In the early years of this century, even as many Americans were licking their wounds following the burst of the dot-com bubble, a new bubble was forming. It was the real estate bubble. It grew quietly, at first. It started as investors eager to offset their tech losses grabbed hold of cheap, widely available credit and bought up the American Dream.
In fact, it wasn’t only Americans — the entire globe was awash in cash looking for something to invest in, and it found U.S. housing. The unprecedented year-in-and-year-out run-up in house prices that followed was thought to be unstoppable. In retrospect, like any bubble, there were indicators that a correction was in store. But in the eternal ebb and flow of Greed and Fear, Greed was winning.
Complicated instruments were constructed to build on investors’ gains. With names — some catchy, some opaque — like “collateralized debt obligations,” “no-income-no-job mortgages” and “naked short selling,” they compounded into a crash in U.S. real estate and cascaded into the global economy in general. But despite the multi-year run-up in real estate (and the subsequent multi-year decline), these concepts remain poorly understood both in the media and among housing consumers in general.
All of us — every politician and banker and regulator and Realtor and average citizen — are looking for the signs that will help us answer some simple questions: When will the housing market return to normal? When can we come out of our bunkers and look up to see blue sky? And, of course: When can I finally list my home at the price I’ve always thought I deserved?
Reviewing historical data provides a reality check. Certainly, we have seen periods of extreme distress in the U.S. housing market. The Great Depression and the S&L bailout of the late 1980s and early 1990s are two examples. What happened to housing inventory and mortgage rates during these periods?
Unfortunately, both surged. But let’s throw out those anomalies for a moment and look at the rest of the 20th century. A comparison of the number of home sales to the number of owner-occupied households shows that the “normal” rate of absorption historically is 5.9 percent per year. This means that in any healthy year, “SOLD” signs are put out in front of 5.9 percent of all American homes.
Rate of Absorption: A Reliable Barometer
Anyone who has followed real estate in the past five years knows (and has celebrated) that this average has been greatly and consistently exceeded. It peaked in 2005 at 8.1 percent. So, a simple answer to the question of when markets will resemble what we might call normal is: when sales balance back out to the historic absorption rate of about 5.9 percent of households annually.
In fall 2008, sales actually are very close to this watermark. Some of the most ailing states, like Florida, Nevada and California, are even reporting month-over-month increases in sales, driven largely by increased foreclosure and “short” sales — at prices below the value of the current owners’ loans. But still, they are selling, bouncing along what the CEO of one national real estate company calls a “sloppy bottom.” From here they can be expected to improve only at the rate of household formation, which is about 2 percent per year. This means we’ll be ringing in 2018 before sales return to their 2006 peak.
Insiders will recognize this as a classic, 12-year real estate cycle. Gulp.
Furthermore, we must acknowledge that today’s situation is without precedent, because by definition, housing won’t cure the economy. In every other economic downturn of the past 100 years, American housing led the way out. Not this time. Sadly, the hair of the dog won’t do here.
While we’re waiting, there are three signs to watch for, to tell us whether things are getting better, getting worse or staying the same:
• Number of sales, or absorption rate (as described above)
• Pricing patterns
• Mortgage applications
Of course, overlaid onto all three statistics is the fuzzy nature of psychology, which, as we’ll see, can have every bit as much impact on the recovery as the numbers.
Consider pricing patterns. You can consult a List Price Advance/Decline Index that compares increases and decreases in listing prices. This index reveals what sellers are assuming about the market. They raise their initial listing price when the market seems to be showing signs of activity — even if, as is often the case these days, the activity in the market is actually being driven by distress. They discount after they’ve waited far too long and must sell at any price. As would be expected, most, but not all U.S. markets are showing a high ratio of falling list prices. But which gains are “real” and which are driven by false signs of hope?
Sellers’ entrenched expectations about pricing are an important theme of the past two years and help explain the List Price Advance/Decline Index. Some homeowners attempt to sell at bubble prices — to get the profit to which they feel entitled — which only adds to a glut of inventory and, ultimately, the disconnect between listing and sales price. Buyers certainly aren’t paying bubble prices. In aggregate, we still see a spread of 18 to 20 percent nationally between listing and sales price.
Why do sellers do it? In some cases, the owner isn’t serious about selling and sets an unrealistic price. Tragically, it’s more often true that the owner is so strapped that he or she must sell at a certain price. Note to owners: If you need to sell now, assess the fair market value of your property, and then list it at 20 percent below that price. If you have 120 days or more, price it at fair market value. If you don’t have a deadline, and don’t actually need to sell, go for that premium price If your home is extraordinary, maybe you’ll get it. Better yet, do the market and yourself a favor and don’t bother — languishing properties don’t help anyone.
Owners Yield to Market Forces
Price evolves because of psychology. If we examine national listing price averages over the past 12 months, we see those entrenched expectations; strictly rational pricing would have kept pace with or exceeded the retreat in sales. When inventory begins to straighten out, it means homeowners are finally responding to market forces.
Now let’s go back to that absorption rate. The concept of a “sloppy bottom” involves advances and retreats. The ebb-and-flow pattern fundamentally says that we’re now at the right rate of absorption in terms of sales (the bottom). But because these sales are largely driven by misfortune, it’s unclear where we go in terms of price.
Absorption is also driven by liquidity, which the $700 billion federal bailout of the financial markets will attempt to provide. The U.S. government is prepared to nationalize responsibility for evaluating and repackaging high-quality debt in the lenders’ portfolios, and siphoning off the bad ones for a fire sale. Just as important, the government is trying to exhibit confidence and influence psychology.
We don’t know whether the tactics will work, but the strategy has been proven: a government takes control of ruptured assets, peels them off, sells them at grotesque markdown and turns a profit on rest. (Exhibit A is the Resolution Trust Corporation.) Sweden did it. Japan made the opposite choice in the 1990s. The Japanese government didn’t have the courage to intervene; the result was a dozen years of economic stagnation.
Which brings us to our third barometer, mortgage applications. The Mortgage Bankers Association reported a 23 percent decline in new mortgage applications for the last week of September. Until recently, this key measure of mortgage activity has sagged but not collapsed. This kind of extreme drop reflects an utter evaporation of confidence — I won’t even bother trying to buy a home, the consumer says — akin to Punxsutawney Phil seeing his shadow and heading back inside to continue his nap.
By looking at these three relatively simple indicators — absorption, pricing and mortgage applications — we gain guideposts to an incredibly complex crisis that has been met with only the vaguest of solutions so far. Will housing stock clear at a certain price? Yes, always. Will prices then start to go up? Yes, up to the point of sustainability. How long will it take to work all the foreclosed and distressed properties out of the system? Quite a while. By many estimates, nearly 20 percent of the U.S. housing stock would need to turn over today in order to eradicate the epidemic of negative equity and distress.
Two other shifts should be taken as encouraging signals, if they happen. Distressed homeowners are having an incredibly difficult time working with lenders to modify the terms of their loans, in no small part because the infrastructure to assume these challenges is simply not up to the task, and not solely as a function of lenders’ unwillingness. The current consolidation in the banking industry could lead to greater capacity to work with owners on compromises. The consumer-centric banks at the forefront of the consolidation have the culture to respond to homeowners promptly and in good faith. Keep an eye out for new practices being deployed at banks to work out explosive loans; higher workout rates would be a very promising sign, indeed.
In addition, the more first-time homebuyer activity, the better. First-time buyers are the foundation of our housing market, and they are motivated by affordability. Although they are concentrated in the lower tiers of the market, their presence — however tentative — is a hopeful sign for the entire ecosystem.
And yet, even as we deal with the aftermath of the real estate bubble and its impact on the entire global economy, undoubtedly a new bubble is growing. This new, new bubble will help lead the way out of our current predicament. It could be anything — gold, art, another country’s economic advance. The one thing we know for sure is that it won’t be the American home. Other than that, only hindsight is certain.