prices could reverse.

  • What happens if the mortgage interest deduction is capped or eliminated?
  • What happens if the conforming limit is lowered from $625,000 to $417,000?
  • What happens if the FHA limit is lowered from $729,750 to $417,000?
  • What happens when interest rates go up?

Other economists also advised caution in the fast-rising markets.

“It does concern me a bit,” said Zillow.com chief economist Stan Humphries. “It encourages people to think about housing as a short-term investment.”

Investment thinking is what creates volatility. When houses were looked as as a consumer good, people didn’t bid up the prices, but once they become viewed as an investment, people buy at stupid prices because they believe prices will go even higher.

The other creator of the index, Robert J. Shiller of Yale University, said that prices, when adjusted for inflation, have not risen as sharply as the big percentage increases may indicate, particularly in cities such as Phoenix. Those increases indicate that prices may have fallen too far during the housing crash. Nevertheless, cities can enter into a collectively risky mind-set, Shiller said, a mentality to guard against.

The recovery from a depressed valuation is the case I made above.

“Phoenix became a boom city,” Shiller said. “I was there in 2004, and I remember everywhere people were talking about real estate, even the cab driver.”

Since 2006, I’ve spoken with web designers, construction foremen, waiters, and many others who told me about losing their mortgage business. To me, the best indicator of a bubble is the mass entry into a particular business from people who know nothing about it. Have you ever noticed how many people get real estate licenses when there’s a boom?

The price jumps mask the continuing troubles of borrowers with underwater mortgages. In fact, the prices are driven in part by such homeowners being trapped in those homes, tightening supply.

Also helping home prices rise is a drop in foreclosure activity.

The rate at which lenders have foreclosed on mortgages in the Los Angeles area fell to 1.67% of all home loans in November, data firm CoreLogic said. That compares with 2.67% the same month a year ago. That rate was lower than the national average, which was 2.97% in November.

I can’t stress enough that the decline in foreclosure rates is not due to a lack of delinquent borrowers to foreclose on. Most people looking to buy houses today assume the mortgage mess is behind us, and that is just plain wrong.

Despite concerns over fast-rising prices, many economists call the increases a welcome trend.

“Rising house prices, in turn, are supporting broader economic growth,” wrote PNC Financial economists Tuesday. “As house prices increase homeowners are wealthier, inducing them to spend a bit more. Rising house prices also support the banking system as losses diminish and homeowner equity increases.”

One man’s mortgage debt is an entire neighborhood’s equity. Let’s be realistic, this is all being done to bail out the banks. Prices will rise for the short term. They will go up until we reach the limits of income affordability. When this happens depends on mortgage interest rates. If rates remain at record lows over the next three years, prices locally could rise another 25%. If interest rates rise, then the price appreciation could flag much sooner. After that, it depends on wage growth. And with high unemployment, wages won’t be going up significantly any time soon.