Anatomy Of A Real Estate Crash
Sol Palha
In the real world, nothing happens at the right place at the right time. It is the job of journalists and historians to correct that.
Mark Twain
Real estate has always been one of the ways to make fortunes. In fact, real estate and the stock market have made more millionaires than any other field. The sad part is that most individuals that speculate in either of the two areas end up losing. The era of extreme low interest rates, propaganda that landlords are getting rich at the expense of their tenants and that it is the American dream to own a house, no matter how outrageously it is priced, have resulted in prices going through the roof. Lets stop now and examine some real life events.
Florida, 1926
The amount the market declined from peak to bottom: Land that could be bought for $800,000 could, within a year, be resold for $4 million before crashing back down to pre-boom levels.
The prices were so inflated that to buy a condo-style property in 1926, you would've had to pay the same as you would now have to pay for a luxury home in the guard-gated communities in Miami ($4,500,000)--without adjusting for inflation!
www.taxopedia.com/features/crashes/crashes4.asp
In the 20's Florida became a popular destination for those who were seeking to escape the cold. Unfortunately, housing could not keep up with the demand, so as prices started to go up as people started to compete for housing.
Soon a speculator decided to jump in and before you knew it an ocean of money was chasing limited housing. House started to double and triple in value.
The only way to realize profits was to sell at a higher price than you paid for the house. For a while everything was great but the supply of idiots willing to pay such inflated prices for property came to a halt. That is when the situation abruptly changed and individuals started getting vaporized by the hundreds. Before you knew it, the prices had fallen down to pre boom levels. If you look at the price of some houses, you will see that after almost 70 years some houses are still selling for less than what the owners paid for them.
The Florida real estate crash of 20's did nothing to quench Americans desire to speculate and they carried on pushing money into the stock market until the now infamous year of 1929. In October 1929 in one day the market lost 22% of its value, subsequent plunges wiped most of the stock market.
The Argentina Debacle
George you can put in some other notes here, if you want you can give a more detailed synopsis.
Overnight, properties that were worth millions dropped in price and could not even be sold for half their original value. Today a few years later, individuals are struggling to sell houses for 1/3 of their former values. The high-end real estate market has virtually come to a halt. There are no mortgages in Argentina; everything is dealt with on a cash basis. An associate notified me that owners of a 5 million dollar mansion were still having problems trying to get anything over 500k for their place. For a second try to imagine what would happen if we had no mortgages in the US.
The Japan Debacle
The Japan real estate bubble was one of the most spectacular in history. At the peak, one square foot of downtownTokyo land was worth over 1 million dollars. The bubble burst in the early 1990s, about three years after the stock market crashed and still hasn't recovered. Commercial property was the hardest hit with some buildings losing over 80% of value. On average Japanese commercial property is down over 60% from the peak and residential is down over 40%. Extraordinarily low interest rates and massive money creation was not enough to save Japanese real estate, will the same prescription work in the US?
Weapons available to keep the real estate market going.
Low interest rates
Greenspan has openly stated that interest rates would have to be raised at some point, if deflation was no longer a threat. Even if the Feds were to lower rates more, they don't have as much room as they once did. So pushing it to 0 is not something they could do even if they wanted to. As signs of inflation are now appearing all over the place, most notably in the energy sector as reflected by higher prices, most Americans are now facing higher prices at the pump. Long-term rates, on the other hand, have slowly been moving up. The market has already decided this trend is UN sustainable.
Foreign Investors
Much of the money made available for mortgages is coming from foreign sources, particularly Asian. These countries receive boatloads of dollars and need to reinvest those dollars in income producing assets since we do not sell anything that they want to buy. Mortgage-backed debt is preferred because it pays a higher rate than US treasuries and is available in massive quantities. In fact there is more US mortgage debt outstanding than US National Debt. It is ironic, but the money flow into US mortgages and real estate is highly dependent upon continuation of large US trade deficits. Should US consumers tire of buying cheap imported goods, the flow of mortgage money would be disrupted and interest rates may rise. Foreign investors and central banks are now fully integrated into the US property bubble and will probably work to maintain it, but the mortgage machine could be short-circuited if these countries come into conflict with the US over rising international tensions.
No income verification, no documentation loans
These programs were designed to push individuals that have much lower credit scores or problems making payments in the past to buy new houses. When you extend credit facilities to individuals that are already a credit risk, you simply are delaying the inevitable and asking for trouble. If they have problems keeping up with current payment, what makes anyone think they will be able to make their payments on their mortgages? It is significant that the subprime market now represents a large component of new home purchases. Their credit records imply that these are unsophisticated buyers and often overpay, further fuelling the home price spiral.
40-year mortgages
To keep this market going, several banks have started to market the new 40-year mortgage. The ploy is simple; one is made to believe that the payments are now affordable simply because they can stretched by an additional 10 years. Sooner or latter people are going to wake up and question the need to tie a rope around their necks for approximately half of their life.
Reverse mortgages
These are loans where the lender pays the homeowner in exchange for a part of the equity in the house. The costs associated with this type of financing can be as much as 6% of the value of the loan. These type of mortgages are mostly for retired individuals, and what better market to target. These are the individuals that usually have very decent levels of equity in their houses. They are made to look very attractive, because you only need only be at least age 62 and there are no income requirements.
In addition, they are tax-free and it does not cut the size of your social security or medicate benefits. But it can impact your Medicaid benefits. This type of financing is only going to delay the inevitable. When one has to take on additional credit to make payments or just to be able to survive, the end is very near in sight.
The retired and elderly are the last group that should be forced to take on additional new debt. They have worked hard all their lives and just want to be able to sit down and enjoy their Golden years. But increasingly it looks like the heavy chains of credit are finding a way to imprison them just as they have completely imprisoned most of the younger generation.
Conclusions by Sol Palha
Real estate taxes have gone up significantly; so much so that it is having an impact on housing purchase. Yahoo carried a story about 2 weeks ago, stating that many new homebuyers were thinking twice before buying new homes because of increased property taxes. Almost everyone now thinks that real estate is a good investment and prices will just keep going up.
The average person has no idea or real understanding of how interest rates affect the real estate market, or how illiquid the market can be once prices start to plunge. These people are basing 90% of their decisions on faulty information and illusions that real estate prices are only going to go up in the future.
Retired folks who have actually managed to pay off their homes fully or are close to paying them off are now being tricked into taking money out of their homes. People who can barely meet their monthly payment obligations are being enticed into buying new homes.
There are even programs that will help individuals with the down payment. When you target the groups in both extremes of the spectrum, it is usually indicative of a long-term top. When the real estate market crashes, it will not be a pleasant sight; all you have to do is look to Argentina for a real life example.
This is a chart of one of the homebuilders as you can see it has had a terrific run up. From the low, which was about 7 dollars to the high of roughly 110, this stock has gone up 1571%. This certainly indicates that the upside in this stock is rather limited. It could perhaps go up another 30-50%, but it certainly is not going to go up another 1000%. This is just one of the many homebuilding stocks. If you chart them, their respective charts all have similar patterns. When these stocks start to crash, it will indicate that the housing boom is close to an end or has come to an end. As they say one should not wait till the last minute before exiting, as it is very easy to slip and fall in these last stages. Buying property for the most part is not a good long-term investment anymore. A serious wash out is needed to remove the excessive speculative money that has entered into this sector. Couple in the recent rising rates, the Maestro's comments that the economy is improving and that rates will rise in the future and the picture starts to lose its luster. Extremely low rates are all that have kept this market going. Once you take those out of the equation, you chop the legs of this market.
Observations by George Paulos
Editor/Publisher www.freebuck.com
When I was I young man in the early 1980s, I used to play in a rock&roll band in Minneapolis. Like many bands of the era, we rented a "band house" to live and rehearse. Most of the band houses were located in Southeast Minneapolis. There were many large homes in that area for rent and the price was cheap. Our band house was a large two story home that was built sometime in the 1920s. It was a two-unit rental with an upstairs kitchen and bathroom. We packed four guys into the house and still had plenty of room for rehearsing and all-night beer bashes. We didn't know much about the history of the place, but it was obviously converted from a single family home. Ours was very typical of Southeast Minneapolis band houses. Some were even larger, with three stories and multiple living units. Many were quite ornate, with carved woodwork, large windows, and fancy staircases. All were in various stages of disrepair. Although parts of the area were quite beautiful with nicely paved sidewalks and tree canopies over the streets, it was also a bit of a slum. But it was perfect for us. The landlords were very lax about the properties which allowed us a lot of freedom.
We often wondered about the original owners of these mansions. It was obviously a wealthy neighborhood at one time. Many of the homes in the area were huge and intricately designed. What happened to these people and why was the area now so downtrodden? Many years later I learned about the Depression and how it affected land prices and neighborhoods. It turns out that Southeast Minneapolis was at the frontiers of development in the 1920s. Although within the city limits, they were essentially the suburbs at that time. Homes like our band house were the McMansions of the day. They were built for a burgeoning upper middle class who had increasing incomes and easy access to credit.
When the Depression arrived, these neighborhoods were hit pretty hard. This is because there was a high concentration of new homes that were purchased at a relatively high price and had relatively low equity. In some areas, whole blocks were foreclosed. The residents of some of these homes often worked out a rental arrangement with the banks that allowed them to remain within the home, but all equity was lost. Others, like our band house, were turned into multi-unit rental housing and have remained that way until the present.
The real estate bust of the 1930s had a permanent impact on many neighborhoods. The once wealthy neighborhood that surrounded our band house was still suffering 50 years later. In recent years, some of the areas of what is now urban Minneapolis have become "gentrified" and restored to their former splendor. Others are still some of the most troubled parts of the city. Even in the middle of a huge real estate boom, these neighborhoods are so blighted that they are still shunned.
We are seeing many troubling trends developing in housing that are reminiscent of previous busts. People are flocking to new suburban housing developments armed with an aggressive mortgage company and a willingness to outbid all other takers. This is creating a dangerous concentration of high debt-to-equity ratios within these neighborhoods. In older developments, purchase prices were lower and therefore debt ratios are lower. If a bust occurs, the decline in prices will hurt, but not be devastating for older established neighborhoods because few would owe more than the house is worth. But the newer developments will undoubtedly be hit with a much higher foreclosure rate. Imagine what would happen to property values if even just 10% of the homes in an area went into foreclosure. Such a large number of homes coming onto the market in distress would immediately slash the value of the rest of the nearby homes. For homeowners with little equity, even a small drop in prices would put them underwater. Some may stick it out, but other homeowners may panic and try to liquidate. Such a process could become self-reinforcing and cause a neighborhood to become blighted. Many developments have maintenance associations that may go bankrupt, causing the whole development to sink into disrepair and further decimating the value of the homes and condos within.
The real estate bust of the 1930s holds important lessons for today. It showed that homeowners are bound together with their neighbors by chains of finance. Even responsible homeowners who maintain low debt can be undermined by their financially irresponsible neighbors. It may be that your best neighbors, the ones who have been aggressively upgrading their homes, are the ones who have been racking up the most debt. A closure of a large local employer or even a large tax increase could be the tipping point for homeowners on the edge.
It is difficult to predict how the mortgage industry will react to widespread defaults. Will they try to negotiate with troubled creditors or will they foreclose en masse? Local banks do not hold much mortgage debt any more; a large amount of it is in the hands of foreigners who may not have any patience with deadbeat Americans. It does not take a large number of foreclosures to materially affect home values. If a neighborhood gets a bad reputation, it can be hard turn around. Failed neighborhoods can take generations to recover from a bust.
I recently visited my old band house. It was just as I remembered it. The hedges were massively overgrown, the siding was still rotting, and the porch was still sagging. It was a bittersweet vision. The rest of the neighborhood was a mixed bag. Some homes have been nicely renovated and others were still crumbling. Judging by the condition of the local businesses, the neighborhood is even more distressed that it was in the 1980s. Seventy years after mass foreclosures and the place still hadn't recovered. How will it fare during the next real estate bust?
George Paulos
gpaulos@freebuck.com
Conclusions by Alan Lunt
Tactical Investor
Contributor
It was only a matter of time. This from the Reserve Bank Governor of New Zealand:
Reserve Bank of New Zealand
News Release
29 April 2004
OCR increased to 5.5 per cent
The Reserve Bank today increased the Official Cash Rate from 5.25 per cent to 5.5 per cent.
Commenting on the decision, Reserve Bank Governor Alan Bollard said "The New Zealand economy continues to perform strongly and this is being supported by further improvements in the global economy. However, domestic inflation pressures remain strong and annual CPI inflation looks set to rise over the year ahead, as we projected in our March Monetary Policy Statement. Moving interest rates to less stimulatory levels appears prudent to ensure inflation remains within the target range over the medium term.
"Looking forward, the Reserve Bank will continue to monitor the data to see what it implies for medium-term inflation. At this stage, it remains unclear whether the fall in the exchange rate over recent weeks will be sustained and thus what its impact on activity and inflation pressures will be. Within parts of the domestic sector, such as housing and construction, some data suggest a cooling in activity, but the evidence is mixed and pricing pressures remain strong. Given these uncertainties, a further adjustment to monetary policy cannot yet be ruled out.
"However, as noted in March, a number of factors are likely to have a dampening effect on inflation pressures over the next year or so, reducing the need for policy action. Two such factors would include a further fall in net immigration and the delayed effects of the recent high exchange rate on activity in the export sector.
Comment: Net migration fueled inflation with an influx of money from offshore, driving prices higher. It also created demand. Now neither factor is present to the same degree. Prices in the demand areas peaked in December 2003. So now we have an interest rate breakup, which will flow into prices. The NZ Herald ....Most major banks have previously had floating interest rates of 7.5 per cent but if they raise these to 7.75 per cent in response it would cost lenders about $19 a fortnight more on a 30-year mortgage of $240,500 -- the median New Zealand house price in March.
Then we get this stupid government supporting the market, .....this from the beehive,
The NZ Herald.... The Government is proposing an increase in the accommodation supplement as part of a package to help low income earners. Housing Minister Steve Maharey is due to release a discussion document on a 10-year strategy for low and middle income earners in Auckland later today. More help for first-home buyers was also part of the strategy, but that would not happen until next year's budget. Mr Maharey wants to increase the help for home buyers which is now offered by the Kiwibank mortgage insurance scheme. It provides 100% per cent mortgages to couples earning up to $55,000 a year, but rising house prices have compromised loan thresholds.
Comment; we are given by the Government an independent Reserve Bank to control inflation, then in the next breath the Government fuels inflation by proposing to support house prices. That is hypocritical.
In a K-winter there is nothing a Government can do that will be beneficial, are they not better to let property become affordable again to the working man. This proposal smells of inflation, and in inflation everyone pays. And why only Auckland? Governments accommodation supplements were the catalyst for the price rises to begin with. I do have to wonder at the quality of the Ministers thinking.
The property top is in, interest rates and inflation will do the rest.
© 2004 Sol Palha
TACTICAL INVESTOR
www.tacticalinvestor.com
info@tacticalinvestor.com
4 May 2004
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