The housing bubble - why I think real estate bubble is here and going to get uglier : Bad Credit Advisor

The housing bubble - why I think real estate bubble is here and going to get uglier

Wed Jan 10, 2007 12:01PM | By Tony

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The housing bubble is here, there is no question about. That the real estate bubble has basically burst is not obvious as media downplays and worse, denies that the bubble ever going to happen. Everything is shiny and rosy, and there is soft landing ahead of us. Just like CNBC used to tell you in 2000, that the only way stock market can go is up. Or that there is no inflation save for gas and heat. Last time I checked, a pound of apples or a gallon of milk costs about 40 cents more that 2 years ago. And the housing prices that finally are going down, had gone up rather considerably, won't you say. You all know about Florida and Vegas condo projects that never started, or could not get finished. But by looking around your neighbourhood, you can really feel that the real estate bubble has hit closer to home.

Diminished buying power will accelerate the housing bubble

One of the biggest problems is that the income buying power vs. the home prices has decreased dramatically. When I got my Master in Mechanical Engineering in the very end of 1992, my starting salary was $38,500. I was able to afford a condo for $92,000 with 7 year balloon mortgage at the interest rate of 7.5%, and a brand new, just redesigned Honda Prelude SI for $16,800. Today, the same degree may or may not start you at $50,000 or so. The exact same condo sells for around $180,000, and comparable car goes for about $27,000. How in the hell anyone making $50,000 or even $60,000 can afford this?

Information technology professionals were making anywhere from $50 to $150 an hour, thanks to Year 2000 overblown bug, and smart executives like Bill Gates of Microsoft, Larry Ellison of Oracle and the rest of execs in Cisco, Nortel, Lucent, Sun Microsystems, who were pushing new software and hardware day and night, making corporations spend huge money on network engineers, programmers, database and system administrators. They were able to afford huge new houses and real estate taxes pushing the price higher and higher. These days, some are still making $80 even $90 an hour, but the homes which were bought for $400,000 in 1999 and 2000, sell for $700,000 today.

Other numerous software related jobs were created as well, paying less but still very high. Software testers, project managers, folks who worked for consulting companies - recruiters, account reps, administrative stuff, you name it. Thanks to Dell, Gateway and others, seemingly everyone bought a desktop or laptop computer. That in turn lead to a great demand in call centers.

In short, this new influx of highly paid jobs pushed real estate prices sky high. Today however, many of those positions are outsourced to India. Indian programmers coming here in huge numbers, depressed the hourly rates and salaries even further. It didn't happen over overnight, mind you, but over several years.

Real estate tax and real estate bubble

The real estate tax is the additional humongous expense nearly doubling in many counties across the country in less than 10 years. Those homeowners who paid $6,000 - $8,000 a year, now are facing $12,000 - $16,000. And don't tell me that those who live in the $600,000 house can easily afford paying $12,000 in real estate taxes. It is an additional $1,000 a month, if you have escrow account, or $6,000 you must come up with twice a year. Many homeowners are already so stretched financially, they can barely afford making their monthly mortgage payments, never mind paying sky rocketing tax bills.

Home Equity Lines of Credit with a variable rate

The old saying goes - what appeared to be a blessing, turn out to be a curse. How many people used Home Equity Line of Credit or HELOC with a variable rate to buy cars, boats, second homes, jewelry and so on? With the tax deductible interest and smart amortization, that was the greatest idea from to 2002 to 2004, when the HELOC's interest rates were under 5%. These rates, you see, are tied to the Prime rate, whereas conventional mortgage rates follow closely 10 Year Treasury Bond. There was a time, when the prime rate was below 5%, and so was the HELOC's rates. Today, the Prime rate is 8.25% and the best rate on a Equity Line you can get, "Prime minus 1%" is 7.25%. Imagine someone who used to have $200,000 line of credit at 4%, making a minimum payment of $667 a month, only to face now a payment which is almost twice as much. Of course, many managed to refinance locking at a safe fixed rate, but quite a few couldn't.

Baby boomers - the X factor that may get things even worse

I haven't seen any research on how this huge population segment may affect the real estate, but considering that almost all of boomers have kids out of high schools, and in colleges by now, they are likely to sell for several reasons:
- to finance their kids college education
- to move into warmer or colder climate
- to indulge themselves in the golden years
- to simply downsize
Finally to stop paying insanely high real estate taxes they don't need anymore, since their children don't need the best high school money can buy. Considering that there are about 35 millions of baby boomers, and only 1%, which is 350,000, of them will have to sell quick, the impact on sale prices can be quite severe.

Still, the biggest culprit is supply vs. demand

Too many homes were built and still being built. This also will accelerate the real estate bubble. Who will buy all those houses? People have to unload the present homes which have a lot of paper equity in them, but not too many buyers are out there.

That is why I think, a "buyer's market" will be soon redefined. Just 3 - 4 years ago, there were 10 buyers on a single house in some areas, and builders couldn't build enough with people camping overnight to get a chance to buy something in a hot school district. Now the very same houses are on the market for 6 months with prices dropping, and 20 sellers for each buyer.

The scary thing is that builders keep building. They can't stop, obviously completely, but the number of homes being built is simply ridiculous. Of course the initial price is set so high, that a buyer can get another bedroom or bathroom thrown in the deal and feel good about it, but soon that won't be enough.

Who is going to suffer?

There are several categories that have been hurt and will get hurt even more. No, I don't say they deserve this. It is just that people need to understand what's coming to them and take any precautionary measures that are still possible.

Small time builders
Average person keeping the day job, hiring general contractor or playing one on his or her own, which they can, if they claim that the house is going to be a personal residence. It became a national pastime, and some made tons of money, and were smart enough to get out on time and stop. Take a construction loan from Countrywide or Washington Mutual, Countrywide is much better, by the way, build it, and put it on the market. The bigger and more luxurious the house, the more money is to make. That had been a winning formula until a year or two ago, and did make some rather wealthy.

These days almost no one can't sell. Big houses built by small timers have very big mortgages. Many still have another mortgage on the house the live in, so they have to get rid of whichever house is easier to sell. I however know too many, who haven't been able to sell either.

Smart ones sold their houses first and rented apartments while building, so now they are moving in their brand new, completely unaffordable, forbiddingly expensive castles. They still are trying to sell. They are lucky for the first year, because the property tax on a brand new construction is very small. They will run out of luck as the house is reassessed for second year, and tax bill will be the killer. As I look around my area, there are about 60 houses over a $900,000 that were mostly built by the people who had never touched a hammer in their lives before. Vast majority has been for sale for more than a year on average. But again there are others building more. If you throw in condo conversions, the sheer inventory of homes on the market is mind boggling.

Homeowners who ran in some financial troubles
They must sell, and they try, but have mortgages that are way higher than the amount anybody is willing to pay today. So many homes are being foreclosed where mortgage is from $50,000 to $100,000 higher than current market prices. The subdivision next to me has 157 single houses built 4 years ago. There are 6 three bedroom homes with two and half baths on the market in a range from $440,000 to $470,000. The have been for sale for as long as I can remember. The houses are nothing spectacular, the mass produced homes in a nice neighborhood with a bad high school district. They were bought for pre-construction prices around $287,000 in 2002. Now each of them has the first and second mortgages of over $420,000. The mortgage rates are over 9.5%. Forget it, the poor schmucks are finished as no one will pay anything close to the asking price. They will have to sell way below of what the owe. The lenders, which all are the leading sub-prime banks, will get what's coming to them too. I don't feel particularly bad about those banks, as they have their ways to get around with Chapter 11 or simply closing the doors, or what have you, but that leads us to the third category.

Banks and other lenders
When Jill buys house from Joe for a very inflated price, managing to get a fraudulent appraisal and later loan in a process, it is a felony. Joe splits the proceeds of the sale with Jill, then Jill defaults on the mortgage, and adios, goes overseas or simply doesn't care about her credit. The bank which loaned the money, is left with a house that can not be sold to anything close what loan amount is, and bank loses. That is federal offence this days with feds on the lookout, and considered a main mortgage fraud. However many lenders got themselves into much bigger troubles quite knowingly, willing to lend money, thinking that the values will keep on rising, and now being stuck with many homes as described above. Those money they never will see again, and they must sell to minimize the losses, and this will further depress the prices.

Recent landlords
The newbies who bought condo conversions, apartment buildings, town home and single home rentals where the positive cash flow or even breaking even is as distant as for the Bears to beat the Seahawks this weekend. Too many got sold on Carleton Sheets, John Beck's Free and Clear commercial, and other real estate wonder schemes, only to realize too late, that nothing is free and clear, nor fast and easy. Actually, I have to take the football game analogy back as the predicament many newbies find themselves is far, far worse than the Bears becoming the first ever team to loose its first playoff game three times in a row after a bye. Without calculating all the costs, and considering high vacancy rates, repairs, bad tenants and myriad other unpredictable problems, many have been forced to dump their investment properties at prices that are way below of what they paid, or face foreclosure. As two partners who are my long time clients told me, they were so happy to finally get rid off the six-flat they bought for $620,000 two years ago, they let go for $550,000.

Middle size builders
Many will survive but badly bruised. Some will declare corporate bankruptcy to simply get out, other will have to cut the prices drastically, or throw in fat incentives. It will put even more pressure on individual sellers and small time builders, who will have to lower the prices even further. A friend just came from central Florida where he looked at the community for the 55 years of age and over. Beautifully built with a golf course, located within less than 2 hours from both, the Golf and the ocean, it has about 300 units with only 180 sold in two years. The asking price was $200,000 for a three bedroom, 2 bath ranch house. He managed to get another bedroom and den thrown into the deal. His final price was $187,000.

Large nationwide builders
Toll Brothers, Centex, Pulte Homes and other names that you will hear on CNBC, CNN Money and Mad Money. These builders build so much, they can really affect the house prices. The huge single home, golf course subdivision one of these builders built two years ago few miles from where I live, has foreclosure rate of 20%, and on the top of it, about 10% completely finished homes are still unsold. The prices went down by $75,000 on average in the last 4 months, but it doesn't help. The one-time golf membership cost is now meager $30,000 that can be financed into the house mortgage, courtesy of this builder mortgage division. Previously, the same membership cost $50,000 and couldn't be financed.

In conclusion

Just when I am about to finish, I came across three stories -
- in USA Today which has rather ominous title - Home prices drop in 45 metro areas; sales fall in 38 states

- in Las Vegas Sun - Assessed value of many homes being reduced. It is only beginning, of course this is one man opinion.

- in Detroit News - 300 foreclosed Detroit homes go on the block. This one shows what is coming to many regions where blue collar jobs are being lost.

Comments

thank-you

Posted by: duncan | January 13, 2007 03:36 PM

Thanks for having the courage to say what most people don't want to believe. As a small time investor, I don't want to believe it either, but it is a good reminder to be very cautious.

Posted by: John | January 26, 2007 02:51 PM

The cost of homes for sale is now on the decline. Buyers go out and negotiate.

Posted by: Tim R | February 25, 2007 12:44 PM

Great, it is interesting to all.

Posted by: Ravi | March 26, 2007 10:22 AM