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September 01, 2006

The Consequence of Real Estate Bubbles
by Bob Hoye

Bears, bulls, and the merely complacent are all commenting on the condition of the housing market.

The following articles cover real estate booms and busts back to Roman times. Including the latter is not too farfetched. Secular contractions inspired the New Deal in Old Rome, which suggests that policymakers respond to the same stimuli in the same way - no matter what millennium or condition they find themselves in.

Some of the articles are lengthy, but it is important to place the latest mania in housing in perspective.

This could be consolidated into one lengthy article, but we have found that financial history becomes more vivid when contemporary sources are frequently quoted.

The first article covers the post-1929 secular contraction in real estate and credit. Published with permission here, it's from the April 24, 1992 edition of Grant's Interest Rate Advisor. An interesting line was "last glacial, deflationary bear market in New York City real estate" (begins with "The Slowest Asset").

The next article reviews today's precarious condition of Florida real estate. Mike Morgan (mike@morganflorida.com) is the author and it is titled "Ghost Housing Market".

This is followed by Frederick Lewis Allen's riveting description of the 1920s land bubble in Florida. This is extracted from Only Yesterday. Published in 1931, it is a classic account of the "Roaring Twenties" bubble.

This is followed by a Wrap, which briefly reviews the bubble collapse of 1343 to 1346, as well as other examples.

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Ghost Housing Market (Florida, 2006) - Mike Morgan

We recently had two more of Wall Street's finest out on a tour of Florida real estate markets. After the first day, these guys needed diapers. They've been listening to the garbage from home building company management teams and what dribble they hear on the conference calls. I showed them reality, and it hit them like a ton of bricks.

Here's a review of reality.

Inventory -- Our current levels are all time highs. We've never seen anything like this. If you want to believe the NAR numbers, so be it. In the previously hot markets, inventory levels are well beyond a year, and in some markets 2-4 years. You have hundreds of thousands of homes in the hands of flippers, not to mention all of the unsold inventory the builders are sitting on, and you still have the normal market of people selling for reasons like death, new job, etc..

Ghost Market -- Why so much inventory? The Ghost Market of so called "investors." These people were not investors. Maybe speculators, but even that is too kind. They were uninformed gamblers. For the last two years, you had better odds at the Big Six Wheel in Vegas. And the builders knew it. The builders saw buyers flipping contracts before closing a few years back. There response was to include a contract provision that you could not assign the contract, and you must close with the builder. They told the Street they were doing this to control investors. Well, that's pure nonsense. If they wanted to keep investors out, they could have demanded sworn affidavits. They could have put deed restrictions in regarding sale and rental of the home.

But there logic was not to eliminate investors from the market, but rather to capitalize on them. So with assignments prohibited, the new wave of lemmings had to buy from the builders. And away we go! So now we have a market flooded with people that had no intention of living in the home. When, in the history of the world, have you seen millions of people buying multiple homes like a box of donuts? Like donuts, the value of these homes is dropping as they sit on the market.

Quality - Builders have been selling the vast majority of their homes to flippers. Flippers don't care about quality. Rarely does a flipper order a competent home inspection. Rarely does a flipper even do a walk through. They are only concerned with flipping the contract as soon as they close. The builders did not let this opportunity go unnoticed. They built lower and lower quality homes, often ignoring building codes. How? In many markets the pace of construction has outpaced the ability of the local authorities to inspect homes, so these markets allow the builder to hire their very own private inspectors. Now if you hired an inspector that flagged your homes, how long do you think you would keep that inspector? So the builders find inspectors that are willing to look the other way. Many of the homes on the market today do not meet building codes. We are seeing an escalation of defective roofs, defective trusses, defective stucco and the list goes on. We actually set up a website to help home buyers with information. I'd like to report on all of the home builders, but for now our site is focused on just one builder www.Lennar-Homes.info. We'll be adding new sites over the next few months.

Location - Once again, builders realized they could sell anything as long as they pegged it as "pre-construction." Building next to dumps, rail lines and depressed areas became the norm. Flippers never bothered to visit the sites. Let's look at Miami. Out of area flippers just hear two things. "Miami" and "pre-construction." Our trips through Miami reveal that many of the construction zones are in depressed areas full of crack houses, empty warehouses and worse.

The flippers didn't care, and neither did the builders. But the "real" buyers that might live in these condos and homes care. And they are not going to buy these projects.

Cancellations - If you think the cancellation rate is less than 50%, I've got a bridge for sale. Flippers are dumb, but they are not going to wipe themselves out. If they bought a property for $500,000 and it is now selling for $400,000, why would they close? They will simply walk away from their contract, leaving the builder with more unsold inventory. Here's one example to drive this point home. An investor client of ours was recently released from his contract price of $490,000. The builder just resold it for $315,000. That's a "real life" example. That's a 36% haircut for the builder. Margins? There are none at these prices. P/E ratio low? How about no P/E ratios?

One final note: The flippers have about 3% in closing costs with the builder. Then they have about 10% with the new buyer. So they need a 13% increase in price to break even. What would you do if prices have already fallen by 20%? Lose another 7% or walk away from the contract?

Affordability - Prices skyrocketed artificially because flippers did not care about price. They only cared about one thing . . . Were they getting pre-construction pricing? Now we have a flood of inventory on the market that buyers cannot afford. First time buyers generally need homes under $300,000. Even in previously hot markets like Port St. Lucie, we saw average home prices rise above $300,000 for pre-construction homes. And the high end market is not immune to this problem either. Buyers that purchase million dollar plus homes are far more astute then the first time buyer. The high end buyers read the Wall Street Journal and follow the numbers. They see the massive build up of inventory, and they all tell me the same thing. "We're looking, but we're going to wait till prices come down." And with that kind of logic, prices will continue to drop.

Interest Rates - Compounding the affordability problem are interest rates. A little over a year ago a buyer could secure a $300,000 mortgage for $1,250 a month (less if they used an ARM). Now the same buyer is looking at a $1,750, or $6,000 a year more in mortgage payments.

Florida Bust - 1926 - Frederick Lewis Allen

"It [Florida real estate] began obviously to collapse in the spring and summer of 1926. People who held binders and had failed to get rid of them were defaulting right and left on their payments. One man who had sold acreage early in 1925 for twelve dollars an acre, and had cursed himself for his stupidity when it was resold later in the year for seventeen dollars, and then thirty dollars, and finally sixty dollars an acre, was surprised a year or two afterward to find that the entire series of subsequent purchases was in default, that he could not recover the money still due him, and that his only redress was to take his land back again. There were cases in which the land not only came back to the original owner, but came back burdened with taxes and assessment which amount to more than the cash he had received for it; and furthermore he found his land blighted with a half-completed development."

"The final phase of the real-estate boom on the nineteen-twenties centered in the cities themselves. The tower-building mania reached its climax in New York - since towers in the metropolis are a potent advertisement - and particularly in the Grand Central district of New York. Here the building boom attained immense proportions, coming to its peak of intensity in 1928. New pinnacles shot into the air forty stories, fifty stories, and more; between 1918 and 1930 the amount of space available for office use in large modern buildings in that district was multiplied approximately by ten."

"The confidence had been excessive. Skyscrapers had been over-produced. In the spring of 1931 it was reliably stated that some 17 per cent of the space in the big office buildings of the Grand Central district, and some 40 per cent of that in the big office buildings of the Plaza district farther uptown, was not bringing in a return; owners of new skyscrapers were inveigling business concerns into occupying vacant floors by offering other buildings; and financiers were shaking their heads over the precarious condition of many realty investments in New York."

Wrap: It is true that "they are not making real estate any more", but prices are subject to intense speculation whereby leverage is over-employed.

This is inevitably followed by forced liquidation and such financial crises related to real estate are noted in the literature. The 1343 - 1346 crash in mortgages and property in northern Italy is well researched.

The Monetary Policy of Fourteenth Century Florence by Carlo M. Cipolla is worth reading.

Some notable points would include the heading to Chapter 1 "The Great Crash of 1343-1346". Cipolla records that the crises ended "a period of secular growth and the beginning of a long and arduous search for new equilibriums".

Florence was the principal financial market, so the effect of the crises was comparable to a collapse in the senior stock exchange in our times.

During the euphoria of the preceding decades, merchant and banking houses had loaned out substantial amounts of money in what was regarded as perfectly secure investment yielding a good return.

The damage was widespread geographically and, according to Cipolla, "The collapse of the banks brought losses to all who held deposits in them; in the more fortunate instances depositors were able to retrieve only a half, or a third, or a fifth of their funds. The list of the Antellesis' creditors [includes] ... magnates, as well as artisans, widows, and orphans."

The contemporary chronicler, Giovanni Villani, used the phrase "manacamento della credenza", which translates simply as a "want of credit".

Cipolla also writes that the crises were attended by "wild fluctuations in the relative values of gold and silver".

This could be important as, recently, the gold/silver ratio has been increasing in volatility.

The financial history of the Roman Empire is not thoroughly detailed, but includes mention of a number of crises in mortgage and property markets. These are significant in implementing virtually all of the schemes dreamt up by Roosevelt's deluded "New Dealers".

More recently, more than a decade of speculation in financial and tangible assets climaxed in the summer of 1873. The consequent contraction endured from 1873 until 1896 and was named "The Great Depression" by leading economists and analyzed as such until as late as 1940.

Fortunately, there is an index of U.K. farmland values in pounds per acre. After soaring from 37 to 55 in the 1870s, the index declined to a little less than 20 in 1896.

The decline in rents for the same period ranged from 32% to 43%. One researcher mentioned that the problem of collecting rents needed to be recognized and was estimated at times as only 90% successful.

It is important to understand that this was a depression within which there was an outstanding improvement in agricultural productivity.

In drawing some conclusions, typically big booms in real estate have been followed by long consolidations in both price and credit conditions.

Shorter-term examples include regrettable U.S. experiments in "wildcat banking", when land bubbles erupted in 1837 and 1857. These were followed by brief but severe contractions. The 15-year bear market in Japan's real estate is the most recent big example and is well reported.

Of course, there is no certainty that recent manias in real estate will lead to a contraction, but then there is no certainty that they won't.

Bob Hoye
Institutional Advisors

The opinions in this report are solely those of the author. The information herein was obtained from various sources; however we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

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Moreover, from time to time, members of the Institutional Advisors team may be long or short positions discussed in our publications.

Copyright © 2003-2008 Bob Hoye

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