Feb022009

Will the market perish in fire or in ice?

Desire, greed, avarice: house prices rose at unprecedented rates because people motivated by greed were enabled by lenders (who were also motivated by greed) to bid prices higher and higher. There is a certain Karmic justice to the idea of the market perishing in fire. Those who were motivated from desire should suffer in direct proportion to the greed to which they succumbed. In fact, all moral hazard problems emanate from this relationship. If people are not punished by this behavior, it is magnified in the next generation as more and more people choose to behave unwisely. In short, each bubble grows bigger than the last because the survivors tell their tales. If you don’t believe this is true, take a look at the series of bubbles in California since the 1970s, and you will see a series of higher peaks and deeper corrections. It is Karma in action.

Some say our market will crash and burn in a dramatic firestorm; some say prices will experience a long deep freeze at current levels. Today we will look at these two possibilities and try to determine which outcome we will see.

So you think you got it all figured out
You’re an expert in the field, without a doubt
But I know your methods inside and out
And I won’t be takin’ in by Fire and Ice

First, let’s take off the table any ideas of a return of sustained or rapid appreciation before prices return to fundamental valuations. The only people who suggest such ideas are self-serving liars and those who chose to believe them. Anything is possible, but this outcome is so unlikely that I will not waste any print  discussing it.

Above is a look at the Fire and Ice scenarios for Irvine median home prices. There is a tendency when looking at charts like this one to assume that one scenario is aggressive and the other conservative, so the truth must be in the middle. Don’t make that assumption.

Take a look at the grey line in the graph above. That is the fundamental value. It is calculated based on income growth (which has now stopped), 6% interest rates, and a 30-year conventionally-amortized, fixed-rate mortgage with a 20% downpayment and a 28% DTI. That is where house prices would be if we would not have had a real estate bubble. The Federal Reserve is working to raise this line by lowering interest rates, but even a drop to 4.5% will not raise it enough to intersect those falling lines at a significantly higher price point. Prices will fall to this line before they find support.

There are several reasons I believe the fire scenario is far more likely:

  1. Price momentum
  2. Return to stable financing terms
  3. Increase foreclosure due to ARM resets

Look at the time it takes fundamental valuations to catch up. Does it seem likely to you that prices would hover in a tight range for 12-15 years? Would it be better to drop quickly then resume its ascent? or it is better to have a slow deflation as Japan did?

The year-over-year price declines have been breathtaking in most markets, although Irvine has held up better than others. The momentum of prices is downward. This will not change until buying makes sense again, and that does not occur until prices are aligned with rents.

The credit crunch has seen the purging of the worst of the “financial innovations” of the housing bubble. We are on our way back to conservative financing terms. Since people will not be able to borrow more, prices will fall to levels consistent with the new loan terms. That is lower than today’s pricing.

I have flogged the deceased equine over ARM resets, but I still see astute observers who believe that low interest rates will stop this bomb from going off. Until that craziness is gone, I will keep mentioning the ARM reset problem. It will create massive numbers of foreclosures. In fact, last Wednesday, I went to a BIA function and I was talking with a representative of Wells Fargo. He told me the foreclosure problem is far worse than most people realize. As he started telling me about the growing problems with Alt-A and Option ARMs, I felt like he was reading from the IHB. He did not know I am Irvine Renter.

 

The fire and ice scenarios are also playing themselves out in different neighborhoods and different market strata. I lifted the chart above from Piggington.com. As you can see, all market segments are dropping, so the aggregate is dropping steeply. However, different market strata are dropping at different rates. The high end is not dropping as fast as the low end. This doesn’t mean the high end is not going to catch up. In all likelihood, the low end will bottom before the high end, and the lines will all intersect just after the market bottoms.

You can see this same phenomenon if you look at cities or neighborhoods. Santa Ana has experienced Armageddon, and its resale value chart looks like the orange line above. Tustin would be the blue line, and Irvine would be the green one. If you wanted to break down Irvine’s neighborhoods, you would see the same pattern going from the least desirable (like El Camino Real) to the most desirable (like Turtle Rock).

It is important to note that this does not mean that premium neighborhoods will retain a premium on their premium. This is another common misperception. For instance, Turtle Ridge commands an approximate 10% premium over Quail Hill on rentals for identical floorplans. Since the rents are 10% higher, the resale prices will be 10% higher as well. The GRMs in both neighborhoods would be the same. It is not that Quail Hill will bottom with a GRM of 160 while Turtle Ridge bottoms with a GRM of 200. The premium is already factored into rents. There will be no premium on premiums at the bottom. GRMs will be very similar across the entire market (although individual properties will see variations as some drop to investor cashflow levels).