The Real Estate Fountain

This is awe-inspiring.  Based on data compiled by Professor Robert Shiller of Yale University, this real estate decline has been just as deep as the one before and during the Great Depression.  But the current real estate decline has been far more rapid, accomplishing the same 30% price decline in three years that played out over eight years during the Great Depression.

Source:  Prof. Robert Shiller, Yale University

No wonder the U.S. banking system was insolvent.  And no wonder the Federal Reserve has taken such extreme measures.

By the way, while I was warning how severe this decline could be, I had to listen to real estate brokers and salespeople here in Miami and Coral Gables claim that I had it wrong.  One prominent broker repeatedly accused Professor Shiller, who was also very bearish, of being not only wrong but dishonest, because Shiller has an interest in a firm that makes a market in options that track real-estate prices.  It was a disgusting display of ignorance and intolerance.  Wonder how many customers that broker’s firm ushered into personal financial hell.

Be careful whose counsel you keep.

Your monthly payment for a home — assuming you take out a loan — consists of principal, interest, taxes and insurance.  PITI for short.

If you’re not from South Florida, you might not appreciate how expensive insurance is here.  Homeowner’s insurance can easily cost 1% to 1.5% of the home’s value per year.  And those are non deductible, after-tax dollars.

But you can’t do without it.

Hurricane Andrew

Insurance varies depending on the size of the home, the exact location and the type of construction, among other things.  Older homes like the classic Old Spanish houses in Coral Gables can be very costly to insure, not because they aren’t generally built well but because their roofs are not fastened to the rafters and exterior walls the way current building codes would require.

Windstorm mitigation can make a huge difference in your premiums.  On an old house, going from no mitigation to impact windows and a roof retrofit can probably save 25% to 50% on premiums and pay for itself in a fairly small number of years.

It can be hard for working professionals to find a nice home at a decent price in Coral Gables.  Seriously.  Even here, in boom-and-bust South Florida.  And even now, well into one of the worst real estate downturns of all time.

If you’re a hard-working professional making a couple hundred thousand dollars a year, you ought to be able to buy a handsome home by levering that income three to four times, as the old conservative banker’s formula would permit.

Unfortunately, that puts you in a price range — say, $750,000 and up — where sellers remain stubborn about lowering prices.  In recent market activity, sellers in the $500k to $750k price range were nearly twice as likely to reduce their prices as sellers in the $750k to $1 million price range.

Someone buying a in the $750k to $1 million price range is probably not much more wealthy than someone buying in the $500k to $750k price range.  Yet sellers’ behavior appears to be much more demanding.

Maybe that’s why there’s such an unusually dramatic inverse correlation between price ranges and sales activity, as noted previously.

The previous post reported the current outlook of hedge fund manager Kyle Bass, who made a fortune off the recent collapse of the financial-realty complex.  Essentially, Bass sees hyperinflation in America’s future, like what happened in Zimbabwe.  At the same time, Bass sees median real estate prices staying flat at best for several more years, and high-end real estate prices heading lower.

Anyone see a contradiction in that?  Would real estate sputter along if hyperinflation took hold?  Hardly.  Real estate is a classic inflation hedge.  Property prices will skyrocket if hyperinflation develops, just like in Zimbabwe, where property prices increased at an annual rate of 5,000% during that country’s hyperinflation.

About the only thing confirming the hyperinflation thesis is the price of gold and other precious metals.  But that could well be a fad that will end in tears just like every other bubble that sucked in money from the weakest among us before popping.  The gold-bug advertising littering all media right now could signal that the end is near.

The last time gold shot to the moon (in 1979-80), inflation was already soaring into the double-digits, eventually exceeding 14% year over year.  Are we experiencing anything like that now?

Likewise, the last time gold shot to the moon, wages were leaping ahead in a desperate struggle to keep pace with inflation.  Now?  We’ve just finished the latest gap down in a 30-year, secular downtrend of wage and salary disinflation (i.e., lower and lower inflation).

So far, the inflation crowd has been waiting for Godot.

Maybe someday the Fed will spur some inflation.  But there’s no clear evidence of that yet.  And until then, we’re sticking to our story.  Real estate in Miami and Coral Gables generally remains overpriced relative to the fundamentals: incomes, rents, historical values, and (in the upper price ranges) months’ supply.  Buyers have time on their side.

In other words, we agree with the Kyle Bass who sees real estate prices flat to down for several more years before a new phase of rising prices, not the Kyle Bass who sees hyperinflation.

It’s a PITI that people don’t know better.  Your payments on a home include Principal, Interest, Taxes and Insurance.  Yet often one or more of these — usually taxes, insurance or both — is conveniently omitted in pitching how attractive home ownership supposedly is.

For example, the Miami Herald runs an article every now and then titled “What Can You Get for $. . . .”, with a different arbitrary price point each time.  The article presents about five properties for sale at about that price point in Miami, Miami Beach, Coral Gables and surrounding real estate markets.  An introductory paragraph says how much your mortgage payment will be, but notes that taxes and insurance are not included.  Estimated taxes are listed separately in the information for each property.  The cost of insurance is stated nowhere.

If you’re not careful, you might think that the cost of ownership is basically the cost of the Principal and Interest portion that’s stated very precisely.  In the latest installment, the Herald asks What Can You Get for $647,000.  Readers are told that “[m]onthly mortgage payments (not including taxes or insurance) would be $2,561.”  Such precision.  So little meaning.

For the first property listed in the $647,000 article, taxes are estimated to be $14,163.  It’s not a big house, but insurance will surely cost thousands more.  (Would it really be so hard for a reporter to get an insurance quotation for each property before running a story?)  The monthly payment is probably more like $4,500, not $2,500.  Think that makes a difference to your budget?

Oh, and don’t forget maintenance.

As a rule of thumb, you would do well to regard the true cost of ownership as about 10% of the purchase price — o.k., maybe 9% in these days of extraordinarily low interest rates.  Why so much?  Currently, you can figure that the Principal and Interest payment is about 5%, Taxes are about 2%, and Insurance is usually about 1% to 1.5% (depending on the storm-resistance characteristics of the house).  Maintenance will add about 1% on average over time, once you take into account the intermittent big jobs (roof, paint, pavement, etc.).  Yes, you get a tax deduction for the interest and property taxes, but that’s only a benefit to the extent it exceeds the standard deduction you can get anyway.

In the example from the Herald, the reporter assumes a hefty 20% downpayment, compressing the Principal and Interest payment to about 4.7% of the purchase price.  The estimated taxes amount to another 2.2%.  So you’re at 6.9% before insurance and maintenance.  You might come in a little under 9% of the purchase price, but only if you put that 20% down.

Don’t be fooled.  Do the math.

Looking to buy a house in Miami or Coral Gables?  Great!  How much will you need as a downpayment?  Why, 100%, of course!

Cash deals are not normal in real estate — not in Miami or Coral Gables, or anywhere else for that matter.  But these are not normal times.

All-cash deals have become a stupefying 60% of all single-family home sales in the Miami and Coral Gables area.

For luxury homes selling for more than $2.5 million in Miami and Coral Gables, the share of cash deals has reached 72.8%.  But you expect a high proportion of cash deals (o.k., not that high) from people who are truly wealthy.

The really amazing numbers are in the price ranges where you know people ordinarily borrow to buy.  For 63% of deals below $425k to be cash, or 53.9% of deals between $700k and $1 million to be cash, is flabbergasting.  Who knew everybody had so much cash lying around?

Are investors replacing failed would-be homeowners and suddenly deciding to become landlords in Miami and Coral Gables?  Or did this many people see it all coming, sell their houses near the peak and rent for a couple of years, so they can come back in now with cash?  A recent post showed how rentals rose dramatically and appear to have peaked.  But it’s hard to believe that so many people timed it all so well.  We’re talking 60% of sales.

Whatever the explanation, what happens next?  As economist Herbert Stein famously said: “If something cannot go on forever, it will stop.”

Certainly cash deals cannot continue to make up 60% of all transactions in the Miami and Coral Gables real estate market.  And indeed, the degree to which the percentage this year exceeds the percentage in 2009 is less than the degree to which the percentage in 2009 exceeded the percentage in 2008.  The second derivative is slowing.

As the cash buyers fade, what happens next?

At the top of the market, you were a putz if you didn’t own a home — and preferably more than one.  Renters were losers.

Well, the worm certainly turned, eh?

In Miami and Coral Gables, renting a home shot up in popularity as it dawned on people that it’s better to pay half the cost of ownership and skip the massive capital losses.  Why buy a depreciating asset with borrowed money, especially when you can rent it for half the cost?  Certainly the advice you got here was to rent, not buy.

Alas, home ownership is a relentless lure, and the stabilization in home prices in Miami and Coral Gables appears to have turned the tide from real estate rentals back toward real estate sales.  This is true across the board for single-family homes: in Coral Gables as well as Miami-Dade County, and for larger homes (4 bedrooms or more) as well as the entire market.

The number of rentals appears to have peaked in 2009, as the pace in 2010 is running behind the pace of last year’s high.

In Coral Gables, rentals went from barely more than 10% of real estate transactions to nearly 50% of real estate transactions.  Considering that real estate agents make about 90% less on rentals than sales, you can assume a lot of people found themselves with essentially no income.

Same story in Miami as a whole:

Data are from MLS and therefore do not account for sales outside MLS.

No money down loans from the government for homebuyers. Makes for a sensational story, but keep in mind that standard FHA loans require only a 3.5% downpayment.

At present, the no money down program is available in only four states, not including Florida. So anyone looking to buy real estate in Miami or Coral Gables will have to come up with the usual 3.5% if they want an FHA loan.

As noted previously (see Mortgage Rates May Drop Again, May 6, 2010), the rate on a 30-year fixed mortgage is closely related to the yield on the 10-year U.S. Treasury note.  When the yield on the 10-year rises, mortgage rates go up, and vice versa.

Lately, it’s been all about the vice versa.  The 10-year yield has collapsed on renewed fears of economic weakness, deflation, and impotence trumping stimulus.  The yield is now back to where it was in spring 2009 when the stock market bottomed amid widespread despair.

Source: Yahoo! Finance

That’s good news if you want a mortgage to buy a home in Miami or Coral Gables, because the rate on a 30-year conventional mortgage is hitting its own new lows in the 4.5% range.  Of course, the question is whether home prices in Miami and Coral Gables will fall further if the bond market is right about the severity of renewed economic weakness.  It doesn’t make sense to buy a depreciating asset with borrowed money, no matter how cheap the financing.

Neither a borrower nor a lender be;

For loan oft loses both itself and friend

– Shakespeare, Hamlet, Act I, Scene III

Evidence has mounted in recent months of a second leg down in housing and a possible double-dip recession in the broader economy.

The problem, ultimately, is that there is really no way out for a people who have gorged themselves on debt.  Once you’ve reached the point where you can no longer spend today another dollar that you planned to get tomorrow, it takes a long time to wring out all the excess borrowing.

[youtube]http://www.youtube.com/watch?v=NJ6xBaZ92uA[/youtube]

Debt is like hydraulic power.  Banks and other lenders take one dollar and lend it 9 times over, or in the case of some failed Wall Street institutions, 30 times over.  Government agencies (Fannie Mae, Freddie Mac) and yield-hungry investors who take the loans off the institutions’ books absorb the flow of debt and thus free up the lenders to create more.  Eventually, a peak is reached as the most speculative drop of borrowed money is pushed through the system.  As borrowing begins to recede, asset values fall, and borrowers, lenders and investors vanish.

Real estate can make you rich.  There is nothing more beautiful than paying 5 times your income for a house with almost no money down, and seeing its value go up 10% a year.  That’s like getting a 50% raise — with 10% annual compounding on top of it.

But real estate can also make you poor.  There is nothing more destructive of your wealth than buying a depreciating asset with borrowed money.

So where are we in this cycle?  Previous posts have explained that real estate prices usually fall for about 4 years from the time they really begin declining to the time they reach an ultimate low.  In Miami and Coral Gables, real estate prices did not begin declining until about the beginning of 2007, which suggested that the enthusiasm of the past year was premature.

And this is not a typical downturn.  Real estate was far more overvalued and overbuilt than in typical cycles.  In the broader economy, we are arguably in a depression masked by extreme government intervention.

The government and the financial-realty complex turned a firehose of money on the decline in real estate values, and the most we can say is that prices stopped collapsing.  There is less pressure in that firehose now, and not only have prices failed to rise, they have begun to weaken again.

Risk remains.