Where's the Bottom, Dude?

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September 13, 2007

The phrase "We have hit bottom" will be used a lot over the next couple of years; especially by the paid cheerleaders in the financial and political media. The "Don't worry, everything is okay" crowd will become shriller as events occur that they truly never believed possible. But the sky is not falling, just another pyramid scheme petering out. Of course there is a bottom and the market will stabilize at lower price levels. It's anybody's guess what level that will be at and how long it takes to get there. So is how the declining paper value of real estate assets will affect the paper value of, well, paper assets. At least the stone, sticks and dirt has some value, while colored pictures of politicians on paper have limited uses when the curtain is pulled back.

I wish I had a nickel for every time someone told me that "real estate never goes down" and (because) "they aren't making any more of it." The history of real estate is packed full of booms and busts, yet every time a new boom comes along, those who counsel caution are scorned. Then the masses drink the credit money Kool-Aid and the market turns down. Soon after that, the media and politicians line up pointing fingers at scapegoats while ignoring their own involvement. The remedy is always the same: more state regulation and market intervention. That's just digging the hole deeper.

The root of the problem, fractional reserve banking, isn't even on the radar screen for 99.9% of the population. The financial system is on the brink of collapse and elite policy makers trot out the old bugaboo of "animal spirits" causing the market to get out of hand. You know: "irrational exuberance." The Fed has made fools of both lenders and borrowers through easy credit money policies to "stimulate" the economy, again. There will be some show trials of private lenders, committee meetings and law signings to "do something," and a whole range of periphery screening. Alas, when the game is corrupt, additional rules can't purge that corruption.

Taxpayer bailouts of banks in exchange for more regulations of lending practices will just make matters worse in the long run. It will possibly stave off the worst until after the election though, the primary concern of politicians. The fact that people can only borrow so much before they can't pay it back somehow doesn't come up. That's okay, just lower interest rates and let them refinance. The collective insanity of the "hair of the dog that bit ya" mentality so prevalent among supposedly intelligent, well educated experts boggles the mind of this humble analyst.

Central banks themselves don't cause bubbles, they are just the means used to make bubbles look okay. Several articles recently have disingenuously, but correctly, pointed out that bubbles were occurring long before the Fed was created. What they don't point out is that the Fed was publicly touted as the means of preventing boom/bust cycles (especially the bank run part at the end) that always accompany the creation of credit money through fractional reserve banking. That they have obviously failed at this task still does not raise discernable calls for ending the national socialist banking system. The license to steal that central bankers get from politicians is just a façade for dishonest private bankers to hide behind. Now we get bigger bubbles that do more damage.

The argument is now which Fed policy is the correct one: a little inflation or a lot of inflation. Eliminating fractional reserve banking, fiat money and its enabler the Fed is only something kooks and conspiracy theorists talk about, don't you know. Note that eliminating fiat money and going to a gold standard won't do it all, though that is required to get back on safe ground. Fractional reserve banking on a gold standard still involves the creation of credit money "out of thin air."

The above links to previous articles I've written on the subject go into much more detail on this subject. To cut to the chase: How far can the value of your home fall? Nobody can predict the future, and estimating the timing of future events adds immeasurable difficulty. Every property is unique, and surrounding market conditions vary to great extremes. So generalizations about aggregated historical data must be looked at in this light. Such is life; considering what has happened to extrapolate what will likely happen is useful for mitigating risks and choosing appropriate strategies.

First, bank on the housing market getting worse (pun intended), much worse, before it gets better. The main reason is that about two million ARMs (adjustable rate mortgages) are going to be reset over the next few months. Millions more will continue to be reset until peaking sometime in 2008. Heading this tsunami off is why the Fed will lower interest rates in September, perhaps by half a point. It won't be enough.

As foreclosures mount and the credit money created out of thin air goes back into thin air, the Fed's only tool of inflation to stealthily devalue the currency will result in more rate cuts. The Fed must do this with an eye towards trillions of dollars held overseas because hyperinflation is a real threat if the Fed is seen as doing this too quickly. The Chinese are already reported to be dumping dollars and Treasuries, which will cause some pause. Helicopter Ben, like all Fed Chairmen, wishes to be seen as an inflation fighter for this reason. It's a ruse because inflation is what they do. Therefore, we will have decreasing real home values, but it is possible to have stable nominal home prices as the price of everything else goes up around them. Keep that in mind below.

The following chart has been all over the internet for a good reason. Check it out:

The chart shows what inflation-adjusted average home values have done since 1890. Note that with the exception of the post-WW II increase that was largely due to Depression-era pricing rebounding, the following decrease mirrored the preceding increase. The two most recent bubbles of the 1970s and 1980s are nearly symmetric. Some of us old enough to remember these events will note that prices did not fall that far nominally, especially in the 1970s, because of inflation. This is why real estate is also known as an "inflation hedge." That means the relative value of your home goes down while the price remains the same. Great best case scenario, huh?

Let me back up a second and mention that people should never look at their home as "the biggest investment you'll ever buy." A home is a place to live and possibly raise a family. A home is not an investment. Therefore, whether you buy or rent your home is irrelevant. What makes a home out of a house is the people who live in it. Whether you pay a landlord or a bank for the right to stay there changes little on that count, especially when you have 25 or 30 year mortgages.

For instance, my wife and I had the house that we call home built in 1999 on a waterfront lot in a great neighborhood near my office. Similar homes were selling around the neighborhood in 2005/2006 for about three times what we paid in 1999. If it was just my wife and I, then we would have cashed out in a heartbeat last year for a handsome profit and rented somewhere else. But we have two children whom we wished to provide a stable atmosphere to grow up in, and we really like the place. After much consternation and discussion, we decided that the home we built was more important than the house we built. Neighbors, friends and a great place for our kids to grow up trumped our greed. I also didn't need the extra money for any compelling reason. Easy come, easy go.

The dynamic described above is why real estate bubbles typically do not crash like other asset bubbles. The large increase in existing inventory at the end of bubbles is due to people seeing what their neighbor's houses are selling for and they decide that they will cash out if they can get a high price. When they can't, they just go back to living in their homes and inventories decline, causing prices to stabilize. This will cause inventories to decline somewhat over the next few months. Also, builders have slowed building new units significantly. Some people must move, will never rent and will keep the pump primed. Also, about 35% of all homes do not have a mortgage, providing a solid base of steadfast owners.

Unfortunately, the current inventory of bubble houses on the market from new and recently built houses (especially condos) that were purchased as investments or second homes is huge. The percentage of people who don't live in the houses they own are at historic highs (about one in eight is the best guess I've seen). When you combine the number of people who just can't afford the loan they shouldn't have ever gotten with the people who will just walk away from a bad investment, the potential for crashing prices looks scary. Lowering interest rates will not help these "investors" because their strategy was to "flip" the house, not rent it out. Without the prospect of increasing prices, refinancing does nothing for them.

The psychology of the market has thus gone from a feeding frenzy because "they aren't making any more of it" silliness to a very prudent "wait and see" attitude. The gap between the asking prices of sellers and the price point that will get a buyer to sign a contract is widening. Sales are slowing down at an alarming rate. As prices decline, sellers heretofore focused on sunk costs must turn to escalating carrying costs. Euphoria stimulated from credit money infusions into the real estate market (and economy) must lead to the pain of withdrawal symptoms.

If the house/condo can't be rented out at a rate that at least comes close to breaking even (and most can't), then the empty houses will flood the market at desperate prices. Bank foreclosure lists will also be dispersed at fire sale prices. The contraction of credit money will be difficult to re-inflate, but Helicopter Ben will be pumping his little heart out is my guess. It's my guess that the Chinese and other foreign central banks and corporations will help him out so he will be successful. Mr. Bernanke and Mr. Cramer, you should be careful what you wish for.

Purchasing a home to rent out to a tenant at a profit is a great entry level way to become a real estate investor. Covering the debt service and expenses plus a little with the rental income will always be a sound investment strategy. Relying on the "Greater Fool Theory" that someone will come along and pay even more for an over-priced asset than you did is appropriately named. The coming opportunities for people who have the cash and credit ratings to scoop up the glut of houses/condos from the fools left holding the bag and their lenders will be plentiful. Bringing sanity back into the market will cause prices to stabilize at the price point where smart investors will start buying again.

I project a 30% to 40% average decrease in single-family residential unit (houses) prices and 40% to 50% decrease in multi-family residential unit (condos/townhomes) prices over the next three years in markets like Florida that have gone sky-high over the past five years. Note that it only takes a 50% decrease to wipe out a 100% increase. This is based on current rental rates that could also decrease due to the increased number of rental units that will be flooding the market. Basically, most locations will revert to the mean as seen in the chart above.

When investors are able to purchase units and rent them out at a profit, then the market will hit bottom, level out and start to rebound. The residential real estate will get much worse before things get better. When the collapsing residential real estate market starts bleeding jobs from the economy, directly and indirectly, we will be faced with the worst economic conditions since the Great Depression. Capitalism and "speculators" will be blamed once again and the fascists that seek to control the economy will get more power even though they are the root cause of the problem. The sad part is people like "Mad Money" Cramer will be begging for it. What a ship of fools.

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Mark Davis is a husband, father and real estate analyst/investor enjoying the freedoms we still have in Longwood, Florida.