Monthly Archives: January 2010

Fundamental Valuation of Houses – Part 1

What they are saying about The Great Housing Bubble

“The author, Larry Roberts, is best known for his daily posts as
IrvineRenter on the Irvine Housing Blog. Long before Lehman crashed,
Fannie Mae was taken over, and even before home prices were dropping
nationally, he was one of the few voices presenting real information on
the housing bubble.

The author’s background is in new housing development in Southern
California. It was a good start to understanding how things worked.
Supplemented by knowledge from countless posters at the housing blog,
he has been able to show why home prices couldn’t stay elevated. Price
to income ratios, price to rent ratios, and other factors detailed in
the book showed how far out of line prices had become by 2006. A full
year before house prices started to crash, he was predicting it, and
many of the crash’s details. While some people are permanently bullish
or bearish on housing, the best are able to understand and explain the
mechanisms, tell you what will happen in what sequence.

The Great Housing Bubble is an excellent read, and an important one.”

Brian WhitworthPrincipal, FinancialPatents.com

Fundamental Valuation of Houses

The fundamental value of all housing prices is equivalent rents.
Rents define the fundamental value of real estate because rental is a
direct proxy for ownership; both rental and ownership provide for
possession of property. Equivalent rents are a major component of the
United States Government’s Consumer Price Index (CPI). [1] According
to the US Department of Labor, “This approach measures the change in
the price of the shelter services provided by owner-occupied housing.
Rental equivalence measures the change in the implicit rent, which is
the amount a homeowner would pay to rent, or would earn from renting,
his or her home in a competitive market. Clearly, the rental value of
owned homes is not an easily determined dollar amount, and Housing
survey analysts must spend considerable time and effort in estimating
this value.” Prior to the first California housing bubble in the late
1970s, the housing cost component of the CPI was measured using actual
price changes in the asset. When this bubble created an enormous
distortion in this index, the rental equivalence model was constructed.
It has been used to smooth out the psychologically-induced housing
price bubbles ever since.

An argument can be made for the real cost of construction as the
fundamental valuation of houses. If house prices in a market fall below
the cost of new construction, no new houses will be built because a
builder cannot make a profit. If there is continuing demand for
housing, the lack of supply will create an imbalance which will cause
prices to increase. When new construction becomes profitable again, new
product will be brought to market bringing supply and demand back into
balance. If demand continues to be strong, builders will increase
production to meet this demand keeping prices near the real cost of
construction.

Based on a theory of rational market participants, one would expect
that when prices go up and the cost of ownership exceeds the cost of
rental, people choose to rent rather than own, and the resulting drop
in demand would depress home prices: The inverse would also be true.
Therefore, the proxy relationship between rental and ownership would
keep home prices tethered to rental rates. However, this is not the
case. [ii] If there were only a consumptive value to real estate, the
cost of ownership and the cost of rental probably would stay closely
aligned; however, since there is an opportunity to profit from
speculative excesses in the market, rising prices can lead to
irrational exuberance as buyers chase speculative gains.

Rental rates tend to keep pace with wages because people normally
pay rent out of current income. As people make more money, they compete
for the available rentals and drive prices up at a rate about 1%
greater than the overall rate of inflation. [iii] There are times when
supply and demand issues in local markets create fluctuations in this
relationship, but as a rule, rents track wages pretty closely. Since
house prices are tied to rents, and rents are tied to wages, house
prices are indirectly tied to wages. When house prices increase faster
than wage growth, the price levels become unsustainable, and if the
differential is too great, a bubble is inflated. [iv]

Figure 10: National Rent-to-Income Ratio, 1988-2006

Ownership Cost Math

A useful way to look at the cost of housing is to evaluate the total
monthly cost of ownership. There are 7 costs to owning a house.
Although some of these costs are not paid on a monthly basis, they can
be evaluated on a monthly basis with simple math. These costs are:

  1. 1. Mortgage Payment
  2. 2. Property Taxes
  3. 3. Homeowners Insurance
  4. 4. Private Mortgage Insurance
  5. 5. Special Taxes and Levies
  6. 6. Homeowners Association Dues or Fees
  7. 7. Maintenance and Replacement Reserves

Mortgage Payment

The mortgage payment is the first and most obvious payment because
it is the largest. It is also an area where people take risks to reduce
the cost of housing. It was the manipulation of mortgage payments that
was the focus of the lending industry “innovation” that inflated the
housing bubble. The relationship between payment and loan amount is the
most important determinant of housing prices. This relationship changes
with loan terms such as the interest rate, but it is also strongly
influenced by the type of amortization, if any. Amortizing loans, loans
that require principal repayment in each monthly payment, finance the
smallest amount. Interest-only loan terms finance a larger amount than
amortizing loans because none of the payment is going toward principal.
Negatively amortizing loans finance the largest amount because the
monthly payment does not cover the actual interest expense.

Property Taxes

Property taxes have long been a source of local government tax
revenues. Real property cannot be moved out of a government’s
jurisdiction, and values can be estimated by an appraisal, so it is a
convenient item to tax. In most states, local governments add up the
cost of running the government and divide by the total property value
in the jurisdiction to establish a millage tax rate. California is
forced to do things differently by Proposition 13 which effectively
limits the appraised value and total tax revenue from real property.
[v] Local governments are forced to find revenue from other sources.
Proposition 13 limits the tax rate to 1% of purchase price with a small
inflation multiplier allowing yearly increases. [vi] The assessed value
can only increase 2% a year regardless of actual market appreciation.
The assessed value is set to market value when the property is sold.
Often the lender will compel the borrower to include extra money in the
monthly payment to cover property taxes, homeowners insurance, and
private mortgage insurance, and these bills will be paid by the lender
when they come due. If these payments are not escrowed by the lender,
then the borrower will need to make these payments. The total yearly
property tax bill can be divided by 12 to obtain the monthly cost.

Homeowners Insurance

Homeowners insurance is almost always required by a lender to insure
the collateral for the loan. Even if there is no lender involved, it is
always a good idea to carry homeowners insurance. The risk of loss from
damage to the house can be a financial catastrophe without the proper
insurance. A standard policy insures the home itself and its contents.
Homeowners insurance is a package policy which covers both damage to
property and liability or legal responsibility for any injuries and
property damage by the policy holder. Damage caused by most disasters
is covered with some exceptions. The most significant exceptions are
damage caused by floods, earthquakes and poor maintenance.

Private Mortgage Insurance

Mortgages against real property take priority on a first recorded,
first paid basis. This is known as their lien position. This becomes
very important in instances of foreclosure. The first mortgage holders
get paid in full before the second mortgage holder get paid and so on
through the chain of mortgages on a property. In a foreclosure
situation, subordinate loans are often completely wiped out, and if the
loss is great enough, the first mortgage may be imperiled. Because of
this fact, if the purchase money mortgage (first lien position) exceeds
80% of the value of the home, the lender will require the borrower to
purchase an insurance policy to protect the lender in event of loss.
This policy is of no use or benefit to the borrower as it insures the
lender against loss. It is simply an added cost of ownership. Many of
the purchase transactions during the bubble rally had an 80% purchase
money mortgage and a “piggy back” loan of up to 20% to cover the
remaining cost. These loan pairs are often referred to as 80/20 loans,
and they were used primarily to avoid private mortgage insurance. There
were very common during the bubble.

Special Taxes and Levies

Several areas have special taxing districts that increase the tax
burden beyond the normal property tax bill. Many states have provisions
which allow supplemental property tax situations. The State of
California has Mello Roos fees. A Community Facilities District is an
area where a special tax is imposed on those real property owners
within the district. This district is established to obtain public
financing through the sale of bonds for the purpose of financing
certain public improvements and services. These services may include
streets, water, sewage and drainage, electricity, infrastructure,
schools, parks and police protection to newly developing areas. The
taxes paid are used to make the payments of principal and interest on
the bonds.

Homeowner Association Dues and Fees

Many modern planned communities have homeowners associations formed
to maintain privately owned facilities held for the exclusive use of
community residents. These HOAs bill the owners monthly to provide
these services. They have foreclosure powers if the bills are not paid.
It is given the authority to enforce the covenants, conditions, and
restrictions (CC&Rs) and to manage the common amenities of the
development. It allows the developer to legally exit responsibility of
the community typically by transferring ownership of the association to
the homeowners after selling off a predetermined number of lots. Most
homeowners’ associations are non-profit corporations, and are subject
to state statutes that govern non-profit corporations and homeowners’
associations. In cases where a large number of houses are unsold, in
foreclosure, or are owned by lenders, remaining homeowners may
encounter large increases in assessments. In some cases, the additional
cost can become unaffordable to remaining homeowners pushing more of
them to sell or be foreclosed on by their own homeowners association.

Maintenance and Replacement Reserves

An often overlooked cost of ownership is the cost of routine
maintenance and the funding of reserves for major repairs. For example,
a composite shingle roof must be replaced every 20-25 years. It may
take $100 a month set aside for 20 years to fund this replacement cost.
Also, condominium associations often levy special assessments to
undertake required work for which the reserves are insufficient. In the
real world, most people do not set aside money for these items. Most
will attempt to obtain a Home Equity Line of Credit (HELOC) to fund the
repairs when they are necessary. Of course, this assumes a property has
appreciated and that such financing will be made available.

Tax Savings

There are two other variables people often consider when evaluating
the cost of ownership that is not included in the prior list: income
tax savings and lost downpayment interest. When a borrower takes out a
home loan, the interest is tax deductible up to a certain amount. For
borrowers in the highest marginal tax bracket, the savings can be
significant, and this can make a dramatic difference in the true cost
of ownership. However, this benefit diminishes over time as the loan is
paid off and the interest decreases. Plus, contrary to popular belief,
it is never good financial planning to spend $100 to save $25 in taxes.
Also, these benefits are almost universally overestimated by people
considering a home purchase. Renters considering home ownership will
need to remember that they will be giving up the standard deduction
when they itemize to obtain the Home Mortgage Interest
Deduction (HMID). [vii] A “married filing jointly” taxpayer will forgo
a $10,700 deduction in 2007. This reduces the net impact of the HMID.
Anecdotally, even those in the highest tax brackets usually do not get
more than a 25% tax savings.

Hidden Savings

This is the forgotten benefit of a conventionally amortizing loan:
forced savings. Most people are not good at saving. The government
recognized this years ago when they started taking money out of
people’s salaries to pay income taxes because they knew people would
not do it on their own. People who become homeowners during their
lifetimes often have the equity in their home as their only source of
retirement savings other than social security. To accurately calculate
the cost of ownership, this hidden savings amount needs to be deducted
from the total cost of ownership because this money will generally come
back to the borrower at the time of sale. Since taxpayers in the United
States get a capital gains exemption up to $250,000 per person or
$500,000 per couple, this savings amount does not need to be adjusted
for capital gains taxes in most circumstances.

Lost Downpayment Interest

Unless 100% financing is utilized, a cash downpayment will generally
be withdrawn from an interest bearing account to purchase a house. The
monthly interest that would have accrued if the downpayment money was
still in the bank is a cost of ownership. This is perhaps the most
overlooked ownership cost. For instance, if you are putting 20% down on
a $244,900 property, you will be taking $48,980 from a bank account
where it would have earned 5% in 2007. This $2,449 in interest comes to
$204 in lost interest the moment this money gets tied up in real
property. If someone chooses to rent rather than buy, this interest
income would be earned. Of course, this earned income is also taxed, so
75% of this number is the net opportunity cost of a downpayment.

To establish the cost of ownership, each of these costs, if
applicable, must be quantified. When the total monthly cost of
ownership is equal to the rental rate, the market is considered to be
at fair value for owner-occupants. In fact, this is the equilibrium in
most real estate markets across the nation. In a strange way, the
bubble did not upset this equilibrium. The use of negative
amortization loans with artificially low teaser rates allowed borrowers
to obtain double the loan amount with the same monthly payment: double
the loan; double the purchase price. This is how prices were bid up so
high so fast without a commensurate increase in wages. The elimination
of these loans is also the reason prices collapse.

Running the Numbers

Below is a typical cost of ownership for a $244,900 Median property in the US (2006):

Equation 1: Cost of Ownership for 2006 Median Property in United States

$ 244,900

Purchase Price

$ 48,980

Downpayment @20%

$ 195,920

Mortgage @ 80%

$ 1,238.35

Mortgage Payment @ 6.5%

$ 204.08

Property Taxes @ 1%

$ 51.02

Homeowners Insurance @ 0.25%

$ 51.02

Special Taxes and Levies @ 0.25%

$ 100.00

Homeowners Associate Dues or Fees @ $100

$ 306.13

Maintenance and Replacement Reserves @1.5%

$1,950.60

Monthly Cash Cost

$ (278.06)

Tax Savings @ 25% of mortgage interest and property taxes

$ (177.11)

Equity hidden in payment

$ 153.06

Lost Downpayment Income @ 5% of Downpayment

$ 1,648

Total Cost of Ownership

Notes:

  • The mortgage payment assumes a 30-year fixed-rate conventionally amortized mortgage at 6.5% interest.
  • The property taxes are set at the 1% limit imposed by Proposition 13.
  • The homeowners insurance is estimated at one-quarter of one percent per year.
  • Private Mortgage Insurance is estimated at one-half of one percent
    per year. It is not included in the calculation above because this
    example utilized 80% financing. If the financing amount required PMI,
    the costs would have been over $100 a month higher.
  • Special Taxes or Levies (Mello Roos) is estimated at one-quarter of
    one percent per year. Some neighborhoods do not have Mello Roos as the
    bonds have been paid off. Some Mello Roos fees are as high at 1%.
  • HOA dues are estimated at $100: some are lower, and some are much higher.
  • Maintenance and replacement reserves are estimated at 1.5%. This
    may be the most contentious estimate of the group because most people
    assume they will simply borrow their way around these costs when they
    are incurred. This certainly has been the pattern during the bubble
    years when credit was free flowing. This method of home improvement and
    maintenance may be significantly more difficult as the credit
    crunch and declining values make financing much more difficult to
    obtain. In any case, these costs are real, and failing to acknowledge
    them denies the realities of home ownership.
  • The sum of the above costs is the monthly cash cost of ownership. A
    homeowner may not write a check for each of these costs every month,
    but the costs are still incurred, and renters do not pay them.
  • The tax savings are based on the maximum interest payment at the
    beginning of a loan amortization schedule. This tax savings will
    decline each month as the mortgage is paid off. Contrary to popular
    belief, this is not a bad thing. Also, the property taxes are also
    deductable, but Mello Roos are not fully deductible (even though most
    people mistakenly deduct it).
  • The opportunity cost of lost interest assumes a 5% interest rate on
    the downpayment reduced by 25% for taxes on this earned income.

The actual cost of ownership on a typical $244,900 property would be
approximately $1,648 per month. Some will be higher and some will be
lower, but the calculation above, when adjusted for the specific
property details being examined, yields the cost of property ownership.

Price-to-Rent Ratio

So what general relationships can be inferred from the ownership
cost breakdown provided above? First, notice the relationship between
monthly cost and price. This property is worth 154 times the monthly
cost when you fully examine the cost of ownership. Also, notice the
relationship between monthly payment and price. This property is worth
198 times the monthly payment. Common mistake homebuyers make when
considering a home purchase is to look at only the payment and ignore
the other costs of ownership. Most assume, or have been told by
realtors and mortgage brokers trying to make a commission that the tax
benefits offset the other costs of ownership. Clearly, this is not the
case. The true cost of ownership is about 30% higher than the monthly
payment.

The price-to-cost and price-to-payment relationships become
important when one wants to evaluate the relative value of the property
compared to market rents. Since housing is a consumer good that can be
obtained through either renting or owning, it is rational to compare
the costs of each method of possessing property to see which provides a
better value to the consumer. Just as stocks have price-to-earnings
ratios (PE Ratios) used to establish relative value, houses have a
price-to-rent ratio to establish relative value. [viii] When a property
can be rented for an amount equaling its monthly cost of ownership, it
is at rental parity. This is the breakeven point where a consumer would
be indifferent in financial terms to own or to rent. Of course there
are reasons to own or to rent which are not financial, but from a
strictly financial standpoint, this is where the fundamental value lies.

The price-to-rent ratio is very sensitive to changes in interest
rates. When interest rates are low, the cost of money is low, so larger
sums can be borrowed and vice-versa. Nationally, the price-to-rent
ratio increased steadily from 1988 through 2004 in a range from 157 to
199 while mortgage interest rates declined from 10.34% in 1988 to 5.84%
in 2004. This increase in price was mostly the result of lowered
interest rates as the out-of-pocket expense remained relatively
constant. The dramatic increase in prices after 2004 was not supported
by incomes or rents, and it is part of the evidence of a real estate
bubble. [ix]

The price-to-rent ratio is also the basis for a commonly used
valuation measure used in the property management business, the Gross
Rent Multiplier (GRM). The GRM is a convenient way to evaluate whether
or not a rental rate will cover the monthly cost of a particular
property. It was developed by landlords seeking a method to quickly
evaluate the purchase price of a property to see if it would be a
profitable investment. When performing such an evaluation, a cashflow
investor will typically look for a GRM near 100 to find a property with
positive cashflow. This method can also be easily adapted to calculate
the breakeven point where an owner/occupant would break even compared
to renting. Considering the full cost of ownership–including those
costs often ignored–the price-to-rent ratio and Gross Rent Multiplier
is lower than most think. The GRM is a convenient measure of value
because it spares you the toil of performing the above, detailed
calculation to evaluate a large number of properties.

Figure 11: National Price-to-Rent Ratio, 1988-2007



[1] There are a number of research papers discussing the pros and
cons of various methodologies for calculating equivalent rent. Hedonic
Estimates of the Cost of Housing Services: Rental and Owner-Occupied
Units (Crone & Nakamura, 2004) Treatment of Owner-Occupied Housing in the CPI (Poole, Ptacek, & Verbrugge, 2005).

[ii] Robert Shiller noted “that real owners’ equivalent rent and
real building costs track each other fairly well, as one might expect.
But neither of them tracks real home prices at all, suggesting that
some other factor – I will argue market psychology – plays an important
role in determining home prices.”

[iii] Depending on the market, rental rates grow at a rate around 1%
over the rate of inflation. Rental rates are closely aligned with
income growth, and in markets where income growth is strong, rental
rates increase at approximately the same rate.

[iv] John Krainer, chief economist for the Federal Reserve Bank of
San Francisco, pointed out in 2004 “The price-rent ratio for the U.S.
and many regional markets is now much higher than its historical
average value.” (Krainer & Wei, House Prices and Fundamental Value, 2004) This is one of the first papers (other than those by Robert Shiller) to recognize the data was pointing to a housing bubble.

[v] The full text of the Proposition 13 law can be found at http://www.leginfo.ca.gov/.const/.article_13A

[vi] In California, the first half of regular secured property tax
bills are due November 1st, and delinquent after December 10th; the
second half are due February 1st, and delinquent after April 10th each
year. If the delinquent date falls on a Saturday, Sunday, or government
holiday, then the due date is the following business day.

[vii] All information regarding tax rates comes from the Internal Revenue Service. http://www.irs.gov/

[viii] There are many studies that have mentioned the use of
price-to-rent ratios as being similar to price-to-earnings ratios of
stocks. Some of the studies are good, and some are not. Bubble, bubble,
toil and trouble is of the latter variety (Haines & Rosen, 2006).
Typical of these studies is that they will look at the data, see the
obvious signs of a bubble, and proceed to dismiss the obvious as
something else. Even though the national data for price-to-rent clearly
shows a bubble, even in their own graphs, the authors dismiss the idea
because “all real estate is local.” The paper was written for the
Federal Reserve, but it could have been written for the National
Association of Realtors. Another silly statement they make is “Thus,
what appears to be a bubble in some markets might just be a reflection
of normally high volatility in those markets.” This is like saying
“what appears to be a bubble isn’t a bubble because bubbles are normal
in these markets.” When the authors can look right at the data and not
understand what they are seeing, there is little hope the paper will
draw the right conclusions.

[ix] The study A Trend and Variance Decomposition of the Rent-Price
Ratio in Housing Markets by Sean D. Campbell, Morris A. Davis, Joshua
Gallin, and Robert F. Martin (Campbell, Davis, Gallin, & Martin, 2005)
uses method of estimating the investment premium people pay for homes
in bubble markets based on the expectation of future rental growth.
This entire approach is flawed as it assumes people are investing based
on cash flows. This would be a rational approach, but most people who
buy in financial manias know little or nothing about cashflow or how to
value it. The real reason they are “investing” is to capture
speculative price changes. Trying to determine a fundamental valuation
based on cashflow is an interesting exercise in math and statistics,
but it completely fails to capture the real motivation behind buyers in
the marketplace.

IHB News 1-30-2010

Anyone going to the Irvine Company model homes this weekend? They've hit the reset button on our housing market, so it's time to start all over.

55 PLANTATION Irvine, CA 92620 kitchen

Irvine Home Address … 55 PLANTATION Irvine, CA 92620

Resale Home Price …… $849,000

{book1}

We can break the cycle – We can break the chain

We can start all over – In the new beginning

We can learn, we can teach

We can share the myths the dream the prayer

The notion that we can do better

Change our lives and paths

Create a new world and

Start all over

Start all over

Start all over

Start all over

New Beginning — Tracy Chapman

IHB News

Irvine Company Opens New Models

In case you have been hiding under a rock, I want to let you know that the Irvine Company is opening its new models to the general public this weekend. I will likely go visit myself soon and blog about what I see. As an industry observer and participant, and Irvine resident, I want to see them be successful. The success of the Irvine Company is inexorably tied to the success of Irvine itself. As they do good work, we live the results.

House of Blues Benefit Reminder

A long time reader of the Irvine Housing Blog recently contacted us for our support.

Todd Larsen, director of the Irvine Music Academy has been struck with leukemia at age 44. He was the family's sole wage earner taking care of his wife and 10 month old son by teaching music and coaching swim lessons in Irvine.

Thankfully Todd has great health insurance but unfortunately did not have disability insurance. As you can imagine his family's world has been turned upside down. The Irvine community has been holding walk-a-thons and auctions to help the family make ends meet. (Click below to read more about how the Irvine community is rallying around the family – the second link is to Todd's blog where tickets to the event can be purchased.

http://www.ocregister.com/articles/larsen-todd-family-2606906-leukemia-supporters)

Tickets to the event can be purchased on Todd's blog at http://www.toddrockinleukemia.blogspot.com/.

Housing Bubble News from Patrick.net

In Foreclosure 101: Non-Judicial Foreclosure, I discussed how mortgage debt is not discharged, and lenders can still try to collect from borrowers. Bloomberg, Calculated Risk and Mish all had articles on that subject this week.

Lenders Pursue Mortgage Money Long After Houseowners Default (bloomberg.com)

Fed Keeps "Extended Period" Pledge To Screw Savers; Hoenig Dissents (bloomberg.com)

So. CA Shadow Inventory (doctorhousingbubble.com)

Bankers have a NEGATIVE value to the rest of us (bloomberg.com)

Fed Weighs Interest on Reserves as New Policy Rate (bloomberg.com)

Unemployment rises in 43 states (articles.moneycentral.msn.com)

Fed Buys Another $12bn of Fannie, Freddie Crap With Counterfeit Money (housingwire.com)

Rents Fall to 3 1/2 Year Low in Orange County (calculatedriskblog.com)

No bottom

Outlook for housing market muddied by anemic rise in prices (latimes.com)

Housing Market: Even More Pain in Store? (foxbusiness.com)

Bottom In House Prices, a Decade Away (zerohedge.com)

Housing recovery could take a decade, say optimists (washingtonpost.com)

House values won't regain bubble heights for AT LEAST a decade (latimes.com)

Home sales decline

House Sales, uh, "Worse Than Expected" in December (nytimes.com)

House Sales See Biggest Monthly Drop In 40 Years (npr.org)

Existing House Sales: The Lemmings Slow Down (seekingalpha.com)

Foreclosures

Foreclosure plague: 2009's worst-hit cities (money.cnn.com)

10% of Merced Houses Are In Foreclosure (centralvalleybusinesstimes.com)

Fear and foreclosure in Las Vegas (telegraph.co.uk)

28% of Orlando-area rental apartments, condos, town houses vacant (orlandosentinel.com)

Hawaii Foreclosures Reach Record High for December (abcnews.go.com)

New Home Sales

New-House Sales Fall, Capping Worst Year (bloomberg.com)

US housing news keeps world markets in retreat (sfgate.com)

Excess Supply of Existing Houses For Sale Equals 600,000 Units (newobservations.net)

Miscellaneous

The Lessons of Oregon's Vote to Tax the Rich (business.theatlantic.com)

Inflation: An Old People's Disease (greatdepression2006.blogspot.com)

Banks defeated soverereignty of USA (seekingalpha.com)

Why Are We Donating $2,000 Per Family to Wall Street Bonuses? (huffingtonpost.com)

The Fed: Reappoint Captain Smith of the Titanic? (newgeography.com)

Doing the Bernanke Dance: Rational Irrationality (newyorker.com)

What us, worry? Banks double down on risk (reuters.com)

The Only Country With No Debt (kitco.com)

The New Mortgage Revolution: Walk Away (housingwatch.com)

Insider's View of the U.S. Real Estate Train Wreck (marketoracle.co.uk)

It only gets worse this year for commercial real estate (mcclatchydc.com)

Housing Unaffordability as Public Policy (newgeography.com)

Tishman's "Strategic Default" on Stuyvesant Town in NYC (blogs.wsj.com)

No worries about "morality" in biggest real estate default in history (finance.yahoo.com)

Dummy Bidding: Inside real estate auction's notorious fraud (jenman.com.au)

West Coast Wasteland (thenation.com)

Housing bust keeps consuming California jobs (latimes.com)

The new breed of perma-renters (marketplace.publicradio.org)

2010: The Year of the Renter? (nytimes.com)

What Could You Live Without? (nytimes.com)

The housing bust and what to expect next (opednews.com)

Excellent Explanation of Bubble (debtdeflation.com)

Volcker Rule Vindicates Former Fed Chief (bloomberg.com)

Stakes are high as government plans exit from mortgage markets (washingtonpost.com)

55 PLANTATION Irvine, CA 92620 kitchen

Irvine Home Address … 55 PLANTATION Irvine, CA 92620

Resale Home Price … $849,000

Income Requirement ……. $178,405

Downpayment Needed … $169,800

20% Down Conventional

Home Purchase Price … $678,000

Home Purchase Date …. 12/27/2007

Net Gain (Loss) ………. $120,060

Percent Change ………. 25.2%

Annual Appreciation … 10.4%

Mortgage Interest Rate ………. 5.13%

Monthly Mortgage Payment … $3,700

Monthly Cash Outlays ………… $4,730

Monthly Cost of Ownership … $3,470

Property Details for 55 PLANTATION Irvine, CA 92620

WTF

Beds 3

Baths 2 full 1 part baths

Home Size 1,964 sq ft

($432 / sq ft)

Lot Size n/a

Year Built 2007

Days on Market 2

Listing Updated 1/28/2010

MLS Number S603288

Property Type Condominium, Residential

Community Woodbury

Tract Wdst

BEAUTIFUL HOME IN PRESTIGOUS WOODBERRY!! STONETREE MANOR WAS BUILT BY JOHN LAING HOMES**DESIRABLE FLOORPLAN OFFERS MAIN FLOOR BEDROOM AND AN ADDITIONAL MAIN FLOOR DEN/STUDY**MANY UPGRADES INCLUDE GRANITE KITCHEN COUNTERTOPS AND LARGE ISLAND**KITCHEN AID STAINLESS STEEL APPLIANCES***SECOND BEDROOM OFFERS PRIVATE BATH**BAMBOO FLOORING**TUMBLED MARBLE FLOORING IN ALL BATHS**DESIGNER CELING FANS IN ALL BEDROOMS AND CUSTOM PAINT**HUNTER DODUGLAS WOOD BLINDS THROUGHOUT**INSIDE LAUNDRY ROOM**MASTER OFFERS DUAL SINKS WALK- IN WARDROBE CLOSEST.MASTER SINKS AND TUB w MARBLE BACK SPLASH*RECESSED LIGHTING*ATTACHED TWO CAR GARAGE W/ BUILT-INS.

WOODBERRY!! Does an embarrassing misspelling like that make you want to cringe?

Is there something wrong with a period as end-stop punctuation? Is using two or three asterisks more efficient?

The Changing Face of Flipping

Are flippers the scourge of the earth, or are they capitalists exercising their freedom to make money? Depending on the circumstances, most flippers are somewhere in between.

388 FALLINGSTAR 39 Irvine, CA 92614 kitchen

Irvine Home Address … 388 FALLINGSTAR 39 Irvine, CA 92614
Resale Home Price …… $549,000

{book1}

Dear Prudence, won’t you come out to play
Dear Prudence, greet the brand new day
The sun is up, the sky is blue
It’s beautiful and so are you
Dear Prudence won’t you come out to play

Dear Prudence open up your eyes
Dear Prudence see the sunny skies
The wind is low the birds will sing
That you are part of everything
Dear Prudence won’t you open up your eyes?

Look around round round
Look around round round
Oh look around


Dear Prudence
— The Beatles

Flips first attracted me to the Irvine Housing Blog. My wife discovered the IHB in November of 2006, and showed me property flips Zovall and IrvineSingleMom were profiling. I found flips funny because I foresaw flippers in the bag with bubble kool aid enduring equity seizure, and sadly to say, I enjoyed the schadenfreude (and picking on floplords).

Some notice that my attitudes and opinions about many facets of the housing bubble change over time. As circumstances change, new information becomes available, and hopefully with a small measure of wisdom from seeing a bigger picture, my views change — hopefully improve. Over the last year, I have been maligned by bulls for “missing the bottom” and various other spurious claims, and I have been attacked by the bears for losing my purity of vision and accepting that massive unprecedented government intervention may make the most dire of my prognostications unlikely. At times I feel like a politician hearing criticism from both extremes, but unlike a politician, I don’t have to please anyone; I need only report what I see and what I believe.

With that preamble, I want to look at flipping and relate my current opinion on the most common forms.

Knife Catcher Award

Retail Flipping

Retail flipping is the kind where a flipper purchases a normal resale home, does nothing with it while withholding it from the market briefly, then attempts to resell at a profit. Some will argue retail flipping is capitalism and the flipper earns money through taking risk. Fair enough, but consider the impact this has on families.

In a market without flippers, demand is lower, and so are prices. If a family buys a home, they pay less money, and any increase in value improves the family balance sheet. Contrast this to a flipper who is reselling for a profit; any increase in home value improves the flipper’s income statement, not his balance sheet. This income is robbed from the collective equity of families and instead is converted into flipper income, which in turn, provides a way of life for a person providing no tangible value to society (like realtors).

If retail flipping did not exist, many thousand people would no longer make money for nothing, and they would go find productive work.

Rehab Flipping

Rehab flippers, like many who watch HGTV, are at least attempting to add value to make a living. Most people who slap pergraniteel on property believe they are adding huge value, and many make a profit who have done this; however, the profit came not because they added great value, but because appreciation made money for everyone. The linkage of cause and effect — pergraniteel adds value — is deficient because improvements add about seventy cents value per dollar spent, and appreciation turns the loss into a gain — something painfully obvious to those who attempted rehab flipping since 2006.

The people who consistently make money rehab flipping are professionals who can add improvements at wholesale. For instance, a general contract can use his or her own crews to perform work at a cost less than its value resulting in profit. Only those with special advantages — or those willing to put in sweat equity — can make money this way.

Entrepreneurs investing their own time and effort to add value and make a profit are admirable, and when we see families doing it on HGTV, we can all relate. Wow! We can do that! We could either make money, or we could improve our balance sheet.

I have no problem with good rehab flipping that requires risk and special expertise. If these operators did not exist, our housing stock would quickly run down in marginal areas, and once dilapidated, it would never recover; think Detroit. Since retail flippers can’t make a living in a non-appreciating market environment, rehab flipping and Trustee Sale flipping will be the only successful flips over the next decade.

Trustee Sale Flipping

Trustee Sale flipping has the same dynamic as a rehab flip; a buyer risks cash to make a profit and takes special advantage of their cash.

Cash is king.

When a property is going to Trustee Sale, it is either going to be purchased by the first lien holder’s (lender’s) opening bid, or a third party must bid higher. In most cases these properties discount significantly from resale, and either the bank or the third party is going to obtain the resale finance market premium for buying at Trustee Sale: the bank hopes the additional funds will cover their processing losses and help them recover capital; the third-party buyer hopes to make a profit. Banks hope to improve their balance sheets while flippers improve their income statements.

Income Statement or Balance Sheet

The disdain for retail flipping and the delight in family rehab flipping are rooted in its impact on a family’s balance sheet. Retail flippers profit at the expense of family balance sheets, and family rehab projects improves it, but what about Trustee Sale flipping?

For reasons discussed at length in Foreclosure 101: Mechanics of a Trustee Sale, families rarely bid at Trustee Sales; consequently, Trustee Sales have no impact on family balance sheets. One of the things that appealed to me about offering a Trustee Sale Service was that we could put families into Trustee Sales, and the discount from resale is added to a family’s balance sheet rather than a bank’s balance sheet or a flipper’s income statement.

Have I gone soft on flips because I can make money off them? Perhaps I delude myself, but I don’t think so. When I put a family into a Trustee Sale and put equity on their balance sheet, I will feel I earned my fee.

388 FALLINGSTAR 39 Irvine, CA 92614 kitchen

Irvine Home Address … 388 FALLINGSTAR 39 Irvine, CA 92614

Resale Home Price … $549,000

Income Requirement ……. $115,104
Downpayment Needed … $109,800
20% Down Conventional

Home Purchase Price … $423,000
Home Purchase Date …. 11/4/2009

Net Gain (Loss) ………. $93,060
Percent Change ………. 29.8%
Annual Appreciation … 109.0%

Mortgage Interest Rate ………. 5.11%
Monthly Mortgage Payment … $2,387
Monthly Cash Outlays ………… $3,200
Monthly Cost of Ownership … $2,560

Property Details for 388 FALLINGSTAR 39 Irvine, CA 92614

Beds 3
Baths 2 full 1 part baths
Home Size 1,411 sq ft
($389 / sq ft)
Lot Size n/a
Year Built 1985
Days on Market 5
Listing Updated 1/19/2010
MLS Number S602409
Property Type Condominium, Townhouse, Residential
Community Woodbridge
Tract Sg

Gorgeous end unit townhome with hardwood floor. All newly upgraded/installed: Kitchen cabinets,Granite countertop,carpet,paint,baseboard,water heater,light switches,door knobs,blinds. No mello Roos assessment. Move-in ready.

Now that I point out the word “gorgeous,” do you see how overused it is?

This flipper is likely to discount this property to sell it quickly, but a significant amount of that $93,060 will be made, and it could have gone to provide security to a family instead.

Just Sayin’

Irvine Housing Blog No Kool Aid

I hope you have enjoyed this week, and thank you for reading the Irvine Housing Blog: astutely observing
the Irvine home market and combating California Kool-Aid since
2006.

Have a great weekend,

Irvine Renter

Irvine Home Improvements Show No Bounds

Today we have another over-improved property bought at the peak. Properties like these will rival the North Korea towers for the most foolish investments during the bubble.

15332 MONTPELLIER Ave Irvine, CA 92604 front 2

Irvine Home Address … 15332 MONTPELLIER Ave Irvine, CA 92604
Resale Home Price …… $1,250,000

{book1}

WTF

I know you’re still just a dream
Your eyes migth be green
Or the bluest that I’ve ever seen
Anyway you’ll be blessed

And you, you’ll be blessed
You’ll have the best
I promise you that
I’ll pick a star form the sky
Pull your name from a hat
I promise you that
I promise you that
Promise you that
You’ll be blessed

Blessed — Elton John

California real estate is truly blessed; you can spend unlimited amounts on acquiring and improving houses, and someone will always come along and pay enough for the owner to recoup all their foolish spending and then some. Back in October of 2009, I covered the topic of Superadequacy and looked back on a number over-improved homes littering the Irvine landscape.

Castle 1

Do you remember the
Castle at Kron and Ecclestone Circle? Or perhaps the monstrosity at Angell and Michelson? Or the Joke on Karen Ann Lane? The trend in over-improvement during the bubble is most noticeable in the omnipresence of pergraniteel.

During the bubble, the more you spent, the more you made. People
actually believed that adding common improvements — something anyone
could do to their own taste — would add more value than the
improvement cost. Flippers made money because they were there; breathing was the only prerequisite to success. Skill
and financial acumen had nothing to do with it, as evidenced by the losses they took when they were left holding the bag.

2 Angell Front

4931 Karen Ann Ln front

Home improvement and flipping shows became so common, they developed
their own channel. Like moths to a flame, fools flocked to flip houses.
The infamous flops are profiled here.

Today’s featured property is another one where you have to ask yourself, why?

Why did someone take an ordinary house — overpay for it — then
proceed to demolish it in favor of something that is vastly
over-improved for the area. This makes no sense. If this made sense, we
could drive our entire economy on building and rebuilding homes…
wait, we tried that once, didn’t we?

Yesterday’s featured property was another in the superadequacy genre.

111 HILLCREST   Irvine, CA 92603  inside111 HILLCREST   Irvine, CA 92603  kitchen

Over the last year or so, WTF asking prices have been somewhat less common as sellers simply did not bother. Now with a hint of stability in prices sellers are behaving as if the bubble never happened, the decline was a aberration, and prices have already surpassed the peak on their way to the moon.

15332 MONTPELLIER Ave Irvine, CA 92604 front 2

Irvine Home Address … 15332 MONTPELLIER Ave Irvine, CA 92604

Resale Home Price … $1,250,000

Income Requirement ……. $262,076
Downpayment Needed … $250,000
20% Down Conventional

WTF

Home Purchase Price … $770,000
Home Purchase Date …. 2/2/2006

Net Gain (Loss) ………. $405,000
Percent Change ………. 62.3%
Annual Appreciation … 12.3%

Mortgage Interest Rate ………. 5.11%
Monthly Mortgage Payment … $5,436
Monthly Cash Outlays ………… $6,630
Monthly Cost of Ownership … $4,620

Property Details for 15332 MONTPELLIER Ave Irvine, CA 92604 Superadequacy

Beds 5
Baths 5 baths
Home Size 3,800 sq ft
($329 / sq ft)
Lot Size 6,000 sq ft
Year Built 2007
Days on Market 10
Listing Updated 1/22/2010
MLS Number P718464
Property Type Single Family, Residential
Community El Camino Real
Tract Rc

Located in the heart of Irvine, spectacular and magnificent home custom designed by a renowned architect and completely remodeled in 2007, with spacious living room, dining room, family room, den, office, and 5 spacious bedrooms upstairs, each with attached full baths and built-in closet organizers. Top-notch materials, including imported travertine, wood, and bamboo flooring, iron-wrought stairway, upgraded crown molding, baseboards, and window treatments, all new electrical, plumbing, dual-pane windows, enhanced insulation, dual central AC/heating, and so much more to impress your guests. Gourmet kitchen with upgraded dark cabinetry, stainless steel appliances, and granite countertops. Upstairs laundry, large driveway, 3-car direct access garage, close to nearby park, schools, shopping & freeways. Great Irvine school district. Don’t miss this rare opportunity to own this incredible home! * Seller bought another home. * Not a short sale. * Please call to schedule a showing.

Gourmet Kitchen Award

Not a short sale. Sure at this ridiculous asking price, it will not be a short, but when it rolls back to comparable value, it might end up a short.

The owner bought the original house at the peak, and demolished the value that was there, and spent hundreds of thousands rebuilding while comparable values were tanking. If he is lucky, the improvements may have brought the house back up to his purchase price, but recouping the renovation costs and making a profit?– I don’t think so.

Loan Modifications Make Payments Affordable

The current government loan modifications programs offer borrowers true payment affordability — if borrowers want to take advantage.

111 HILLCREST   Irvine, CA 92603  kitchen

Irvine Home Address … 111 HILLCREST Irvine, CA 92603
Resale Home Price …… $3,188,000

{book1}

I watch the ripples change their size
But never leave the stream
Of warm impermanence and
So the days float through my eyes
But still the days seem the sameAnd these children that you spit on
As they try to change their worlds
Are immune to your consultations
They’re quite aware of what they’re going through

Ch-ch-ch-ch-Changes
(Turn and face the strain)
Ch-ch-Changes

Changes — David Bowie

Changes. Borrowers and lenders both want changes; borrowers want payments they can afford, and lenders want borrowers to make payments. There is supposed to be a meeting-of-minds before a loan is funded, but now in our era of retroactive loan qualification, lenders are forced to cope with lax underwriting standards of the bubble through loan modifications.

The Coto Housing Blog recently featured an excellent post on loan modification programs simply titled Loan Mods:

“The loan modifications in the news and brought forth as the second coming are government sponsored loan mods. The government wrote the qualifications and the government wrote the terms and the government is paying both the lenders and the borrowers to modify their loan according the terms the government has decided is best. HARP is government sponsored loan mods for Fannie and Freddie guaranteed loans. HAMP is for non Fannie/Freddie loans. But there are qualifications. The loan must have originated before January 1, 2009. The borrower must be able to prove they are having difficulty making their payments. The amount owed on the first mortgage must be equal to or less than $729,750. The loan must be for your primary residence. DTI must be more than 31%.

There are three terms that HARP or HAMP may modify and those three terms are approached in a specific order. The second term will only be modified if the first modified term does not bring the DTI equal to or below 31%. And the third term will only be modified if the second term mod does not bring DTI below 31%. The first term is the interest rate which will be lowered to bring DTI to 31% with a minimum rate of 2%. Not bad, eh? Wouldn’t you like you have your interest rate lowered to 2%. If the modified interest rate is below the market rate, the modified rate will be fixed for a minimum of five years as specified in the modification agreement. Beginning in year six, the rate may increase no more than one percentage point per year until it reaches the rate cap indicated in the modification agreement. The cap is equal to the prevailing market interest rate on the date the modification is finalized as published by Freddie Mac based on a survey of its customers. This cap means that your rate can never be higher than the market rate on the day your loan was modified. If the modified rate is at or above the prevailing market rate, the modified rate will be fixed for the life of the loan. Simply, after five years, the interest rate will increase 1% per year until it gets to about 5.2%. …

The 2nd term that can modified is the length of the loan, and it can be extended up to 40 years to bring the borrowers DTI under 31%. …

The 3rd term that can modified is the principal, although under the conditions of HARP and HAMP, the principal may be foreborne, that is, the principal can be reduced for the period of the loan, but must be paid back when the house is sold, or foreclosed on, or borrowed on. … It changes a non-recourse portion of the loan into recourse.

Borrowers are enrolled in a three month trial period paying an amount equal to or less than the amount agreed upon in their loan modification agreement. If the borrowers do not make their new payments on time during the trial period, their trial period is extended. If the borrowers do not turn in the appropriate documentation necessary to qualify for the loan mod, the trial period is extended. If the borrower fails to meet the requirements of the trial period is any way, the trial period is extended. Currently, no borrower who is enrolled in the loan modification program may fail. On January 31, some of the trial loan modification extensions will end, unless they are extended again. If the maximum time period for a foreclosure proceeding is reached while a trial loan mod is in effect, the foreclosure is canceled.”

I appears that amend, extend, pretend is an integral part of the system.

Notice that the first loan amount must be under $729,750. That means every loan in Irvine in excess of $729,750 is ineligible, and since our median peaked above this number in 2006, it is fair to assume many loans in Irvine are over this threshold.

If you have a loan under $729,750, the 2% interest rate is a sweetheart deal. In 2006 at 6.5% interest, the payment on $729,750 is $4,612 per month, but at 2%, the payment falls to $2,697 — the ridiculous payment of 2006 is affordable. However, if this is not affordable enough, the term can be extended to 40 years which takes the payment down to $2,210 — less than half the original payment. If that is not enough, principal forbearance can lower payments to whatever level is necessary for a few years (sounds like an Option ARM).

When you look at how the terms can be modified and how significant the reductions in payments really are, it is surprising that everyone is not successfully modifying loans. Of course, if you are 30% underwater, you probably don’t see the point, but payment affordability is not a legitimate borrower excuse.

111 HILLCREST   Irvine, CA 92603  kitchen

Irvine Home Address … 111 HILLCREST Irvine, CA 92603

Resale Home Price … $3,188,000

Income Requirement ……. $668,398
Downpayment Needed … $637,600
20% Down Conventional

Home Purchase Price … $2,150,000
Home Purchase Date …. 4/12/2008

Net Gain (Loss) ………. $846,720
Percent Change ………. 48.3%
Annual Appreciation … 21.7%

Mortgage Interest Rate ………. 5.11%
Monthly Mortgage Payment … $13,863
Monthly Cash Outlays ………… $17,770
Monthly Cost of Ownership … $12,650

Property Details for 111 HILLCREST Irvine, CA 92603

Gourmet Kitchen Award

Beds 5
Baths 3 full 2 part baths
Home Size 5,475 sq ft
($582 / sq ft)
Lot Size 15,023 sq ft
Year Built 1987
Days on Market 5
Listing Updated 1/20/2010
MLS Number U10000273
Property Type Single Family, Residential
Community Turtle Rock
Tract Cs

Exquisite family home perched on an oversized double lot at the top of Turtle Rock Crest featuring sweeping views from Catalina Island to the San Bernardino mountains. Recently completed remodel offering customized finishes and quality craftsmanship throughout. Dramatic entry with soaring cathedral ceilings leading to formal living and dining rooms, each with their own fireplace. Gourmet kitchen with dual island work stations with granite counters, custom cabinetry, walk-in butler’s pantry, built-in refrigerators and top of the line stainless steel appliances. Extensive use of hardwood and stone flooring, custom wainscoting and moulding throughout. Large family room with French doors opening to side courtyard with cascading fountain.Upstairs bonus room with panoramic views, balcony, custom built-ins and private bath. Gracious master suite with dual walk-in closets, exercise room and luxurious master bath. This is truly a rare offering and must be seen firsthand to appreciate.

First, I want to recognize the excellence in photography shown in these listing pictures. The photographer would probably lament the poor lighting caused by the gray sky outside, but the photos themselves are outstanding. These were obviously taken with a wide angle lens, but there is barely a hint of distortion. The angles the photographer selected took advantages of interesting reflections and shadows making for beautiful photographs that display the property very well.

Second, I have to wonder WTF the owner was thinking when he (1) overpaid in 2008 and (2) over-improved a property he overpaid for. If someone steps up and pays $3,188,000, then Orange County must have infinite capacity for supporting high end real estate, and everyone should start flipping those.