Wednesday, July 20, 2005
Pop!
There's a nasty surprise lurking in the economy, and it's probably going to go off before the next presidential election. I'm talking about the housing bubble in the US, which has already expanded beyond the breaking point. It's very near exploding, and when it does, a lot of people are going to find themselves up shit creek, with neither paddle, raft nor lifevest.
Simply put, housing prices have shot up much faster than inflation in the last few years. Before this was news, speculators managed to hop in and make a fortune by "flipping" houses -- that is, buying a property, fixing it up a little bit, then selling it within a few months for an enormous profit. Flipping is the kind of thing that heats up a market, because people start to hear stories of other people making a killing, and are so inspired to go get them some as well. Multiply the frantic buyers, and the value of the product on sale goes through the roof. Supply and demand, baby.
Sound familiar? It should, because we're pretty much in the same situation the stock market was during the tech boom of the 90s. Remember those days, when millionaires were made over night? That happened because stocks were issued, buyers thought, "Wow, I can make a fortune." They bought bought bought -- demand drove up price, the lucky ones sold out. And when the lucky ones sold out and became millionaires over night, the frenzy was fed. It got to the point where buyers were paying premiums for companies that didn't provide anything -- no products, no real content yet, just a web address and an idea. And then, blam, the whole thing went bust.
There are a few factors pushing the housing market in that direction right now, with a few more on the horizon. First off, median home prices are out of range of most families just starting out. For the moment, gone are the days when a just-married couple with an infant child and one or two meager incomes could buy a house for a reasonable monthly mortgage with the expectation that it would grow in value, equity providing funding for those college educations down the line. At current interest rates, the monthly payment for a typical home in Los Angeles -- $600K -- is $4,000. That's $48,000 a year, just on house payments, meaning the family should be making at least $96,000, if not more, just for this to be a feasible deal. Hidden in the cost are property taxes -- which, at inflated prices come out to inflated amounts. True, they're a Federal Tax deduction, but the higher the income, the less this is a benefit, so these families get caught in a Catch-22: in order to be able to afford that "starter" home, you have to earn so much that you lose out on a lot of the traditional tax benefits of buying that home.
It gets worse. Many buyers are operating under the delusion that prices will keep going up, but that's just impossible. They may continue to go up for a quarter or two, but eventually real estate will price itself out of the market. Prices will stall, then fall. As soon as trends turn and prices start to drop, speculators will cash out as quickly as possible, meaning there will be a lot of houses available. At that point, it goes from the current seller's market to a buyer's market, and the inevitable consequence of a buyer's market is this: prices drop, and drop.
Now, let's get back to the family that bought the $600K house two years ago, expecting it to appreciate. And perhaps it did, hitting a high of $750K. But, at this point, no buyer is going to want to invest at $5,000 a month. Houses that would have been snapped up in a day earlier are going to go on the market and sit there. Eventually, there's a housing glut -- more properties for sale than there are buyers to purchase them. Suddenly, prices start to drop, and probably quickly. It begins with over-extended buyers who want to cut their losses, so they sell for their cash balance and sacrifice their equity. Whoosh, overnight prices dump $150-200K. And then, the bottom starts to slip as buyers sense bargains and make harder deals.
Our hypothetical family's $600K house may very well be valued on the market for $500K now, and that's very bad news for the family. If they've been paying principal first on their loan, they only have $96,000 in equity in two years. This means their debt in the house is $504,000. They can refinance and dump their equity. But if they have a traditional loan where they've been paying principal and interest or, worse, an interest only for five years loan, they're screwed. Suddenly, they owe more on their home than it's worth on the market. They move into negative equity land, meaning their credit records show a massive liability instead of a nice asset. In effect, their investment is worth less than nothing. And, as prices move downward, it gets worse and worse. This may actually serve to equalize the property glut for a while, as people literally cannot afford to sell their homes, but in the long run it's still good for the buyers.
For a while. But... a lot of people signed on for those interest only mortgages, which kick in interest plus principal payments after a certain term, usually three to five years. This is great if the value of your house goes up. But if it doesn't, you're screwed. A vast majority of these loans are set to kick in principal payments in 2006-2007. Mortgage payments for these folks go way up, but there's no chance of cashing in any existing equity to help ease the burden.
That's when the foreclosures start happening, when it's actually more economical for people to give up and walk away. That's when the banks wind up with a lot of property that isn't bringing them income -- and the bargain basement sales begin. Or, not bargain basement, but reasonable prices start to become the norm again, relative to typical income levels.
Beyond the effect on conumers, though, is this: states get spoiled when housing prices are inflated, because it means property tax revenue is inflated. And, in their typical short-sighted way, states don't look at the big picture and say, "What if the property tax base takes a dump in 2008?" Rather, they look at that revenue in 2005, keep adjusting for inflation and assume it will stay the same. So, 2008 rolls around, they're expecting revenue at about 109% of current levels; instead, they get something like 66-75% of 2005 levels. And they panic, and the second round of effects kick in. Services are cut, neighborhoods start to deteriorate, and the devaluation of property continues as under-served communities start to become less attractive places to live.
As a renter, I laugh. And I take note of an example in my own neighborhood. Less than a year ago, a house nearby went on the market. I checked out the realtor's lit while walking the dog. For a 1200 square foot bungalow -- a place barely bigger than my apartment -- they wanted $600,000. It sold in less than a week. Now, it's on the market again (I suspect the new buyers were flippers) and it's been on the market for over a month, with no magic "In Escrow" signs appearing. This time around, the realtor doesn't have flyers with the asking price out front, but I'll bet the seller started out with stars in their eyes and asked way too much. I'm guessing they had the balls to put it on the market for $800,000. True, they did seem to fix it up a bit and paint it nice. But it'll probably still be on the market a month from now, and if I were to ask the price then, I don't think it'll be all that much above the original price of a year ago.
The steam is starting to run out. Or, if you will, the bloom is off the tulip. Which is all well and good, because when a crappy, run-down one bedroom house of less than 900 square feet in a blighted inner-city neighborhood sells for $450,000, there's something very, very wrong with things. I applaud all my friends who got into the market five or ten years ago and who are sitting on goldmines now. I laugh at all the idiots who bought inflated money-pits a year or two ago.
And I wait. The bottom is going to fall out of this market fast, and that's when I'm going to grab me something nice. At a reasonable price, a monthly mortgage that'll be on a par with my current (under-market) rent. And I won't have to worry about flipping or equity, because I'll buy a house for the only real reason anybody should buy residential real estate -- as a home. As the American Dream.
Right now, the American Dream is a nightmare, in more ways than one, but one segment of the sleepers are going to be hearing that alarm clock within the next two years, and there'll be no pushing "snooze" this time around.
Simply put, housing prices have shot up much faster than inflation in the last few years. Before this was news, speculators managed to hop in and make a fortune by "flipping" houses -- that is, buying a property, fixing it up a little bit, then selling it within a few months for an enormous profit. Flipping is the kind of thing that heats up a market, because people start to hear stories of other people making a killing, and are so inspired to go get them some as well. Multiply the frantic buyers, and the value of the product on sale goes through the roof. Supply and demand, baby.
Sound familiar? It should, because we're pretty much in the same situation the stock market was during the tech boom of the 90s. Remember those days, when millionaires were made over night? That happened because stocks were issued, buyers thought, "Wow, I can make a fortune." They bought bought bought -- demand drove up price, the lucky ones sold out. And when the lucky ones sold out and became millionaires over night, the frenzy was fed. It got to the point where buyers were paying premiums for companies that didn't provide anything -- no products, no real content yet, just a web address and an idea. And then, blam, the whole thing went bust.
There are a few factors pushing the housing market in that direction right now, with a few more on the horizon. First off, median home prices are out of range of most families just starting out. For the moment, gone are the days when a just-married couple with an infant child and one or two meager incomes could buy a house for a reasonable monthly mortgage with the expectation that it would grow in value, equity providing funding for those college educations down the line. At current interest rates, the monthly payment for a typical home in Los Angeles -- $600K -- is $4,000. That's $48,000 a year, just on house payments, meaning the family should be making at least $96,000, if not more, just for this to be a feasible deal. Hidden in the cost are property taxes -- which, at inflated prices come out to inflated amounts. True, they're a Federal Tax deduction, but the higher the income, the less this is a benefit, so these families get caught in a Catch-22: in order to be able to afford that "starter" home, you have to earn so much that you lose out on a lot of the traditional tax benefits of buying that home.
It gets worse. Many buyers are operating under the delusion that prices will keep going up, but that's just impossible. They may continue to go up for a quarter or two, but eventually real estate will price itself out of the market. Prices will stall, then fall. As soon as trends turn and prices start to drop, speculators will cash out as quickly as possible, meaning there will be a lot of houses available. At that point, it goes from the current seller's market to a buyer's market, and the inevitable consequence of a buyer's market is this: prices drop, and drop.
Now, let's get back to the family that bought the $600K house two years ago, expecting it to appreciate. And perhaps it did, hitting a high of $750K. But, at this point, no buyer is going to want to invest at $5,000 a month. Houses that would have been snapped up in a day earlier are going to go on the market and sit there. Eventually, there's a housing glut -- more properties for sale than there are buyers to purchase them. Suddenly, prices start to drop, and probably quickly. It begins with over-extended buyers who want to cut their losses, so they sell for their cash balance and sacrifice their equity. Whoosh, overnight prices dump $150-200K. And then, the bottom starts to slip as buyers sense bargains and make harder deals.
Our hypothetical family's $600K house may very well be valued on the market for $500K now, and that's very bad news for the family. If they've been paying principal first on their loan, they only have $96,000 in equity in two years. This means their debt in the house is $504,000. They can refinance and dump their equity. But if they have a traditional loan where they've been paying principal and interest or, worse, an interest only for five years loan, they're screwed. Suddenly, they owe more on their home than it's worth on the market. They move into negative equity land, meaning their credit records show a massive liability instead of a nice asset. In effect, their investment is worth less than nothing. And, as prices move downward, it gets worse and worse. This may actually serve to equalize the property glut for a while, as people literally cannot afford to sell their homes, but in the long run it's still good for the buyers.
For a while. But... a lot of people signed on for those interest only mortgages, which kick in interest plus principal payments after a certain term, usually three to five years. This is great if the value of your house goes up. But if it doesn't, you're screwed. A vast majority of these loans are set to kick in principal payments in 2006-2007. Mortgage payments for these folks go way up, but there's no chance of cashing in any existing equity to help ease the burden.
That's when the foreclosures start happening, when it's actually more economical for people to give up and walk away. That's when the banks wind up with a lot of property that isn't bringing them income -- and the bargain basement sales begin. Or, not bargain basement, but reasonable prices start to become the norm again, relative to typical income levels.
Beyond the effect on conumers, though, is this: states get spoiled when housing prices are inflated, because it means property tax revenue is inflated. And, in their typical short-sighted way, states don't look at the big picture and say, "What if the property tax base takes a dump in 2008?" Rather, they look at that revenue in 2005, keep adjusting for inflation and assume it will stay the same. So, 2008 rolls around, they're expecting revenue at about 109% of current levels; instead, they get something like 66-75% of 2005 levels. And they panic, and the second round of effects kick in. Services are cut, neighborhoods start to deteriorate, and the devaluation of property continues as under-served communities start to become less attractive places to live.
As a renter, I laugh. And I take note of an example in my own neighborhood. Less than a year ago, a house nearby went on the market. I checked out the realtor's lit while walking the dog. For a 1200 square foot bungalow -- a place barely bigger than my apartment -- they wanted $600,000. It sold in less than a week. Now, it's on the market again (I suspect the new buyers were flippers) and it's been on the market for over a month, with no magic "In Escrow" signs appearing. This time around, the realtor doesn't have flyers with the asking price out front, but I'll bet the seller started out with stars in their eyes and asked way too much. I'm guessing they had the balls to put it on the market for $800,000. True, they did seem to fix it up a bit and paint it nice. But it'll probably still be on the market a month from now, and if I were to ask the price then, I don't think it'll be all that much above the original price of a year ago.
The steam is starting to run out. Or, if you will, the bloom is off the tulip. Which is all well and good, because when a crappy, run-down one bedroom house of less than 900 square feet in a blighted inner-city neighborhood sells for $450,000, there's something very, very wrong with things. I applaud all my friends who got into the market five or ten years ago and who are sitting on goldmines now. I laugh at all the idiots who bought inflated money-pits a year or two ago.
And I wait. The bottom is going to fall out of this market fast, and that's when I'm going to grab me something nice. At a reasonable price, a monthly mortgage that'll be on a par with my current (under-market) rent. And I won't have to worry about flipping or equity, because I'll buy a house for the only real reason anybody should buy residential real estate -- as a home. As the American Dream.
Right now, the American Dream is a nightmare, in more ways than one, but one segment of the sleepers are going to be hearing that alarm clock within the next two years, and there'll be no pushing "snooze" this time around.
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