Deflating the Housing Bubble

A Tale of Two Markets

Our Real Estate Columnist Michael Douville takes this latest opportunity to discuss the multiple personalities of today's real estate market. He describes a tale of two markets that coexist within this deflating housing bubble. The two coexist in parallel, but could not be more different in character. Real estate it seems, like most everything else in this world, has its winners and losers, and its profit or its damage control opportunities.

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Deflating the Housing Bubble

It was the best of markets; it was the worst of markets. Timing became essential, and a degree of luck, in determining which market a real estate buyer had entered. As asserted in countless pages written about the "Historic Bubble of 2005-2007," those who purchased during the frenzy, and those who re-financed and stripped the equity from the property, now find themselves in financial trouble. It may take many years to recover fully; those who have experienced hardship, such as a lost job, reduced employment, or health issues, may choose to liquidate the property and start over. Foreclosure of the mortgage(s) may be the only option for some, and that may entail an additional bankruptcy to clear the debts. However, the "Short Sale", where a negotiated settlement of the loan to accommodate a market driven sale, is becoming streamlined, accepted, and quicker than anything else, seems to be the favored venue for both lender and borrower. These sales represent the worst of the market.

"The clearance of these problem properties affects the entire economy."

The clearance of these problem properties affects the entire economy. Lenders are suffering HUGE losses. In the Sand States of Arizona, California, Florida, and Nevada, lenders are liquidating; homes sold for $215,000 in 2005 can now be found and purchased at 50% or more discounts. The lender realizes even less, as the fees and costs are debited from the lender's ledger. This loss is a very large drag on lender reserves, impacts lending practices, and severely reduces the velocity of capital. There are still many yet to be cleared; however, the supply is finite.

There is an acceleration of the process underway as lenders and Realtors have adjusted to the market. The process has evolved with many major lenders committed to a "team and partner" attitude to successfully close the transactions. Many major lenders are participating in the short sale process in earnest. Less than 12 months ago, fewer than 15% of short sales closed; now some statistics are showing upwards of 70% are closing, and the success rate is rising. How can these sales NOT be deflationary?

These reductions in asset prices have spilled over and affected related industries. Home prices have dropped 50%, and average loan amounts have dropped accordingly, as have the origination fees for the lender, the title fees, the real estate commission, and the payment, which are all based on the purchase price. The last 3 years have been for many, "The Worst Market," as the property market stagnated.

Sellers are now able to work with many lenders and liquidate their underwater property. Currently, although every situation is different, the penalty for a homeowner that sells via a short sale is considered to be approximately 24 months; it's 5-7 years for a foreclosure. There exists a huge supply of homeowners that need to sell, but are prohibited from buying. Investors are one of the major sources of buyers for these properties. It is purely economics at play: a large supply of potential properties now, and for the next 24 months, a diminished supply of buyers.

"Rents should trend higher, probably much higher..."

Rents should trend higher, probably much higher, and barring a recession or severe downturn, prices should be stable with a slight bias to the upside for the next 24 months. That's when the penalty period for former homeowners will be over, and when the wave of past property possessors re-enter the market. It's the perfect exit strategy for half of the portfolio. In the meantime, these former homeowners need a rental.

Investors are receiving a generous reward for providing housing to former homeowners - CASH FLOW has returned. Those investors that remained INVESTORS, and refrained from participating with the SPECULATORS (who ultimately were devastated in the real estate crash) enjoy "The Best Market". Savvy investors are now purchasing properties that have corrected, and in many instances over-corrected, and are now generating cash flows and potential future APPRECIATION.

"...there may be a seminal shift in the market."

With commercial financing severely limited, new multi-family and residential development and construction will also be limited. Investors purchasing properties as they correct and come to market are providing housing for the displaced homeowners. For the next 24-36 months, rents should stabilize, and if the trend continues, the potential for 10-15% rental increases are possible. Dispassionate and return-driven investors are the dominant force in the real estate market; they are profit motivated, which has a tendency to depress prices. However, once a homeowner, always a homeowner; when the waiting period for penalized former borrowers has expired, there may be a seminal shift in the market. New demand may enter the housing market, and those properties that "deflated" may start to appreciate or inflate, accelerating the recovery.

This deflation may be considered just a correction to a more appropriate level, with some positive features. First-time buyers are able to enter the market and purchase homes in much more desirable locations, in from the fringe of the city, with much shorter commute time. Average monthly housing expenses are being severely reduced. A property being cleared via a short sale may have a $215,000 mortgage at 6.5%, for a P&I payment in excess of $1300 per month - it's now being sold for under $100,000, with a 4.75% rate and a P&I payment less than $500 per month That's a monthly savings of over 50%.

Can this huge reduction in housing cost be part of the basis for the significant jump in the US savings rate? Former owners transformed into tenants have found that the rent for a comparable home, like that which they have sold, in many instances is half of their former mortgage payment. Buyers are able to purchase with affordability, and less of their discretionary income is therefore dedicated to housing. The new buyer and new tenant are able to spend or save this differential, which may fuel a coming wave of consumer demand. A new base for an expanding economy is being formed. A much stronger economy is being created, and is a mere 24 months away. Is this "Deflation" such a bad thing?

Properties purchased and financed with little regard for fundamental economics will need to correct. Those buyers and lenders will suffer; the result will eventually be a much stronger economy. Huge sums of capital are waiting on the sidelines to be deployed. This stockpile of cash, by some accounts historic in proportion, mitigates the threat of an immediate recession.

In my view, those with a job in the private sector will probably keep their job, while those currently unemployed or working for state or local governments may be at risk. One of the mandates of the Federal Reserve has been to maintain a stable and growing economy; Chairman Ben Bernanke is a student of the Great Depression and will err on the side of too much rather than too little. Until the correction in housing has been completed, all of the financial markets cannot fully heal. The Fed may attempt to accelerate the process by adding additional liquidity to the system via quantitative easing, buying long-term treasuries, mortgage backed securities, and encouraging commercial property lending. Long-term rates could trend lower and bank reserves could spike up; the results would be greater economic activity with the ultimate goal of reflation.

A window of opportunity still exists for the average investor. Could prices trend downward as the clearance sale continues? Possibly, but although the inventory of homes that need to be corrected is large, the inventory is LIMITED. If the economy can skirt a recession for the next 18-24 months, the distressed housing inventory will be greatly reduced. The adage "from weak hands into strong hands" along with "timing, timing, timing" will rule the day.

The fluctuations in price that are inherent in a correcting market, are greatly mitigated by the cash flow of the investment. Using a 5-year investment horizon and concentrating on enhancing the cash flow performance and the income generated should be the investor's focus. Further, a window of opportunity may exist to employ an exit strategy or a sell and reduce debt strategy in 24 months, enough time to qualify for long-term capital gains and reap potential appreciation.



Editor's Note: Article should interest investors in Bank of America (NYSE: BAC), Freddie Mac (OTC: FMCC.OB), Fannie Mae (OTC: FNMA.OB), Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), Wells Fargo (NYSE: WFC), Toronto Dominion (NYSE: TD), UltraShort Real Estate ProShares (NYSE: SRS), Ultra Real Estate ProShares (NYSE: URE), ING Clarion Global Real Estate Income Fund (NYSE: IGR), Xinyuan Real Estate Co. (NYSE: XIN), Rydex Real Estate Fund H (Nasdaq: RYHRX), T. Rowe Price Real Estate Fund (Nasdaq: TRREX), Toll Brothers (NYSE: TOL), Hovnanian (NYSE: HOV), D.R. Horton (NYSE: DHI), Beazer Homes (NYSE: BZH), Lennar (NYSE: LEN), K.B. Homes (NYSE: KBH), Pulte Homes (NYSE: PHM), NVR Inc. (NYSE: NVR), Gafisa SA (NYSE: GFA), MDC Holdings (NYSE: MDC), Ryland Group (NYSE: RYL), Meritage Homes (NYSE: MTH), Brookfield Homes (NYSE: BHS), Standard Pacific (NYSE: SPF), M/I Homes (NYSE: MHO), Orleans Homebuilders (AMEX: OHB), Vanguard REIT Index ETF (NYSE: VNQ), PNC Bank (NYSE: PNC), J.P. Morgan Chase (NYSE: JPM), Hooker Furniture (Nasdaq: HOFT), Ethan Allen (NYSE: ETH), Pier 1 Imports (NYSE: PIR), Williams Sonoma (NYSE: WSM), Home Depot (NYSE: HD), Lowes (NYSE: LOW), AMEX: VAZ, AMEX: NKR, AMEX: MZA, AMEX: NXE, AMEX: NFZ, Nasdaq: XNFZX, Nasdaq: FSAZX and Avatar Holdings (Nasdaq: AVTR).

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