Sep012011

The real state of Irvine and Orange County real estate

Throughout my posts on the IHB, I make references to what I believe is happening in our local housing market. The IHB serves as a valuable market resource to people considering buying Irvine and Orange County real estate. The message for the first nearly 5 years has been simple: don’t buy a home yet. Over the last couple of years as the plethora of market props have been removed, the message has evolved to the more nuanced advice: buy below rental parity if you have a long holding time. That advice will remain our mantra over the next few years until conditions in the market change.rotting_market

Why are you afraid to buy?

If you have been reading the IHB regularly, you have a rational fear to buy local real estate. Prices are falling. Prices will continue to fall for a while.

People who buy today might be trapped underwater and unable to sell their homes without taking a significant loss. Further today’s buyers may miss the opportunity to buy later at a lower price. These are not foolish fears, they are legitimate reasons to delay the purchase of a home anywhere in Orange County.

Why will prices keep falling?

There are five primary factors which will impact the balance of supply and demand in our local market:

  1. High mortgage delinquency rates translates to a large shadow inventory (supply).
  2. Large REO inventory of lender owned properties withheld from the market (supply).
  3. High unemployment has diminished the buyer pool (demand).
  4. Weak California economy has diminished employment and wage growth (demand).
  5. Higher future interest rates will lower aggregate loan balances (demand).

Each of the above factors will contribute to either increased supply or reduced demand. The existence of these factors is not conjecture. They are very real. The way each of them impacts the market is uncertain, but each of them will serve to pressure prices lower over the next several years.

What will cause prices to eventually go up?

Kool aid and the memories of the rewards of the housing bubble are part of our culture. There will always be plenty of desire for California real estate. Even as prices have fallen steadily for the last 5 years, hope springs eternal, every buyer believes they are buying at the bottom, and most believe unlimited wealth and HELOC spending money is just around the corner.

There are several factors beyond kool aid intoxication which will serve to reverse the fall of prices and cause real estate prices to rise again:

  1. Current interest rates are very low.
  2. Payment affordability is relatively high.
  3. The economy and the employment situation will improve.
  4. Supply pressures will abate.

Even neighborhoods which have not historically traded below rental parity are trading below their historic level of payment affordability. On a payment basis, prices in many neighborhoods are similar to what they were in the late 90s and early 00s before the bubble mania took over.

The California economy has been sputtering as it weans itself off the Ponzi borrowing money of the 00s. The transition has been difficult and painful which is why the economy is still so weak. A significant portion of the false demand of the 00s will never return.

When the economy and employment finally picks up, wages will increase, and new households will form. The higher wages will increase the amounts borrowed, and the new households will increase the numbers of loans demanded. Both factors are essential to a housing market recovery.

At some point, the overhead supply of shadow inventory and visible REO inventory will be liquidated. This will likely take several years as lenders sell into any price rallies to recover their capital. There are many ways this could play out.

Lenders hope consistently rising prices will allow them to sell their inventory for the prices they want, and this liquidation will be easily absorbed by the market. I think that scenario is wishful thinking by lenders. The inventories are simply too large for it to work out that way. If lenders can hold their REO indefinitely, they can meter out this inventory over the next decade or more, but I doubt all the banks will be that patient.

As some lenders hasten their liquidations (like the GSEs are now), the resulting sales will push prices lower. As lenders capitulate one-by-one, the collapsing cartel causes brief seasonal rallies followed by deep seasonal drops. This yearly cycle will see consistent year-over-year declines similar to what has occurred in 2011. I believe this is the most likely scenario.

Declines in the liquidation phase of a bubble are not as steep as the first phase when the credit crunch forces lenders to abruptly decrease loan balances, but as was demonstrated in Japan, the liquidation phase results in slow but steady declines in prices until the inventory is purged from the system. Let’s hope our liquidation phase is not as protracted as Japan’s.

What will the bottom look like?

The double dip will be the final decline, and I don’t believe it will be that severe (expect perhaps at the high end). That being said, the bottom will be difficult to time. First, it’s impossible to predict what foolish policies may emanate from Washington. With our current state of gridlock, I have some hope that nothing substantive will emerge from the bowels of government. Any government policy would likely have the effect of delaying the market bottom.

Housing markets nearly always exhibit a seasonal pattern of spring rallies and fall pullbacks with the low for the year in early January. This seasonal pattern will continue, but the spring rallies will be weaker, and the fall pullbacks will be more pronounced. The inventory is often reduced in fall in winter, but the sellers who remain are usually more motivated as many of them missed the prime selling season.

Due to the overhanging inventory, this seasonal pattern with a slightly lower bias will persist for 3 to 5 years. The two or three years following will show the same pattern but with a slightly upward bias. The bottom will form slowly for the reasons listed previously: inventory overhand, rising interest rates, persistent unemployment, and prudent lending standards.

Buyers should not feel a sense of urgency from the fear of being priced out. The window of opportunity will be open for years to buy during this liquidation-bottoming phase.