Who Benefits from Weakness in Real Estate?

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Since it is now official that the US economic outlook has been downgraded and will be soft for the next 2 to 3 years who could be the beneficiaries? In volatile economic environments all assets are open game to a potential downfall.  Speculators of real estate are poised to benefit from these bad economic times in several ways:

If you currently own real estate
Given that macro-economic conditions will remain soft with employment, consumer and business spending at terminal ebbs current homeowners can benefit in refinancing their existing mortgage to historical low interest rates. Government stimulus will continue to keep interest rates low. This will offer the homeowner lower monthly mortgage payments to help cushion household cash flow challenges given the downturn in the job market. If you own rental property refinancing to a lower rate will help drive down mortgage payments as well and improve rental income. A softer economy means fewer speculators will enter the home buying market and should keep rental occupancy rates high. Though his all sounds good on paper, banks underwriting criteria has never been tougher. An equity position of  less than 25% (75% loan-to-value) may disqualify many wanting to refinance. If you purchased your home between 2004 to 2008 chances are near certain that your home has devalued 30% or more. This reduced equity position may not allow you to share in the benefits of lower rates.  A good resource to check current value of you home is http://www.zillow.com/.

If you are looking to purchase real estate:
A perfect storm is when two powerful forces converge to create a miraculous event. Due to a Clinton Administration mandate to increase home ownership and an over abundance of bank liquidity, the years 2002-2007 created an unprecedented surplus of real estate transactions. When the clouds cleared and the bubble burst in August 2007 home values plummeted creating a landslide of foreclosures. In the newly downgraded economy banks will try to maintain a "normal" market by not flooding the pipeline with foreclosed inventory. This will be hard to maintain given how much REO inventory bank's are holding on their balance sheets. As the economy slowly improves the real estate market will improve accordingly. During this time of overabundance of inventory good deals on real estate will be found. Brave buyers will find low purchase prices, bank owned purchase transactions taking up to 90 days to close and seller incentives. I have heard from wealthy people that the only time they buy is when everyone is selling. Now is that time..

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The International Gage of US Real Estate

This week the BBC reported that Ireland is in secret negotiations with  EU officials to bail out and restructure their country's mounting debt load. Fears of an European melt down begin to surface and news pundants fly internationally. These rumors drive down US stocks and  fog the forecast for economic recovery. Given that the US economy is effected by global events how can you realistically forecast? Since the invention of the Internet and the speed by which information can become viral the standards that were once seemed  insignificant are now very significant. All these market over-reactions are the result of nervous investors and a continuing financial recovery from the 2007 banking melt-down. The US will be sailing through very choppy waters (economically speaking). Given that real estate is a bell-weather for the US economy and a key leading indicator, look for the current flat to minimum appreciation market to remain for the next 2 to 3 years.

Buy real estate for the shelter it provides and only if there is value. Incredible deals can be found in real estate these days at fractions of the costs 3 years ago. Below is an good example of a property here in Santa Cruz offered at only $477,500:

http://www.youtube.com/watch?v=en0moQPNPSM

The Forecast of Future Home Values Given Shadow Inventory

There have been many estimates of what could be the amount of foreclosed homes that banks are holding off the market, keeping prices artificially high. Some estimates are as high as over a million units. The term "shadow inventory" represents the amount of homes that are in foreclosure and have yet to hit the market. Once these homes are put on the market for sale it will represent a large price impact to the current inventory of homes as supply will increase and prices will decrease. Shadow inventory has never been clearly estimated, but now reports are beginning to surface on how big this inventory could be given the amount of 5 year ARM and subprime mortgages that were originated between 2006 and 2007. In 2004 to 2007 up to 80% of mortgages originated were ARM loans.

News estimates are being provided my Morgan Stanley that a much higher range between 1 million and 8 million units could enter the market in 2011-2013. One million units could be absorbed into the current market place without much impact, but 8 million units could spell catastrophic numbers for home values over the next 2 years. Some of these homes will never be brought back to the market as they are in very undesirable, blighted areas or remote locations. These homes could be bulldozed and converted into parks, recreational areas or left as open space for future development.

Keeping shadow inventory under control is one of the big banks main objectives. At GMAC Mortgage memos have been sent to executives to halt the evictions tied to homeowners in more than 20 states, easing tensions and supporting prices. Banks views have begun to change to slow foreclosures and keep homeowners in their homes during a time of record seizures.

Real estimates of shadow inventory will be around 3 to 3.5 million units that will enter the market in the coming months and nowhere as large as the 8 million units predicted. Further estimates are that 1 million units per year could be absorbed without a significant impact to home prices. Given this estimate it should take 3.5 years for a normal supply/demand home market to return. This seems like a very long time, but given how bad the banking crisis really was, it is not as bad as it could have been.

Economy Shows First Signs of Growth

We are seeing the first signs that the US economy is showing growth. Though US gross domestic production remained flat in its August 2010 report, other economic gauges are showing that the US economy is increasing production. In it's Beige Book report released on September the 8th the US Commerce Department said that tourism, agriculture, consumer spending, non-financial services and transportation numbers expanded while manufacturing eased. Most of these industries were in decline through the summer and now are showing signs of increased production.


The real estate industry numbers were not as optimistic. As a result of the expiration of the home buyer tax credit in June, the real estate industry continues to show weakness. Median home prices and sales dipped in July and August. Business contraction is also weighing in on the commercial real estate industry. Tenants' shrinking business profits are overshadowing the sector. New pessimism is beginning to emerge as commercial real estate owners seek refinance and banks remain tight on underwriting guidelines. Increased vacancies and banks unwillingness to ease lending policies will increase commercial property foreclosures in 2011 driving the sector into further decline.

The good news in all of this is the Obama Administration latest economic proposals were received as one of the first long term solutions to a declining economy. The plan will stimulate small business growth through decreased payroll taxes and business investment tax credits. Though the plan is not enough stimulus to drive small business into the profit margin, it will provide the initial push the economy needs to increase business investment and hopefully job growth.

States Forecasted for Highest Unemployment

It is such good news to hear that the Obama Administration is starting to get it right in regard to economic stimulus. Today several key financial incentive announcements were unveiled that target business investment tax credits, extensions of the research and development tax credit and infrastructure spending. The stimulus targets the engine that creates cash flow and commerce for millions of Americans; small business. This news arrives in time to counter balance the latest unemployment rate numbers. Compiled below is a top 10 list of the US states that should see unemployment rates rise greater than other states:

1. Nevada 14.3
2. Michigan 13.1
3. California 12.3
4. Rhode Island 11.9
5. Florida 11.5
6. South Carolina 10.8
7. Mississippi 10.8
8. Oregon 10.6
9. Ohio 10.3
10. Illinois 10.3

Why Economic Recovery Will Be Slow

I have been thinking of a good analysis for our economy. Imagine if you were told 2 years ago that you had cancer and needed emergency surgery to live. After the surgery the doctors told you they successfully removed the cancer, but there were several infections that will remain and you need to prepare for a long, slow recovery. I feel the same about the US economy. We are past the bad stuff, but recovery will take time.

One of the "band aids" that was put on the economic "wound" initially was the Obama Stimulus Program. The program was designed to help the economy by creating jobs, prolonging benefits to the unemployed and elderly, provide tax cuts and other stimulus thus kick-starting the economy into growth. But, like drinking a caffeine soda, once the buzz is over you feel drained. The plan had good short-term intentions, but no long-term infrastructure was created by the plan to sustain economic recovery. The plan was intended to maintain household cash flow in a dropping economy, allow consumers debt relief via loan modifications thus increasing savings rates. Now a year later most of the jobs created by the stimulus have been completed, benefits are near end, tax cuts have helped somewhat, but with less income being earned tax cuts will only survive the economy not revive the economy.

The main infection we are facing is the depleting revenue needed to fund the infrastructure of government. Municipalities, being one of the largest employers in the US, are reliant on taxpayer revenue. Property tax, sales tax, payroll tax, personal income tax, retirement tax are all in decline and infrastructure costs (roads, bridges, health care, wages) are on the rise . We have reached a tipping point where alarming cut backs in schools budgets, police force, fire departments, water districts, department of transportation are deteriorating the fabric that holds everything together. Municipalities are searching for alternative revenue sources and will begin to include emergency sales tax increases on November ballots across the country. This move by municipalities will drive the economy into further decline by taxing the heart of the economy, the consumer. What else can government do? Without much needed revenue cities budget deficits face the same bitter economic reality as businesses and individuals. Just such an event is happening with the city of Half Moon Bay, Ca. The city is "strongly recommending" that residents vote to approve a sales tax increase or the city will consider un-incorporating and handing the city of Half Moon Bay back to San Mateo County because they are insolvent. Events like this show the depth of the problem we all face.

What we have a year later is an abundance of pessimism. Yes we are saving more money per household, but spending less as well. Consumer confidence, though currently on the rise, is the life blood of the economic revival. With interest rates low and budget deficits high the government is running out of tools to fix the problem. Small business are the back bone of this great nation. Governments can stimulate small business growth through hiring incentives, revenue tax cuts, payroll tax cuts, temporarily lowering the minimum wage and creating easy qualifier business loan programs. These measures will increase hiring and begin to turn the wheel of economic recovery. With these measures in place our patient will then get of bed and regain the health and strength it once had.

As Median Home Prices Decline Who Are The Winners?

News came out today that median home prices in Santa Cruz have dropped again. The Santa Cruz Sentinel reported that median home prices declined from a jaw dropping $775,000 in 2007 to a median value of $510,000 in July 2010 (down 34%). Initially the report seems to be good news for home buyers and would increase home affordability in a very depressed economy. Unfortunately, just like a snake in the grass when you step on it, the news has the potential to rear back and bite. When home prices plummet and home buyers are still reluctant to buy what does that tell the market?

There are some commodities that consumers will pay any price for (gas, water, air) and personal economics have little effect on demand. Real estate markets have witnessed depressions before, but none have had the meteoric rise and fall as the one we are currently experiencing. The shear magnitude of foreclosures that will be entering the market in the months to come coupled with rising unemployment has driven home buyers into a state of skepticism. Why should anyone buy a home now with future home prices softening?

Median home price drops portray a deeper meaning into consumer confidence. Market price reflects what buyers are willing to pay for a commodity. A large part of consumer confidence is future employment. If the economy reflects soft employment saving cash takes top priority and the need to buy big ticket items go on the back burner. If the consumer believes buying a home is like buying other depreciating assets like a car, a refrigerator or washer dryer then buying a home will take on a lower priority. In tight economies consumers will seek alternatives (buying used instead of new) for less cash. Renting a home will be seen as a cheaper alternative until the economy picks up or prices begin to rise.

So who stands to gain the most when home ownership becomes less attractive? Not real estate agents, not homeowners, not mortgage brokers, appraisers, home inspectors and certainly not home buyers either. Real estate investors are winners on both ends of the this scenario. As home prices fall investor acquisition costs will fall. As fewer consumers buy and turn into renters the demand for rental units will increase. For owners of rental properties (especially multi-unit) value should remain strong, capitalization rates and vacancy rates should fall and rents will rise. Because a large portion of multi-residential values are based the above mentioned factors, values will rise accordingly. It will be a real estate investors that will laugh all the way to the bank gaining both appreciation and cash flow, a rare event in a down economy. Good to know there will be some winners to will keep the sector going.