Real Estate Deflation 12: Beware the Falling Knife!
I want to thank you for your takes on the economy and for telling me what was going to happen. It got me started listening and reading and that has made a big difference in what I invested in. While a lot of people are in shock about what is happening, I see it unfolding just as you said and I have been careful about my investments. Not only that, it's happening pretty much as you said it would.
Happy New Year!
~ Bev Corville, Arizona"
It wasn't long ago my columns on real estate deflation brought their share of "You're an idiot!" emails.
Funny, but I miss those blind-faith, "Rising-real estate-values-are-our-birthright!" scoldings. They always translated into brisk activity in my investment real estate business, not to mention lively banter when I broached the subject at the neighborhood watering hole. Tellingly, I haven't received even one such letter for more than a year now as Americans from coast to coast watch a Japan-style (1992-2006) real estate deflation begin to unfold in their neighborhoods, cities and regions one sad story at a time. Meanwhile, my office phone calls are off, oh, 80-90%. Only buck-toothed bumpkins fresh off the turnip truck are foolish enough to buy conventionally in this environment.
My solace is that astute readers like Bev in Arizona send thoughtful and appreciated comments or tell us about the property they sold a year or two ago that is now worth considerably less than it was then. I'm happy to say that in some cases, readers made the decision to sell because of something they read in one of my Safehaven columns. Just as often, something in their gut just told them to do it before things began to unravel. I applaud those true asset preservationists.
Many of our readers want to know "where things are going from here." Some write in to tell us they've set large sums of cash safely aside and ask that we let them know when the time is right to start buying real estate again. Keep in touch in the years ahead; I promise to do just that.
Alas, my January, 2008 answer is this: Values have a long way to go (down), both in terms of price and timeframe, and the longer you keep your investment capital safe and secure, the more purchasing power that cash will have when the time is right. We're likely just 15 or 20% of the way there, so patience remains paramount. Just know that with each passing year, the buying power of your safe cash will surely grow.
Of course, this story is no longer news. At this point, buying psychology is becoming strikingly damaged, as the mainstream media drone on day after day about the real estate slowdown, the mortgage meltdown, rampant foreclosures, rising homebuilder inventory, massive bank, CDO and SIV writedowns, stricter lending requirements, a choked-off secondary mortgage market, a troubled banking system and an extremely concerned but powerless Federal Reserve Board. Trouble is, the die is now cast; there is absolutely nothing that can be done to turn this growing psychology around, Fed pom-poms and band-aid solutions aside.
Almost everyone knows someone whose real estate ship has hit an iceberg or is about to sink, about the neighborhood awash in foreclosures, or about someone who's lost their job in the real estate, mortgage brokerage, home improvement or construction industries.
Sure, an occasional pundit or biased National Association of Realtors spokesman will throw out some bold prediction that "the housing market should turn around next year" or talk about the problem "working its way through the system" in due time.
Which is true, if your definition of due time is, oh, another ten years or so.
Unfortunately, the news stories are only going to get worse. Going forward, any snippets of good news will be no match against a multi-trillion dollar loss of home equity and its related economic take-down. As millions of loans reset in 2008, 2009 and 2010, forcing the next wave of abandoned homes, deserted dreams and problem-compounding foreclosures, continued bad news will only cement the perception of buyers that real estate values are in full decline. We've really just begun that process.
And once long-term real estate deflation in the U.S. becomes an accepted reality (as it did in Japan), the corresponding and eventual effect on psychology will take many years to overcome.
In the meantime, even your beer-guzzling brother-in-law has concluded that prices will be lower next year. We've told our readers for the last two and a half years that when we got to this point, it would be "ballgame over" for real estate for at least a decade, so I'm sure it doesn't come as news to you when I say that we're all thigh-deep in quicksand, wearing concrete clown shoes at this point.
Predictably, in terms of real estate, "they" told you last year that things would turn around in "the second quarter of 2007." Then it became the third quarter, then the fourth. Then they told you to expect a turnaround in 2008. Now -- surprise! -- 2009 is the more common call.
Get used to more "revised" predictions and real estate industry statistical tap dancing. My best guess (and surely you believe me by now): 2017, if what unfolds is an orderly, stair-step-down real estate deflation similar to Japan's; sooner if some sort of banking or financial crisis or systemic belch drops property values precipitously as property deflation intensifies (a better-than-even chance, in my view). Given all the goofball and zero-down mortgages, secondary market leverage and derivative hanky-panky winding its way through the real estate/finance mania's pipeline, systemic risk will be lurking like a thug in a dark alley for several years to come.
Can a relatively strong global economy hold the U.S. real estate market up by its nose hairs as Japan-style deflation takes greater hold? In the immediate term I'm inclined to say yes, but eventually the answer is likely a resounding "no," as the effects of a U.S. real estate meltdown and larger losses of home equity take greater hold. Japan's real estate deflation persisted without abatement during the entire global stock market mania of the 90's, and in this case, it's not just the United States' misery; the whole investment world has been participating in this preposterous American homeowner's mortgage-your-future-fest.
Meanwhile, buyers with IQ's above 82 simply aren't buying real estate. Forget all the phony government and N.A.R. statistics; sales are down 30-40% in most regions and desperate homebuilders are offering giveaways, auctioning unsold inventory and incentivizing and/or dropping prices to the tune of 30% discounts or more. At the same time, panicky U.S. "policymakers" work to compel teaser-and-liar-loan lenders to freeze mortgage rates for another FIVE years.
Even if you're not reeling from the collapsing housing market, is the nightly news compelling you to go out and buy more real estate right now? Anyone here really want to try to catch that quickly falling knife?
Test your own psychology. How willing are you to risk your hard-earned money or credit right now to buy another house down the street, even if you could procure attractive financing? Could you in good conscience make that move before you had some sense that things were turning around?
Let's say that house could be had for $417,000 right now, but the potential exists for values to drop even 10% more from these levels in the next 18 months or so (and it's going to eventually be a lot worse than that, my friends). In no time you've either lost your cash down payment or you're quickly "upside down" on the loan, or both. Declining interest rates mean nothing when values are eroding and you're losing equity or end up owing more than a piece of property is worth. The number of buck-toothed Americans willing to take on that financial risk right now grows tinier by the day.
The plan to freeze rates five more years for dicey borrowers with even dicier loans might spread out the mess and keep the 2008 election year "Apocolypse-free," but one by one those borrowers will realize all they're doing is treading water while their homes become worth $50,000, $100,000, even $200,000 less than their frozen loan balance. Will they decide to keep making their payments as values continue to fall and the economy falters because of it?
Some will try to stick it out, of course, hoping beyond hope that property values will suddenly rebound (I give that zero chance). But as these folks realize the real estate market is broken, easy-money loans are nowhere to be found, and the value losses have as much chance of coming back as Enron stock, they'll join their fellow disillusioned Americans dumping the albatross and starting over with no home, no equity, no savings and broken credit.
Declining real estate values affect everybody, whether they're leveraged or not, foreclosed upon or not, selling or not, and solvent or not. The nothing-down buyers of 2005 and 2006's are sinking or already sunk. Most in this category purchased with 100% leverage not just because banks allowed them to but also because they had no savings. Therefore they have no backup plan and no margin for error. For these homeowners, sleepless nights and strained marriages are the order of the day.
Will another wave of nothing-down and/or crappy credit buyers come in to save the day? Obviously not. They've gone the way of the Dodo bird, and will no longer be able to artificially support the market from below. These folks, historically unqualified to buy in the first place, fear buying into a declining real estate market, too, while lenders in these categories are back to round-filing those risky applications the minute they hit the desk. The real estate market must somehow adjust to the fact those buyers are gone for at least a generation.
How about the borrow-to-buy-things contingent with no plans to sell their homes, but who, encouraged by low interest rates and increasingly madcap loans, kept upping their loan balances each year? A couple of years ago, the new $500,000 loan on their $650,000, rapidly-appreciating home seemed about right. Now that the house down the street just sold for $495,000 and the one next door is a vacant foreclosure, their ability and appetite to borrow (and spend) has vanished. Their carefree, house-as-an-ATM days are over and they're suddenly living on the financial edge, again with no savings in the bank. Not only is their cushion of equity gone, they can't even sell their home without incurring a loss.
Surely there are less-leveraged homeowners who can keep the economy in check -- the ones who resisted refi's and are in better shape with, say, a $325,000 first loan. Two years ago, their equity was 50%; now it's about a third. Another year or two of real estate deflation could mean a drop to 25% or 20% or even 15% equity. Even these responsible owners are feeling like they're watching their "savings account" dwindle by the day, and they're in no mood to borrow more money (even if they could, which they probably can't). As damaged buying psychology exacerbates the problem, neighboring homes continue to sell for less and foreclosures multiply, everyone in the neighborhood will tighten their purse strings more by the day. Not only can they no longer rely on rising home values, they're bracing for even greater erosion of equity.
Sure, but what about responsible Americans who have quietly lived within their means, resisted the temptation to run up their credit card balances to buy every little thing they see advertised and have conservatively saved up over time to put a conventional 20% down payment in escrow towards the purchase of their new home?
Hey, get up off the floor. Why are you laughing?
The point is, few are in the mood to buy more real estate, and more are joining that chorus each day. Welcome to The Vicious Cycle of Real Estate Deflation -- American-style.
The $64,000,000,000,000 question becomes, "Is this a long-term trend change or merely a short-term pause/dip/splat before values take off again?" Well, valued readers, with all due humility, we have been right about real estate's destiny since we started writing this series of articles on Safehaven in 2005, so you might give our opinion some careful deliberation: I expect an ongoing drop in real estate values for many years to come -- down to at least 1994 values, on average, and likely significantly lower than that -- as all the mortgage and speculative excesses work their way out of (and devastate) the system. It is only a question of how quickly it all takes place as falling real estate values put increasingly more pressure on homeowners, consumers, banks, mortgage companies, derivatives players, Fannie Mae and Freddie Mac. The spreading cancer will simply be too much for the Fed or any other entity to ward off.
Meanwhile, that sound you hear is pocketbooks snapping shut. The Fed-encouraged U.S. borrowing and spending binge of 2003-2007 has officially ended and the time has come to play with the toys we already have instead of buying new ones. The fact that home equity is shrinking, savings are an anachronism, household debt is unmanageable and pent-up demand is nowhere to be found points to increasingly bad economic news here in America.
Global equities performed well in 2007 and I give them an even chance to do well in '08 so long as the global economy holds up (eventually the world economy will fall of the U.S.' real estate deflationary weight, too). As consumer confidence begins to erode, the Fed is doing all it can to goose the capital markets at each initial sign of distress because it knows the economy cannot withstand a severely declining stock market, as well. Bernanke and his minions know full well that once that sucker caves, it's Good Night, Matilda. So as the real estate markets here in the U.S. implode one by one, the stock market is the last line of investment defense in the U.S. and the Fed is aware of that. Real estate's deflationary collapse will eventually be the death of equities and virtually every other asset class, but for now, stocks could enjoy one last moment in the sun. I'm just not sure I'd bet real money on it.
It's football season. Play defense.
NOTE: We'd like to hear about your recent real estate stories, experiences and anecdotes -- good or bad. We may feature some of them in upcoming columns. Feel free to send them to me at StephenLMoyer@aol.com or log on to our website (www.ponderthis.net) and post your comments for further discussion. Thanks.