Movin’ on Up — Theme from the Jeffersons
The conventional wisdom in California real estate is that you buy a home, and when it appreciates, you sell it and move up to a better home. There is some truth to this idea, but not in the way most people think. Let’s examine how it really works.
Let’s look at a hypothetical example. Assume market prices are stagnant, and a small starter home can be purchased for $200,000. The next level up can be purchased for $350,000, and the high end can be purchased for $500,000. The price differential required to move between these classes of housing is $150,000. In a stagnant market, the only way anyone could move up would be to save or make more money. Someone would have to either save the $150,000, or get a large enough pay raise to finance an additional $150,000 to upgrade to the next level of housing. So how does appreciation change the equation? It doesn’t.
Let’s say house prices appreciate at a rate matching the level of inflation. If so, all the properties would become more valuable, and the gap between price levels would increase at the same rate. It would still require savings outside of the house appreciation or a raise in pay to move up. Appreciation alone does not close the gap because all properties will appreciate. There is a belief in the general public that the only requirement to end up in a Mansion on the beach is to climb aboard the “equity train” and wait for the appreciation to transport you to your beachfront paradise. It doesn’t work that way.
So what happens when appreciation exceeds the rate of inflation? Nothing different. All properties will be similarly affected. The rate of appreciation does nothing to close the gap between the various rungs on the property ladder. It is important to note that excessive appreciation is a demand-push phenomenon. When the low end starts to appreciate, prices close in on the next tier of properties. If the gap closes, even by a small amount, people will move up. These move ups, cause prices to rise at higher and higher property tiers. In short, the prices at the bottom of the market push prices up all the way to the top.
Now we’re up in the big leagues,
Gettin’ our turn at bat.
In case you didn’t notice, there is a great deal of price volatility in California. There are significant periods of time where house prices will appreciate faster than incomes increase. This is purely the result of irrational exuberance and kool aid intoxication. Prices cannot rise faster than incomes on a sustained basis, but prices can certainly go up faster than incomes when we are inflating a bubble. When prices start rising faster than incomes, price change alone can serve as a precipitating factor that ignites a rally. When prices rise faster than incomes, people see that the quality of the house they can afford declines. They do not need to fear being priced out forever; they just need to see the reality that they are slowly being marginalized by the increasing prices. This often prompts people to accelerate their buying plans and get what they can today rather than wait until they are more financially capable tomorrow because if they wait, they will have to settle for less. This buying further drives up prices. The rising prices causes more people to notice their buying power is decreasing which prompts even more buying. The irrational rally is on. Once it gets started, then people start buying out of greed to profit from the transaction, and the rally really takes off.
A very similar phenomenon is at work even during our current price decline. As many have noticed, the high end is not falling as fast as the low end. This is happening for two reasons: first, the subprime loans that have already imploded were concentrated at the low end of the market, and second, the activity of prime borrowers with cash (the only people buying right now) is at the higher tiers of the market. The low end has an extreme imbalance between supply and demand while the high end does not — yet.
So why are knife catchers being active in a decline? There are two reasons: 1. They believe they are buying at the bottom (foolish but that is what they believe,) and 2. They fear being priced out of another rally. It is the second fear that is self-perpetuating. As you can see from the chart above, the low end has fallen much more than the high end. This is increasing the gap between the move-up tiers. In this circumstance, people who want to move up are seeing their buying power diminishing, and they buy before it diminishes even more. It is the same phenomenon that it witnessed in a price rally, but it is operative in the initial stages of a decline. This is one of the main motivations of knife catchers, and it explains a great deal of the foolish buying we see today.
Let’s examine the math of this. Go back to our example, and we will start at peak prices where the low end is $500,000, the next tier is $750,000, and the top tier is $1,000,000. Let’s assume each of these tiers has a $250,000 mortgage from their starter home (equity transfer and savings to move up the property ladder). Over the last few years in San Diego, the low end has dropped almost 45%. That would take a $500,000 property down to around $275,000. This would leave the owner with only $25,000 in equity for a move up. The next tier up has only dropped 33%, so the $750,000 property is still selling for $500,000, and the owner would still have $250,000 in equity. The highest tier has only dropped about 20%, so the $1,000,000 home is still selling for $800,000, so the owner still has $550,000 in equity. Despite the huge decline in prices, the gap between the tiers is still very large, and the lower tiers are losing equity faster than the upper tiers. If the price gap is increasing or only decreasing slowly, and the equity in low-end properties is declining rapidly, what money is left over for a move up? Obviously, none. The move up market is dead.
The increasing gap between properties tiers and the lack of equity at the bottom to create the move-up demand push is going to create the opposite affect: demand price pull. Falling prices at the low end is going to pull prices down at the high end. Even if the Alt-A and Prime resets were not looming, this price pulling phenomenon would be enough to clobber the high end.
There is a limit to the number of knife catchers capable of paying the extremely inflated high-end prices. The transaction volumes are very light, and any increase in supply (which is coming) at the high end will crush this segment of the market. There is no support coming from the move up market to help out high end pricing. It is only a matter of time before these market segments join their subprime brethren in the 50% off club.
The San Diego market lead Orange County by one year on the way up, to the peak, and on the way down. Watch their market to see where ours is going. We are not 45% off the peak at the low end yet, but today’s featured property is one of those low end properties getting totally hammered. It is being offered for 32% off its early 2007 purchase price.
Asking Price: $435,000
Income Requirement: $108,750
Downpayment Needed: $87,000
Monthly Equity Burn: $3,625
Purchase Price: $640,000
Purchase Date: 3/21/2007
Address: 302 Terra Bella, Irvine, CA 92602
| Beds: | 3 |
| Baths: | 3 |
| Sq. Ft.: | 1,614 |
| $/Sq. Ft.: | $270 |
| Lot Size: | – |
| Property Type: | Condominium |
| Style: | Contemporary |
| Year Built: | 2001 |
| Stories: | 2 |
| Floor: | 1 |
| Area: | Northpark |
| County: | Orange |
| MLS#: | S552403 |
| Source: | SoCalMLS |
| Status: | Active |
| On Redfin: | 33 days |
Beautifully landscaped, well maintained, community. Unit features 3
bedrooms, 2.5 bathrooms, inside laundry, walk in cloet, close to all in
Irvine. Don’t miss the oppertunity to live in this exclusive
neighborhood. This bank owned beauty will not last!
cloet? oppertunity?
This is another property that has some very suspicious activity. Let’s take a look at the last several owners to see the full story.
Owner #1
This property was purchased on 12/22/1999 for $255,500. The owners used a $204,800 first mortgage, a $51,250 second mortgage, and a $-550 downpayment. According to the property records, these people actually cashed out at closing (unusual in 1999). I find these owners interesting because they behaved like typical irresponsible fools, but they were rewarded for it. They refinanced on 6/6/2002 for $258,000, and opened a HELOC for $47,200 a couple of months later. On 10/9/2003 they refinanced again for $297,000, and a few months later they opened a HELOC for $35,000. These people were nothing special. Just average homeowner using refis and HELOCs to fuel consumer spending. Rather than being punished by the markets, these people sold to owner #2 for a huge profit. I imagine they continued their behavior at their next property.
Owner #2
A family purchased the property on 5/31/2005 for $589,000. They used a
$471,200 first mortgage, a $58,900 second mortgage, and a $58,900
downpayment. This was a corporate relocation, and the property was purchased by a relocation service for $577,500 on 12/6/2006.
Owner #3
This is the owner who has aroused my suspicions. This relocation company found a buyer on 3/21/2007 willing to pay $640,000. Does it seem likely that this property appreciated over 10% in four months during the winter of 2007?
Owner #4
What is even more suspicious is that owner #4 defaulted almost immediately. The property was purchased at foreclosure auction 9 months later on 1/8/2008 for $545,282. The most common form of buyer fraud has the straw buyer make two payments before defaulting. The fraud is harder to prove, and after 2 payments, the penalties if convicted are less severe. The foreclosure process is 7 months if the lender meets all their deadlines. Two payments plus 7 months is 9 months.
So what do you think? Did the relocation service go find a straw buyer to avoid taking a loss? It sure looks that way to me.
{book}
Well we’re movin on up,
To the east side.
To a deluxe apartment in the sky.
Movin on up,
To the east side.
We finally got a piece of the pie.
Fish don’t fry in the kitchen;
Beans don’t burn on the grill.
Took a whole lotta tryin’,
Just to get up that hill.
Now we’re up in the big leagues,
Gettin’ our turn at bat.
As long as we live, it’s you and me baby,
There ain’t nothin wrong with that.
Well we’re movin on up,
To the east side.
To a deluxe apartment in the sky.
Movin on up,
To the east side.
We finally got a piece of the pie.
Movin’ on Up — Theme from the Jefferson
http://www.crackthecode.us/images/strawman_strikes_again.jpg
“It is only a matter of time before these market segments join their subprime brethren in the 50% off club.”
Nice to see your assessment matches mine. The house I am renting peaked near $750K. But its “true value” is about half that.
I love the charts. They give us advance notice of when to buy. Here’s one from Mish Shedlock that superimposes our bubble bust with Japan’s. It is a lot like yours, IR.
http://4.bp.blogspot.com/_nSTO-vZpSgc/STN7bDreVEI/AAAAAAAAD40/KTF00Y_csAI/s1600-h/japan-land-prices-update-2008-11-rgb-176-10-10.png
Let’s try the whole article.
http://globaleconomicanalysis.blogspot.com/2008/12/housing-update-how-far-to-bottom.html
this is awesome. thank you.
Yes, I had seen this earlier today. I find it particularly interesting that the Japanese economy had expanding GDP for years while real estate prices were falling. This is good news.
You know, I’ve never bothered to fudge the numbers on this before. But you are right. Even with appreciation there is no way to move-up without an increase in income or savings.
When I think back on my parents “move-ups”. Each was either due to an increase in income (like when my mom starting working again) or savings (in their case a modest inheritance).
True, but remember that the way many people historically have “saved” is through paying off principal on their residence. If you pay off your existing mortgage, the money you get from the sale is enough to make the downpayment affordable on a larger house.
Of course, you’re not really getting ahead, just getting a larger and more extravagent hamster wheel…
The suggestion about the straw man buyer makes me wonder how many other relocation services are doing the same thing. Just a matter of houses in my neighborhood that promptly flipped into foreclosure a few months after the previous owners took a better job, y’unnerstand.
can someone explain how a straw buyer works? is it someone who gets screwed by their own decision, or is it a purposeful fraud setup (ie: somebody creates an LLC, the llc buys it and then they say the business failed and let the ‘company’ implode)?
My understanding is that the straw buyer is either fraudulent, or a sucker. In the first case, the seller, the buyer, and the appraiser collude to appraise the house at well above its true value. The buyer gets a no-downpayment loan for the inflated value. The three parties split the take. The straw buyer makes two payments and then defaults. The bank takes back the house and the buyer walks away with crappy credit and a big wad of cash.
In the second case, the buyer is sincere, but deluded or tricked. I’ve seen stories involving buyers of subnormal intelligence, people who don’t speak English well, even people who had their signatures forged and thought the deal was something else entirely. The appraiser and the seller inflate the value and split the take. The buyer walks away with crappy credit and no cash.
Unless it is a true scam, in which case he walks away with the cash. So many realtors became so accustomed to not paying income tax on flipping that was obviously income (and lying about their residency status as well), that this kind of behavior really isn’t much of an ethical leap. Nor is it much of an ethical leap from this to selling a 380K house to someone barely making 40K in good times.
“and lying about their residency status as well”
You mean to tell me that undocumented workers (a.k.a. illegal immigrants) have infiltrated the prestigious field of real estate?
No, not that, I’m referring to principal residency for the sake of lower rates and cap gains exemption.
IR, I have to disagree with you on a few poins.
“The low end has an extreme imbalance between supply and demand while the high end does not—yet.”
There are two imbalances: buyers vs motivated sellers, and buyers vs other sellers. At the low end, there are almost no discretionary sellers actually selling homes. The low end has a massive supply of REOs and some short sales.
The high end has a much bigger supply of homes (i.e., months of supply). However, not as many of them are REOs. Many are short sales. The portion which are distress sales at the high end is rapidly rising.
I also assert that the prime difference between the low and high end is the types of loans offered, and the underwriting requirements for those loans. In places where the high end did not go over the old Fannie Mae limit, price declines are almost identical across high and low end. This is the case in Vegas, Phoenix, etc.
In places where the high end was far above the conforming limit, different loans were offered for high end buyers, especially option ARMs. Those blow up later than subprime.
A third difference which needs to be taken into account is that in LA the high end had less % appreciation than the low end. This wasn’t true everywhere, but it was in LA.
You are correct. I should have been more nuanced in my explanation. The imbalance that is causing price declines is created by the motivated sellers.
I did not realize the significance of the conforming/jumbo limit on price performance. With the higher interest rates now being charged on jumbos, when this market collapses, it is going to fall very hard.
Is it true that the high end had less appreciation than the low end? When I look at the beach communities, it is not uncommon to find properties that went from $500,000 to $2,400,000 from the last trough to the peak.
The spread at my credit union is 125 bps. Their 30 year fixed is 5.625% for conforming while their jumbo rate is 6.875%. This spread was typically never greater than 25 bps.
That spread is for fixed loans. Most high end buyers finance with ARM loans. You can get a jumbo ARM between 5.75 and 6.25% today without issue. For those with greater risk tolerance you can get a fully indexed LIBOR ARM at a 4.5ish rate today.
It’s not rates. It never has been. It’s lax lending standards, Automated Underwriting, and no doc loans. Rates can be 1.0% but if you can’t show where your down comes from and what you earn, ya ain’t getting the loan.
My .02
SGIP
“Most high end buyers finance with ARM loans.”
In other words, the foreclosure problem is going to be with us for a long time…
Not exactly. We’ll have problems with ARM loans and fixed loans that were structured between 2001 and 2007 that were NINJA loans. The problem isn’t one of being an ARM, but one of overstating income.
ARM loans have their place. Remember, the big “to-doo” about ARM resets isn’t happening at the scale it was projected to be, what with ARM indexes being as low as they are. The ARM reset problem are neg am loans where people paid the teaser and not the real rate, and again the NINJA loans that were offered to people who had no intention of paying them back.
High end buyers finance with ARM loans because they have a greater degree of risk tolerance and the assets to back them up if there is a problem.
The original discussion was of how high rate spreads are and how it will impact buyers. It’s never the rate, as people can still get attractive financing that isn’t a fixed loan. Why take a 7% 30 fixed when you can get a 7yr in the 6’s, a 5 yr in the 5’s, and a short term ARM in the 4’s? That is why high fixed rate loans are not going to kill the market. What will kill the market will be lack of down payment, McJobs, and ridiculous prices for starter homes. Will the high end suffer? Duh! The question answers itself. The problem loans failing today were not due to the rate, or the adjustment, but because of the lack of underwriting and documentary trail that would have prevented these loans from closing in the first place.
My additional .02
SGIP
I don’t think the ARM problem is overstated. It isn’t just the rate, it is the recast:
https://www.irvinehousingblog.com/blog/comments/the-arm-problem/
The reason you take a 30-year fixed is because it limits your interest rate risk. These low rates are not permanent.
The recast, yes. When you make a 1.0% rate payment in a 5.0% real market, the neg am is crazy. If you take a 4.% rate with a 6.0 margin, as many sub primers did, then yes the recast is going to hurt.
Rates may not stay low for long. We can agree on that. I funded loans in the late 80’s at 10% which people were happy to get after living through the early 80’s with rates in the teens. That said, look as 30 fixed rates over the past 15 years – averaging 5.5 to 7.5 – even for “common sense” ARM loans.
Could we see 10% + rates in the future, as we did during “late Carter, Early Reagan”? Will we have 12+ percent unemployment as we did then? Sure. Will we have stagnant wages? Sure. Will we have high inflation like we did then? Hmmm. Hard to answer. If we did ratchet up rates, who are the investors to buy these securities? Japan? China, The EU? Nope, they all have funding problems as well. So my contention is that rates could go up, as the sun does every day, but do we have a certain environment for higher rates? I don’t believe so, which means ARM rates may not be a bad deal compared to 30 fixed.
In the best possible worlds, sellers would need (compelled is my favored term…) to lower their prices to 1995ish levels before ARM programs become irrelevent.
I’d also favor abolishing ARM’s and standardizing mortgage loans as 30 year fixed products only, although again, ARM loans aren’t the problem – lax underwriting is. If ARM loans were to go away I’d expect prices to fall another 15 to 20% because very few people at these OC prices can afford to buy.
My .03 cents.
SGIP
Given the long-term ownership of a house, I think it is a near certainty that interest rates will be higher when people go to refinance in 5-10 years.
I agree with you fully that people using ARMs is the only thing preventing another 15%-20% drop in prices near term. I still don’t believe these are a wise or viable financing method for the long term.
I don’t know if you guys saw this today but this is the real problem with these arm loans–
http://www.businessweek.com
Investor Sues to Block Mortgage Modifications
A lawsuit against Bank of America claims states and banks will short bondholders $8.4 billion and damage the market by cutting home payments
By Mara Der Hovanesian
Related Items
The battle over the mass modifications of troubled mortgages has begun in earnest. On Dec. 1, William Frey, a private investor in mortgage-backed securities, filed a lawsuit in New York State Supreme Court alleging that the proposed modification of some 400,000 home loans originally underwritten by the defunct lender Countrywide Financial is illegal.
The lawsuit , which seeks class-action status, was filed against Bank of America (BAC), which bought Countrywide in late 2007. It argues that most of the Countrywide loans are not Countrywide’s or Bank of America’s to modify, but rather are owned by trusts that bought them through securitization—the process of financing home loans through the public markets by parceling them out to investors.
Frey says that BofA’s modifications (BusinessWeek.com, 10/23/07) will short bondholders $8.4 billion by reducing borrower payments. While those loan adjustments may help to keep struggling borrowers in their homes today, Frey says those alterations run the risk of permanently damaging the secondary market for housing finance.
“I am an advocate for investors’ contractual rights,” says Frey, 50, in an interview. He has publicly argued since March that loan modifications (BusinessWeek, 11/26/08) are against contract law, and has threatened to sue banks—despite, he says, receiving pressure to back down from Washington. “Investors’ voices have been muted in this debate because they speak of an inconvenient truth: Current solutions sacrifice the long-term viability of this nation’s housing finance system for short-term political gain. No matter how noble the intent, it is not in the interest of the United States now, or in the future, to tell its citizens and the world at large that U.S. contract rights may be bent with the political winds.”
Bank of America Response
(There have been roughly $7 trillion in mortgages financed by global public markets since 2002, according to ThomsonReuters. Of course, not all of those loans are troubled.)
Today Ben Bernanke hinted at lowering rates another 50 bps. What we have is deflation even though the bankers want more interest out of homeowners Ben keeps on dropping the rates to where zero will match Japan’s. This is devastating for income retired folks who are getting next to nothing for their cash along with equities falling off a cliff here cash is being taken out at any opportunity.
As more 401k’s are drained more houses will go up for sale. Further job losses are going to put even more houses up for sale. The only way out is for decreased interest rates. So those homes get sold.
Interesting story — thanks for that. Here’s a link for people who want to read it from “Bank of America Response” on:
http://www.businessweek.com/bwdaily/dnflash/content/dec2008/db2008121_173068.htm?chan=top+news_top+news+index+-+temp_news+++analysis
The maximums were 339.81 for low end (currently home prices under $366,096), 283.44 for mid, 240.26 for high end (currently home prices over $552,784).
If all prices returned to their Jan 2000 levels, the low end would have dropped 71% from peak, mid would have dropped 65%, and high end would have dropped 58%.
There are several reasons for price pull at the high end:
1. The rungs of the property ladder getting further apart, as you mention.
2. Interest rates spreads and underwriting differences between conforming and jumbo. Around LA and OC, homes over $1 million are particularly at risk. They don’t qualify for FHA financing and tend to have higher downpayment requirements. Interest rates are about 1.5% higher for jumbo. Properties just over the jumbo limit with 20% down are under particular pressure.
3. The contrast between what your money buys gets bigger when low end properties drop. People say, “is it really worth twice the price and payment?”
4. In many cases, low end homes can be transformed into matches for high end homes. This is especially true in older neighborhoods where the $1 million home is heavily redone. You can buy a fixer or a vacant lot and create a duplicate home for much less than $1 million. This is a form of upgrade or construction arbitrage. It’s much more doable now than a couple of years ago. Permits are faster. There are far more contractors available on a moment’s notice.
5. A thin move-over buyer market. Because so few high end houses have a loan to value ratio under 80% now, it’s much harder to sell an prior high end home and roll to another new one. This is currently a dreaded contingency by realtors. Some are recommending owners flat out reject such offers.
Good Post.
I want to puke everytime I hear this garbage about “move-up” buyers. You cannot “move-up” unless you have significant increase in income to support it. End of discussion.
Today the vast majority of jobs are seeing stagnant growth or even reduction. Seems like a bad combo for “move-up” buyers.
I love how “east side” becomes a 5 syllable word in that tune. Classic.
The high end is simply less liquid, so it takes longer to reflect prices. I was explaining a friend that almost no seller will sell his house more than 3-5% off the listed price, even in current market conditions. Once that house sells, it becomes a comparable which will be used by the next person to come up with their listing price.
But the high end will get a hurt from all directions. Not only jumbo rates being high, but the stock market dropping a lot. Well, not only the stock market, but every market. Rich people don’t usually have their money in “cash”. They own businesses, they own stock and bonds, they own real estate. The value of all these has been dropping tremendously. I have two stock broker brothers, and I can see this first hand. Many many rich people have been trying to catch the bottom in the stock market all the way down. Sure, they may still have a lot of money left, but now they are worth “half” of what they used to. I have even known of one case where the use of leverage to buy all these “opportunities” have lost this person almost all their fortune which at the high was in the tens of millions.
I can’t believe people don’t realize how expensive homes are. It is not that hard to see.
Now THIS is how you do zero-down right:
http://michellemalkin.com/2008/12/02/terrific-law-breaking-activist-helps-homeless-break-into-foreclosed-houses/