Thursday, June 24, 2004

The Perfect Real Estate Storm

by Blanche Evans, Realty Times

Rising consumer debt, rising interest rates, inflation, low job and wage growth and many other factors are swirling together to form a housing slowdown. But there a few other factors that are adding to the winds that could create the perfect storm - the largest housing recession in modern history.

Take a look at the storm conditions.

Top economists from Alan Greenspan to the National Association of Realtors researchers are telling the public that housing will "flatten," either in sales or prices, respectively. Flat housing prices and sales means that buyers are more at risk in their housing investments because homes will cost more in a rising rate environment, and their liquidity is effected when they can't sell as quickly or for as high a profit.

To a buying market that is used to jumping in and out of properties like daytraders do stocks, this is unwelcome news and a good reason to sit on the sidelines and wait for better conditions. And that's exactly what's happening in many markets across the country, particularly in areas that overheated in the mid-90s like Atlanta, Seattle, Dallas, Austin, and other techno-centers. Which markets are vulnerable next? Las Vegas, San Diego and other multiple-offer capitals that have attracted jobs because of housing, not residents because of jobs.

According to The Harvard Joint Center For Housing Studies' "State of the Nation's Housing 2004 Report," housing has weathered such events as an international financial crisis in 1998, a recession in 2001, and the job depression of the new millennium. The economy and homebuyers benefitted from record low interest rates which helped offset rising prices. In 1989, when an average-priced home in the U.S. cost $211,900, the mortgage interest rate averaged 10.1 percent, notes the report, while in 2003, the average-priced home cost $243,400 and the interest rate averaged 5.7 percent.

But homebuyers in 2004 are facing a set of conditions that previous generations have never had before in the aggregate. National news, economic conditions, lending and borrowing conditions, and buyers' expectations, and much more are creating a perfect storm of conditions that separately and combined could flatten the existing housing market, and impact new homes as well.

On the positive side, the National Association of Realtors (NAR) predicts a record in 2004 for existing home sales of 6.17 million. Chief economist David Lereah predicts that growth in jobs will reach 3 million, dropping unemployment to 5.3 percent nationally. He also predicts that median home price appreciation will slow to 5.4 percent at $179,200, while median new home prices will grow by 7.9 percent to $210,400.

But some markets such as Dallas are reporting that since May, when interest rates rose in earnest, housing sales have fallen off a cliff. New home starts are slowing, and the National Association of Home Builders has already noted a drop of two points in the builder housing index, an index of builder sentiment that fewer people are looking at model homes. Normally, that indicates less interest in housing in general, and that could be bad for the existing housing market.

In other words, there is a calm before a perfect storm brewing in real estate that is being whipped by more wind than rising interest rates.

National and economic news

  • Jobs - Despite recent reports of hundreds of thousands of jobs gained, we have experienced the longest period of job loss since the Great Depression through the first half of 2004. Some housing experts are predicting that a slowing housing market will further hurt economic gains by hurting or eliminating employment related to housing such as mortgage lending, real estate sales, furniture sales, building, contracting, moving, and other jobs. A stagnant housing market means less spending in other areas, as interest rates rise and the cost of borrowing money means less discretionary spending.

    All this puts severe pressure on housing prices. UCLA economist Ed Leamer told the San Francisco Chronicle, that the most likely event is that "we have another recession in 2006, with significant problems in the housing sector."

  • Ongoing terror threats - The Presidential election, the Olympic Games, the rising stock market, the Iraqi prison scandal, and other events are tempting targets for terrorists. With interest rates their lowest in 30 years, the FED has nowhere to go (i.e.interest rate cuts) if another terrorist strike annihilates consumer confidence. The country could plunge back into deflation, where the cost of consumer goods goes down because no one is buying. A more familiar word for the same situation? Depression.
  • Alan Greenspan's housing-flattening comments - On Tuesday, June 15th, 2004, Federal Reserve Chairman Alan Greenspan testified to U.S. senators, "We perceive that the very strong expansion in new and existing home sales is now flattening out. And the really quite unexpected boom in home sales over the recent years is unlikely to be continued. Our forecast is generally flat, not in prices but in aggregate volumes. Where house prices go, I'm not sure, but I would be quite surprised if they showed continued acceleration on the upside."

    This is not music to the ears of homebuyers who don't intend to stay in their homes long enough to ride out the storm. Most prefer a daytrader environment for homebuying. If they can't flip homes quickly and easily for profit, then they'll sit out the home investment dance and put their money in the stock market instead.

  • Inflation: Typically, housing offers homeowners gains of only a point or two above inflation, but according to the U.S. House Price Index (HPI), housing has exceeded the overall inflation rate by more than 40 percentage points over the last eight years. Unfortunately, salaries haven't inflated at the same rate. At some point, buyers have to back away when low interest rates, easy credit and other favorable lending can't get them into the house of their dreams.

    Inflation is impacting other consumables. Milk has doubled in price and gas prices have reached new highs in the last two months. If you assume that all consumer goods and services will rise similarly, then it's easy to imagine that higher interest rates won't be the only thing to daunt homebuyers. They have to recalculate the basics in their budgets to a figure they can't predict. Good-bye inflation-free economy. Hello, more nasty surprises to come at the supermarket, pharmacy, gas station,and everywhere else people spend money.

  • Housing affordability: The Harvard Joint Center For Housing Studies, State of the Nation's Housing 2004 found that despite record home ownership of 68 percent and recent job creations, that most workers in America do not make enough income to afford "even the most modest housing."

    Nationally, the NAR's housing index for April, 2004, the latest month for which there is information, shows "the nation's typical household had 144.0 percent of the income needed to purchase a home at the first quarter median existing-home price, which was $161,500." This optimistic stat was taken before interest rates rose a full point.

    One in six homes in the U.S. are sold in California, so when housing affordability is an issue there, it impacts housing across the nation. A recent June report stated that less than 20 percent of households can afford the median-priced home in California. The minimum household income needed to purchase a median-priced home at $453,590 in California in April, said the report, was $102,550, based on a typical 30-year, fixed-rate mortgage at 5.42 percent and assuming a 20 percent downpayment.

  • Overburdened consumer: According to bond fund manager Bill Gross as interviewed for CNN Money, consumer spending accounts for two-thirds of gross domestic product, and we, the people, are already in too much debt. Interest rate increases could slow consumer spending, which could lead to further job loss. The nation and the world could also be overreliant on consumer spending to lead the nation's economic recovery because terrorism, inflation, and higher interest rates may sideline corporations from giving pay raises, adding jobs or spending to expand infrastructure, according to a recent Duke University study of over 200 CFOs.
  • Debt service: According to CBS Marketwatch chief economist Dr. Irwin Kellner in February 2004, consumer debt has reached a record $9,185 billion, or 110 percent of "people's take-home pay adjusted for inflation, also a record. "Ten years ago, household debt equaled 85 percent of disposable personal incomes; twenty years ago it was 65 percent." The reason debt service is so much higher now is floating interest rates, rates that can change, and make it much more difficult for households to service existing debt. As an example, he notes that the "Mortgage Bankers Association reports that the share of new mortgage applications to be financed by adjustable rate, or ARM, jumped from 13.5 percent in January 2003, to over 30 percent by yearend. Currently 40 percent of consumer debt is based on floating rates. What will happen when those favorable rates go away?

    Home loans and the equity picture

  • Easy loans: Lending products have burgeoned that allow buyers to get into homes with little money, poor credit, and other conditions that weren't present when most housing was built in the 50s and 70s. The gold standard 30-year-fixed loan is now being dissed by no less than Mr. Greenspan as a waste of money when other more appropriate loan products are available, such as ARMs, hybrid loans, and interest-only loans. The problem is that these are lower cost-higher risk loans that could snap back in the faces of homebuyers should a housing recession occur when the terms of these loans are due.

    This alone is impacting the older housing market. The older home seller, who perhaps had to save for years to make a down payment on a first home and spent years in the home before it generated even modest equity, is no match for today's buyer who can buy earlier in life, with little money down, with much more relaxed loan to debt ratios, while enjoying 40-year low interest rates. That makes buyers exposed to much more luxury than they otherwise would be able to afford, which is why they are a lot more picky about what they spend someone else's money on.

  • High tapped-equity asking prices: According to Dean Baker, an economist and co-director of the Center for Economic and Policy Research (CEPR) in Washington, DC, people are borrowing against their houses at a scary rate. "The fact that people are borrowing against their homes at a rapid rate (more than $750 billion in 2003) is more evidence of an unsustainable bubble," writes Baker in his column "Alan Greenspan's Second Bubble." "The ratio of mortgage debt to home equity is at record highs. This fact is especially scary given that equity values may be inflated by as much as 20 to 30 percent as a result of the housing bubble, and that the nation's demographics (with the baby boomers approaching retirement) suggest that many homeowners should have largely paid off their mortgages."

    If these homeowners have spent their equity on credit card debt, vacations, college tuitions and not improved their homes, that gives buyers all the more reason to punish asking prices by demanding more repairs, more improvements, or by ignoring unimproved homes on the market until they sink in price to investor-pleasing levels.

Some of these conditions have existed before. Inflation was slowed by rising interest rates that capped at 19 percent in the 1980s, but homebuyers weren't facing higher costs along with on-our-own-turf terrorism, crushing consumer debt, and the worst job market in decades, along with all these other factors at the same time.

That's why it is conditions in the aggregate that point to a perfect real estate storm, not rising interest rates alone.

The conditions listed above are quantifiable and verifiable, but there are many other factors that also will impact real estate. Find out tomorrow what those are in the next edition of Realty Times, when 'Other Winds Building The Perfect Real Estate Storm' will be featured.

Published: June 24, 2004

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