Monthly Archives: April 2007

Appreciation is Dead

Appreciation is Dead. It is not merely delayed for a temporary housing price crash only to resume its historic 7+% rate. Appreciation is dead. We will never see high rates of house price appreciation again in California. Sacrilege! Yes, but there are reasons to believe this may be true.

In October of 2000, I attended a conference put on by TradingMarkets.com. The NASDAQ had experienced the spring collapse and summer bear rally. The huge fall sell-off (which was the first of many sell-offs before the bottom was reached in the spring of 2003) was just beginning. One of the speakers at this conference was a very successful hedge fund manager named Mark Boucher. Everyone gathered at the conference had just been through the wildest bull market in history. All were convinced that the market was going to come roaring back. We just needed to get past this painful correction. Does any of this sound familiar?

When Mark Boucher spoke he dropped a bomb on the audience — 20% annual gains in the stock market were not going to be seen again in the next 20 years and perhaps in lifetimes of those assembled… Silence… A pregnant pause… One of the most successful money managers on the planet just spoken the unspeakable; the audience had to think the unthinkable. Heresy! Blasphemy! Was this possible? For a few brief moments the audience was exposed to the naked truth; the veneer of denial was stripped from them. It was a paradigm shift with seismic repercussions. Those who heeded his words made wise investment decisions and survived the bear market. Those who failed to listen bought the bear rallies and were destroyed. Seven years after the peak, the NASDAQ is still down 50%, and none of the last seven years favorably compares to the seven that preceded it. Mark Boucher was right.

I am not as smart as Mark Boucher, and I am not a preeminent real estate investor (I didn’t buy the bubble rally.) My words do not carry the same weight. However, consider what I write here, and you may save yourself a lot of money and avoid a lot of stress as the bubble deflates and the post-bubble market emerges.

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Have you ever wondered why California’s housing market bubbles so frequently and other markets do not? It stems from a combination of two factors: limited supply and high wage growth (and, of course, Southern California’s Cultural Pathology).

Supply is not limited in the way most people think. We are not running out of land. Supply is limited because the process for obtaining supply is cumbersome — which is good for me because that is my job. In other areas of the country, when supplies of housing are low and prices begin to rise, a large amount of supply is brought to market quickly to meet this demand. In California, this is not the case. The entitlement process as outlined in CEQA is both lengthy and costly; therefore, when supply runs low, new supply is slow to the market, and prices rally higher than they would in other areas of the country. The point is that supply shortages are a temporary phenomenon not the permanent result of “running out of land.” Have you noticed that during the crash there is excess inventory on the market, and the builders have overbuilt? This is why.

The fundamental value driving up home prices is the growth in wages — at least indirectly. Wage growth drives rental rates higher, and it is rental rates which determine the fundamental value of housing; therefore, wage growth determines the rate at which housing will increase in value. Irvine has experienced wage growth exceeding other areas of the country. This is why pay scales are currently double the national average. However, this trend cannot continue forever.

Factor Price Equalization

When the cost of a good or service rises, people seek out lower cost alternatives. When the same product is available in a different market, buyers will purchase in the lower cost market until prices equalize. This is most notable in labor markets. After NAFTA was signed, wages for unskilled labor declined in the United States and rose in Mexico. Of greater importance to the higher skilled labor of Irvine is the problem we know as “outsourcing.”

Outsourcing

Outsourcing is happening all around us. I have a relative who works in customer support for a major computer maker. They are working to outsource most of his department to Banglore, India. Nissan has relocated its North American headquarters from Southern California to Tennessee. These are examples of high-paying, high-skill jobs leaving our area. This is happening for two reasons: one, they can pay less in other markets, and two, they can’t get employees to move to Southern California because the cost of living is too high. The second problem will lessen as house prices crash, but the first problem is not going away. We are paid too much in Irvine, and businesses are moving where skilled labor can be found less expensively; therefore, we many not see a continuation of 3% wage growth in Irvine for the future.

Wage Growth vs. House Appreciation

House appreciation cannot exceed wage growth forever: trees cannot grow to the sky. People have to earn money to buy a home (unless of course we become a nation of the landed gentry in which real estate is only transferred through inheritance.) Over the last 25 years, house appreciation in Orange County has outpaced wage growth. Wage growth has averaged 3.4% while house price appreciation has averaged 6.9%. Notice the bubble years (1986-1989) where house prices outpaced income growth followed buy bust years (1990-1995) where wage growth made modest recoveries. What is in our future?

Growth in Income and House Appreciation 1981-2006

There are only a couple of ways house prices can outpace wage growth: 1. interest rates must decline allowing people to finance larger sums with less money, and 2. debt-to-income ratios must rise as people put higher percentages of their income toward making payments. Both of these phenomenons have been occurring in Orange County over the last 25 years.

Interest Rates

Mortgage interest rates have been on a slow but steady decline since the early 1980’s. Interest rates were at historical highs in the early 80’s to curb inflation, and the decline from these peaks to the 7% to 9% range was to be expected. This initial decline in interest rates coupled with low inflation caused house prices to begin rising again in the late 80’s culminating in the bubble that burst in 1990 leading to 5 consecutive years of declining prices.

Mortgage Interest Rates 1981-2006

During the early 90’s while prices were declining, notice the drop in interest rates from 10.6% in 1989 to 7.2% in 1996. This 30% decline in interest rates made housing more affordable and help limit the declines in the early 90’s. If interest rates had not declined, house prices certainly would have dropped further than they did. Does anyone think interest rates will decline 30% from the 6.3% they are today down to an unprecedented 4.4% to match the debt relief of the early 90’s? The FED is not going to save house prices. In fact, today’s mortgage interest rates are likely not sustainable. The 6.3% today is 20% below the historic 8% average of the last half century due to global capital markets being awash with liquidity from Japan and China among others. With the declining dollar, growing national debt and inflation pressures, it is more likely that interest rates will rise rather than fall.

Debt to Income

Debt to Income Ratio 1981-2006

One of the often overlooked phenomenons of real estate bubbles is the fluctuations in debt-to-income ratios. DTI ratios is an interesting measure of buyer psychology. In market rallies people act with greed and put larger and larger percentages of their income toward purchasing houses because they are appreciating assets. In market busts, people put smaller and smaller percentages of their income toward house purchases because the value is declining.

Some of the bulls speculate that we have reached a permanently high plateau. This is crazy. The only thing justifying a DTI of 62% is the belief in high rates of appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment? Once it is obvious that prices are not increasing and even begin to decrease, the party is over. Why would you buy under those circumstances, when it is more rational to wait and pay less? Why would you stretch yourself to buy a house when prices are dropping? This is why prices drop until house payments match their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. When the market debt-to-income ratio falls below 30%, the bottom is near.

Future Appreciation Rates

As you can see from the charts above, interest rates are at all-time lows, and debt-to-income ratios are at an all-time high. Prices are going to fall — make that crash. This post isn’t about the crash, it is about the lack of appreciation in the aftermath. House prices over the last 25 years have appreciated at a rate greater than wage growth because interest rates have been falling and debt-to-income ratios have been rising. Interest rates cannot continue to fall. As they rise in the future to rates nearer their historic norms, house price appreciation will be held in check. It is likely that house prices will appreciate at rates of less than 3% while interest rates rise, and it will only match the 3% rate of wage growth thereafter. It is also possible that Irvine and Orange County may not see 3% wage growth in the future due to factor price equalization and outsourcing. Sustained appreciation rates of 7% will not be seen in the next 25 years — assuming of course we don’t have another bubble.

Buying after the crash

So what implication does all of this have on a future buying decision? Don’t count on appreciation. If you need to factor in appreciation to make the math work on a home purchase, you will buy too early, and you will pay too much.

Then again, you wouldn’t be alone. Pros make this mistake too. Some of you may have heard the story about one of our major homebuilders in Southern California who had to close their San Diego office due to poor performance. The president of the division routinely used high rates of appreciation in his financial models when analyzing properties to purchase. As a result, the San Diego division overpaid for almost all of its projects and lost the company a great deal of money. Usually, when a major company has problems at a division, they rotate staff. The problems here were so severe it was judged more prudent to wipe the division out and start over. Amazing.

When the cost of ownership is equal to the cost of rental it is safe to buy. Even if prices drop further — which they might — you will not be hurt by it. If you are counting on increasing rents or house price appreciation to get you to breakeven sometime later, you will probably get burned. Remember, appreciation is dead. Rest in Peace.

Housing Bubble Tombstone

Irvine's Quail Hill

Quail Hill SignThe Quail Hill neighborhood of Irvine is located south of the 405 between Sand Canyon Avenue and Highway 133. South of Quail Hill is a nature preserve and the exclusive Shady Canyon. The primary access is from Sand Canyon and through a unique roundabout. The community increases in elevation from the entry point at Sand Canyon and the 405 to the southernmost portion of the site. The hill gets steeper as you go south, and many of the larger homes on top of the hill have spectacular views of Orange County.

Quail Hill Map

Nearest the entry to the community is the main commercial center gathering place. This is another suburban plaza that functions to provide a sense of place for the community. It is the “third place” for those living in Quail Hill and Shady Canyon.

Quail Hill Center 1

The designers used a combination of trellis work and glass enclosures to define the space and provide noise and wind buffering from the parking lot.

Quail Hill Center 2

An attractive water feature serves as a focal point for the center, and the falling water serves to mask the noise of cars moving in the parking area.

Quail Hill House 1

The homes in Quail hill are attractive and varied, although some of the neighborhoods are a bit too dense, in my opinion.

Quail Hill House 2

The front yards are typically elaborate landscaping rather than grass.

Quail Hill School

Alderwood Basics Plus School is a California Distinguished School typical of the high quality schools in the Irvine Unified School District.

Quail Hill View

The view from of the parks and houses is wonderful; however, the north exposure in Irvine means you don’t get sunsets over the ocean, but you get city lights and distant vistas. Nice place for a picnic, wouldn’t you say?

Quail Hill Park 1

The parks have gathering places for people of all ages.

Quail Hill Pool

The pools are all of the highest quality, and many offer panoramic views from your lounge chair.

Quail Hill Park 2

The children’s tot lots are some of the best in Irvine. They play areas are well landscaped and the groundcover is either sand or a soft rubberized compound which minimizes potential for injury.

Quail Hill Park 3

There are associated gathering areas for adults to have a small group of friends congregate around a fire.

Quail Hill Park 4

Did I mention the view? In case you wanted to enjoy the view while your children played below…

Irvine’s Quail Hill: a great place to live.

Knife Catcher Award

I am introducing an new honor at the Irvine Housing Blog: the Knife Catcher Award. This dubious distinction goes out to all the knife-catchers stupid enough to attempt to flip a property in this declining market.

As you can see the knife-catcher is poised to eviscerate any greedy flipper with a death by a thousand cuts: a slow bleed of monthly cashflow and depreciation. To be eligible for the knife catcher award, the property must be put for sale within 6 months of purchase, and it must look like it has little or no chance of success (admittedly, the last hurdle is not very high).

One would think properties put for sale immediately after purchase would be difficult to find. Some may be bank repossessions, but some are simply delusional kool-aid drinkin’ fools who really believe this “softness” in the market is temporary and they are betting on the speedy return of double-digit appreciation. There is a special measure of schadenfreude for these fools worthy of unique honor on this blog. So without further delay, our first knife catcher award goes to…

Hayward FrontHayward Kitchen

IrvineRenterAsking Price: $567,900

Purchase Price: $505,750

Purchase Date: 2/13/2007

Address: 162 Hayward, Irvine, CA 92602

Beds: 2

Baths: 2Knife Catcher Award

Sq. Ft.*: 1,550

Year Built: 2002

Stories: 2

Type: Condominium

Neighborhood: Northpark

$/Sq. Ft.*: $366

MLS: P570133

Status: Active on market

On Redfin: 20 days

From Redfin: “Beautiful townhome in Northpark with cathedral ceilings. Turn key condition with fireplace in living room. Balcony and windows provide great view of area. Large kitchen. Separate laundry room. Huge two car garage with direct access. Separate formal dining room next to kitchen. Private large master bedroom. Lots of storage throughout. Floor plan is excellent. All the rooms are large. Northpark has many amenities for all ages. Quick access to freeways and shopping.”

This flipper couldn’t even be bothered to replace the tile counters with granite. The unit appears to be empty, so the bleeding has already begun. I have to wonder if this isn’t a realtor or a bank. If this seller pays a full 6% commission, they only stand to make about $28,000. IMO, it doesn’t seem worth the risk. However, if it is an agent paying only half a commission, this could net them $50,000 in just a few months making it at least worth dreaming about.

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Today’s knife catcher award is a double feature as a neighboring property is also a 2007 flip…

Lockford FrontLockford Kitchen

IrvineRenterAsking Price: $590,000

Purchase Price: $545,000

Purchase Date: 1/31/2007

Address: 259 Lockford, Irvine, CA 92602

Beds: 2

Baths: 2Knife Catcher Award

Sq. Ft.*: 1,496

Year Built: 2002

Stories: 3

Type: Condominium

View: Mountain

Neighborhood: Northpark

$/Sq. Ft.*: $394

MLS: U7001632

Status: Active on market

On Redfin: 7 days

From Redfin, “Auburn at Northpark community. Great end unit location directly across from the pool and park. Dramatic 20 ft. ceilings, and decorator touches. Upgraded sile stone counters in kitchen which is open to a great room, great condition, ceiling fans, windows in 2 car tandem garage. Office area outside master bedroom. Home shows well and has easy access for viewing. Washer, Dryer and Refrigerator included. Wonderful gated community with basketball courts, parks and nature trails. For lease also @$2500”

Another treasure trove of interesting information. My first observation is the price to rent ratio of 218 — assuming this floplord could actually get $2,500 a month. I doubt they will get that much rent as there are many better properties in better neighborhoods for less. My guess is a rent ratio of 250 leaving a $2,180 rent is more realistic. Since this flipper has fantasies, let ’em dream. Also, because it is being offered for lease, this isn’t a bank REO.

Another item I found interesting was the photographs. Notice the 2006/10/31 date? It is possible the buyer took these photos and later used them in the MLS listing, but is is also possible these photos came from the previous listing and the same realtor is involved in both transactions. These photos were taken 3 months before the closing, so it was either a very patient buyer, or these were realtor photos.

Knife Catcher AwardSo there you have our first knife catcher award. In the future, you will know these special flips by the knife catcher image next to the property breakdown as it was displayed above. If anyone notices when these sell or rent, please email me at irvinerenter@irvinehousingblog.com and I will be sure to update everyone on the carnage.

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BTW, Redfin updated its look last night. Check it out.

A brief introduction

Hello fellow irvinehousing blog readers. First I’d like to thank zovall and irvinerenter for inviting me to join them and irvinesinglemom as a contributor to the blog. Have no fear readers the failed flips will not go away and if anything we may have more. I decided to join them because I was not adding new posts to my blog ocecon101 which led to little traffic and even less motivation on my part to add new topics. Zovall thought that having me post here would get better traffic without the pressure on me to keep adding new posts. The idea is to add more content without taking anything away from the original purpose of the blog. Most come here searching for more information on the Irvine housing market and my goal is to add interesting and relevant content for those in search of more information.

For my first post I will give you a little background on myself, why I am a housing bear and what subjects I will be writing about. As some of the readers of the forums here know that I was in the mortgage business and for the majority of my time in the business it was for a lender for one of the larger homebuilders. I decided to leave the business for various reasons but it was on my own terms. I really did enjoy working there and gained a tremendous amount of knowledge from it. I am very thankful for all of great people I met there and remain friends with many of them today. I may in the future post topics on some of the reasons why I left if the curiosity is there.

Even though I am a homeowner I am a housing bear. The appreciation simply does make sense as there is no way I could afford my home that I bought in 2002 today. My income has increased more than inflation but housing prices have soared way beyond my income and many others in OC. I am also an investment property owner and I would like to buy more but I have this unique requirement called positive cash flow. Since 2004 it has been almost impossible to find and 2-4 unit investment property any where in OC with positive cash flow. Depreciation is supposed to offset your income from the property not your regular income.

I am a born and raised OC native who remembers the last crash in the 90s and I will be posting topics on the similarities that we are seeing today. My first topic on my blog has the headlines from the OC Register on housing from 1987 through 1993 and it really is not all that different than this time. I also will be posting about the economy and how it relates to housing. It may not be specifically Irvine but Irvine will be affected from these factors too.

Coming soon will be a post on a deeper look into the jobs in OC and what history can tell us.