Tuesday, January 27, 2009

Endgame 6: Housing As Shelter, Not Speculation


As housing and real estate continue to decline, the questions arise: how low will it go? When will it hit bottom? There are powerful reasons to suspect the answers are: much lower, and not for quite some time.

I have been addressing "how low can housing go?" since 2006, as these charts illustrate:










I think the last chart has proven remarkably prescient to date, with the collapse of Lehman Brothers providing the extrernal "shock" (never mind it was entirely predictable, it was a "shock" to the MSM).

We are now approaching "the last gasp of the bottom fishers" which I now expect to last into 2010--that is, everyone has accepted that 2009 will be a year of deep recession, so they're busy buying for the "upturn" which the MSM is predicting will begin in 2010.

The MSM will be as accurate in that prediction as they were about Lehman Brothers or the housing bubble imploding. Bottom-fishers who snap up "bargains" in 2009 (as noted above, houses which once sold for $470,000 can be had for $200,000--such a deal!) will be finding in 2010 that market rents (assuming they're even able to rent their bargains without spending tens of thousands of dollars in repairs) are not even paying their costs of ownership, and so they'll be trying to dump their "bargains" purchased for $200K for $150,000--and finding few buyers.

Even my wife is skeptical of my longstanding calls for housing in once-hot locales to bottom at 10% - 20% of their bubble-era valuations. Thus on the chart above I indicate that a house which sold for $470,000 at the bubble top may well fetch a mere $70,000 at the final saucer-shaped bottom.

(That is, the bottom will not be marked by some sharp capitulation as occurs in the stock market; the bottom will last for months or even years, and the recovery will be akin to watching paint dry.)

I reiterate that this is a prediction based in history--which means that it may not happen, but that the possibility falls solidly in the realm of historic fact. In the depths of the Great Depression, highrise buildings in Manhattan sold for about the value of the elevators: roughly 10% of the cost of the entire building's construction.

In areas with decreasing economic opportunities such as greater Detroit, houses are already sold for $1, and many are listed for less than $10,000. Prices in Manhattan, Honolulu and San Francisco have softened, but watch what happens when global tourism dries up and blows away to a mere 5% of its previous traffic, and what happens when the financial-services sector of the economy shrivels from 18% of GDP down to 2 or 3%.

Then there's the little problem of assessing the risk of buying real estate. Who's to say that this "bargain price" may not fall further? Let's say the house which once sold for $470,000 is now available for $200,000 for 25% down ($50,000). What if that "bargain property" should fall 20% further in value down to $160,000? Not much of a drop, you say, in light of how far it's already declined?

Perhaps--but the bottom-fisher just lost their entire down payment, for after losing $40,000 as the price dropped, the remaining $10K is eaten up by the transaction costs of selling (6% of $160,000 is $9,600.)

But won't the bottom-fishers be rewarded as valuations climb after the recession? As noted here many times, let's start with the fact that according to the Census Bureau, some 18 million dwellings in the U.S. are vacant--and given the homes under construction and rising foreclosures, we can safely round that up to 20 million. That's a lot of supply for an uncertain future demand.

For the 76-million strong Baby Boom is aging and will be seeking to sell their primary residence in order to enter retirement/care homes or smaller dwellings closer to healthcare and other services. These demographic forces are at work regardless of the length or depth of the recession/depression.

As the economy shrinks, as lending tightens, as deflation eats away at assets and as stock and bond declines wipe out pensions, then we have to ask: how long might this real estate recession last? If the answer might be 10-12 more years, then the natural question becomes: why buy now and have your capital trapped for a decade or longer?

Housing did take a sharp fall in Q3 2008 after an illusory period of stabilization in many markets, and so the capital trap has shut on everyone who "bought the dip."

So when does housing finally bottom? In my oft-stated view, two conditions control that timing:

1. Housing must be widely viewed as shelter, and be totally discredited as a speculative vehicle for wealth creation.

2. Market rents must provide a buyer/investor with an absolute cash-accounting positive return, that is, after all repairs have been made and all costs of ownership have been tallied without tax-related legerdemain. This calculation must also include vacancies, i.e. the reality that the dwelling may not be generating income 365 days a year.

When these two conditions have been met, then we'll be somewhere in that multi-year saucer-shaped bottom in housing/real estate.

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