Monday, October 1, 2007


Real estate prices will not rebound any time soon.

Housing is cyclical and we had a tremendous 8 year cycle which produced 150% appreciation between 1997 and 2005. This cycle was extended past its natural course through unprecedented low mortgage rates which bottomed at 4% for "variable" rates that were fixed for 3 or 5 years. Also contributing to the boom were loosened lending rules such as “interest only” loans which keep the payments artificially low and “stated income” loans which bypass income verification, making loans available to people who would normally not qualify. In my home area of Southern California, the prior down cycle also coincidentally lasted 8 years, starting in 1989, bottoming in 1995, and rebounding in 1997, causing 20% haircuts from top to bottom.

These cycles always go through the same phases: greed, denial, fear, pain and resolution. First speculators disappear, prices become stagnant, and houses stay on the market. "For sale” signs creep up as demand vanishes and sellers sit on their houses longer, creating a greater supply and putting more downward pricing pressure. Sellers reduce their asking prices, builders offer special incentives. The inventory builds up, desperate sellers discount further, some default on their payments, and the repossession phase starts. Banks, who are not in the business of owning homes, dump them at or below what is owned on the mortgage. They tighten lending standards as they no longer want marginal buyers, reducing the pool of available buyers in the process. All this drives housing values further down. Builders continue to reduce production to meet the shrinking demand, and lay off employees who in turn put their homes on the market as they no longer can afford a mortgage. The vicious cycle continues until the stage where eventually supply and demand get back in balance, prices stabilize and homes start selling within a reasonable period of time.

Unlike the stock market where corrections take place in real time and sometimes overnight, real estate corrections are slow to go their course. A margin call from your broker forces you to take a loss and re-adjust your portfolio immediately. But if your property declines below the mortgage value, there is no “margin call” from the mortgage lender asking you to add equity or pay down the loan, unless you need to refinance or fail to meet payments. So naturally you will stay put longer and ride out your losses hoping for a turnaround.

This down cycle is just getting started. Inventories are still going up, standing at the highest levels since World War 2, and banks are just now gearing up for repossessions. With 4.5 million unsold homes, builders continuing to add new homes at the rate of 1.5 million a year, and the number of buyers shrinking to less than 6 million this year, there is no reason to think that prices will appreciate again any time soon. We have to work through the supply and demand imbalance, and this will take years, many years, as it always does.

What factors affect real estate and create demand?

1. A growing employment base. It is logical that new jobs cause people to move into the area, and create demand for housing. Regional real estate booms are closely tied to employment in the area. It is no coincidence that the Southern California real estate downturn took place when the aerospace industry , the area’s largest employer at the time, shed 100,000 jobs between 1989 and 1995, unemployment climbed to 10% in Los Angeles county, and real estate plummeted. It took several years for the booming entertainment industry to fill the void, become the region’s largest employer, and add enough new employment to fill the jobs and buildings left behind by the aerospace companies.

2. Interest rates. The single biggest factor affecting your house payment is the interest rate on the note. In 1990, an 11% interest fixed rate mortgage would set you back $3,335 a month for the principal and interest on a $350,000 mortgage. 14 years later in 2004, you could obtain an interest-only loan at 4%, borrow $1,000,000, and the same $3,335 a month would cover the minimum interest payment. So assuming a $100,000 downpayment, you now have the ability to buy a $1.1 million house for the same monthly payment that would have paid for a $450,000 house 17 years earlier. It is interesting to note that a house worth $450,000 in 1990 is now coincidently going for $1.1 million, illustrating what impact the rate reductions had on real estate appreciation during that time!

3. Availability of land for new construction. Some regions are completely built up and no longer react to the simple forces of employment and interest rates. For example, when the bubble burst, the 200,000 jobs lost in the Silicon Valley did not contribute to a major real estate decline because the housing supply was already extremely tight. The demand softened slightly for a few years until the new Google millionaires started the next wave. The same conditions are in place in Manhattan, Beverly Hills, Malibu, and Santa Barbara where normal market forces do not apply.


Unless you think 4.5 million aliens are about to invade the planet and snap up the entire inventory of homes available for sale, or the fed is no longer worried about inflation and will drastically lower rates, then housing is probably in the tanks for years to come.

At this time, Blue Lake Ventures is not investing in home builders or companies related to the building industry. We think it is prudent to wait for the consolidation to start before investing in this market segment. There will be opportunities, but not yet.


Robert Iskander said...

I could not agree with you more! I find your assessment of the housing market honestand factual. Looking forward to your next report.

Robert Iskandet
Alameda, CA

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