This was posted in a thread on Thursday, but it is such important data, it deserves its own post. The blogging software does not do tables very well, so I apologize if it a bit difficult to follow.
The first column is the income range.
The second column is the percentage of the total in each income range.
The third column is the cumulative total. It shows you the percentage of households that makes at or less than the specified range. I find it interesting that 78% of the households in Irvine make less than $150K.
The fourth column is the most expensive house someone who makes the maximum in the range can afford with a total price of 4 times income. Some will argue this is too conservative, and some will argue it is too high. I think it is a bit too high, but the market bottomed at 4 times income last time, so it is a useful point of reference.
The fifth column is the downpayment that would be required assuming 20% down.
B19001. HOUSEHOLD INCOME IN THE PAST 12 MONTHS (IN 2006 INFLATION-ADJUSTED DOLLARS) - Universe: HOUSEHOLDS
Data Set: 2006 American Community Survey
Survey: 2006 American Community Survey
Estimate -- Percentage -- Cummulative -- House Price Limit -- Downpayment
Total: 63,646
Less than $10,000 -------- 4,633 -- 7.3% -- 7.3% ---- $40,000 ---- $8,000
$10,000 to $14,999 ------ 2,015 -- 3.2% -- 10.4% -- $60,000 ---- $12,000
$15,000 to $19,999 ------ 1,159 -- 1.8% -- 12.3% -- $80,000 ---- $16,000
$20,000 to $24,999 ------ 1,973 -- 3.1% -- 15.4% -- $100,000 -- $20,000
$25,000 to $29,999 ------ 1,233 -- 1.9% -- 17.3% -- $120,000 -- $24,000
$30,000 to $34,999 ------ 1,069 -- 1.7% -- 19.0% -- $140,000 -- $28,000
$35,000 to $39,999 ------ 2,021 -- 3.2% -- 22.2% -- $160,000 -- $32,000
$40,000 to $44,999 ------ 2,071 -- 3.3% -- 25.4% -- $180,000 -- $36,000
$45,000 to $49,999 ------ 2,353 -- 3.7% -- 29.1% -- $200,000 -- $40,000
$50,000 to $59,999 ------ 3,108 -- 4.9% -- 34.0% -- $240,000 -- $48,000
$60,000 to $74,999 ------ 6,169 -- 9.7% -- 43.7% -- $300,000 -- $60,000
$75,000 to $99,999 ------ 8,666 -- 13.6% -- 57.3% -- $400,000 -- $80,000
$100,000 to $124,999 -- 7,924 -- 12.5% -- 69.8% -- $500,000 -- $100,000
$125,000 to $149,999 -- 5,279 -- 8.3% -- 78.0% -- $600,000 -- $120,000
$150,000 to $199,999 -- 6,495 -- 10.2% -- 88.3% -- $800,000 -- $160,000
$200,000 or more -------- 7,478 -- 11.7% -- 100.0% -- $-
Irvine's median income is approximately $85,000:
$85,000 * 4 = $340,000 house with a $68,000 downpayment.
I know I should modify this graphic to fix the title, but it is too much work. Just know it is 1986-2006.
I would like to thank a reader for updating this graphic for me. I am not sure if I can post your name, but thank you.
It is what it is. What do you think?
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FYI,
This is for households and not individuals. These are gross income numbers, not after tax or otherwise adjusted.
Methodology:
The ACS program was fully implemented in 2005 in every county of the United States and in Puerto Rico, with an annual sample of approximately three million housing units.
The ACS is conducted using the best mail self-response techniques of the decennial census combined with follow-up techniques that produce high-quality data. For households that do not respond by mail, the quality of data is improved by using well-trained, permanent interviewer staff using computerized interviewing, which incorporates edits into the collection process. Using a permanent coding staff provides additional improvements in data quality.
Households that receive the American Community Survey are required by law to respond. As with all other census answers, a Federal law, Title 13 of the U.S. Code, provides strong confidentiality protections for all individual information collected by the Census Bureau. Violating this law is a Federal crime with serious penalties, including a prison sentence of up to five years and a $250,000 fine. For more information, visit the American Community Survey Web page at http://www.census.gov/acs/www.
Now I don't hardly know her
But I think I could love her
Crimson and clover
Crimson and clover, over and over
Crimson and clover, over and over
Crimson and clover, over and over
Crimson and Clover -- Tommy James and the Shondells
Link to Video
Joan Jett's Version
If your a bear, and you have been waiting for the sign of the apocalypse, this is it. Get ready because I suspect we will see this over and over...
Original Purchase Price: $1,722,000
Original Purchase Date: 12/23/2005
Auction Sale Price: $1,400,000
Auction Sale Date: 8/1/2007
Address: 30 Crimson, Irvine, CA 92603
Beds: 4
Baths: 4.5
Sq. Ft.: 3,403
$/Sq. Ft.: $558
Lot Size: -
Year Built: 2005
Stories: 2
Type: Single Family Residence
County: Orange
Neighborhood: Turtle Ridge
MLS#: S451259
Status: Active
On Redfin: 378 days
Unsold in 90+ days
From Redfin, "* * $100K PRICE REDUCTION!!FOR THIS TURTLE RIDGE SUMMIT HOME. MAIN FLOOR MASTER SUITE W/ CUSTOM CLOSET, KITCHEN W/ CTR ISLAND, NOOK, LIMESTONE FLOOR, STAINLESS STEEL APPLIANCES. FAM. ROOM W/ WOOD FLOORS & FIREPLACE OPENS TO BACKYARD COVERED PATIO W/ BUILT-IN BBQ BAR AND BUBBLY SPA. FORMAL LR, FORMAL DR OPENS TO COURTYARD. WINE ROOM AND 1BR CASITA W/ BATH & PRIVATE ENTRANCE. CUSTOM WINDOW COVERINGS. MEDIA ROOM W/ BUILT-IN 89' TV. EACH SECONDARY BR W/ BATH SUMMIT ASSOC has POOL, SPA, PARKS, TRAILS"
I guess the big price reduction and the ALL CAPS didn't inspire many buyers...
I bet that 89' TV is cool (I suspect that is inches and not feet though.)
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If this were just a listing I was writing about, I would be wishing it a happy birthday. A full year on the market.
For any of you who don't want to break out your calculators, this is a sales price at $411 / SF in Turtle Ridge. This doesn't bode well for the argument that the high end is immune.
This is a scenario we are going to see a lot of over the next few years: Homedebtors unable to sell because they are above the market, and unable to lower their price because they don't have the cash to buy their way out. They put the property on the market at breakeven and hope they get lucky. In the meantime, the carry costs destroy them, they stop making payments, they go into foreclosure, and in the end, their whole financial empire is obliterated in a crimson mushroom cloud.
Evict the Squatters
Someone asked me recently if we should feel sorry for people like this, as if they were victims of circumstance. No we shouldn't.
These people were victims of their own greed and ignorance. The circumstances which lead to this debacle were visible to those willing to see. Greed blinds people to the truth just like denial is blinding them now. There is an element of Shakespearian Tragedy to all of this, but at the root of every morality play is the idea that people are responsible for their own choices in life. These people are no less responsible for theirs.
The sad part, if there is one, is that these people were led to believe they could have this home in the first place. Obviously, they could not afford it, or they would still be there. A great many people in this market have set up a circumstance where they rent from the bank on temporary terms. Now, they are surprised when the bank evicts them. It was "their" house in their own minds. It was all one great illusion they set up for themselves (with some enabling from a lender.) It is a dream which has since turned into a nightmare.
In essence these people are all squatters. They are in possession of real estate they don't really own, and they are crowding out those of us who really could own. Real ownership requires an understanding of what you can and cannot afford. It requires financing terms which provide stability and security (Financially Conservative Home Financing.) Most homebuyers during the rally overlooked this simple fact. When someone is making less money than you are, and they take possession of property that is of superior quality to what you can obtain, they are crowding you out. They are squatting in your house. Would you feel bad evicting a squatter from your property? I don't think so.
Do I feel sad for these people? Sure. It is very sad when someone's dream evaporates into the ethers, but that is part of life. You deal with it, and you move on. I feel compassion for their plight, but it is tempered by the knowledge that they created their own circumstances, and in life, you have to accept the consequences of what you do whether you want to or not.
I would like to thank GavriloPrincip for providing the auction sales information in our forum.
When I wrote Houses Should Not Be a Commodity, I wrote extensively about the psychology of the market and the dynamics which cause prices to rise and fall. Nothing I wrote was new or original.
I have been reading The Disciplined Trader by Mark Douglas. I came across the passage below on pages 199-200:
The reason why a bull market is ready to tum into a bear market when the general public gets involved is because the general public has the least tolerance for risk and consequently needs the most reassurance and confirmation that what they are doing is a sure thing. As a result, they will be the last to be convinced that the rising market represents an opportunity. If a bull market has lasted for any length of time, the general public will feel compelled to jump on the bandwagon so to speak, because of their perception that everyone else is doing it and making money. They will pick up on any reason that sounds the most rational to justify their participation, when in reality, they will know very little about what they are doing, but since everyone else is doing it, how can they go wrong.
A continuing bull market requires the continual infusion of new traders who are willing to pay higher and higher prices. The longer a bull market lasts, the greater the number of people who are already participating as buyers, leaving fewer and fewer traders who haven't already bought and fewer and fewer traders who are willing to bid the price up. These older buyers obviously want to see the market keep on going up, but they also don't want to get caught holding the bag, if the market stops going up. As their profits accumulate from the higher prices, they start to get nervous about taking their profits.
By the time the general public starts buying en masse, the professional traders knows the end is near. How does the professional know this? Because the professional knows that there is a practical limit to the number of people who will participate to bid the price up. There will come a point where everyone who is likely to be a buyer will have already bought, quite literally leaving no one else to buy. The professional trader would like the market to continue to go up indefinitely just like all the other buyers. However, he also understands the impracticality of that happening, so he starts taking his profits while there are still some buyers available to sell to. When the last buyer has bought, the market has no place to go but down.
The public gets stuck because they weren't willing to take the risk when there was still potential for the market to move. For the market to sustain itself, it needs to attract more and more people. As big as this country is or the world for that matter, there are only so many people who will buy. Eventually the supply of buyers runs out, and when it does the market falls like a rock.
The professionals have been selling out their positions before this happens, but once the supply of buyers runs out, the professionals start to compete among one another for the available supply of buyers which is dwindling fast, so they offer lower and lower prices to attract someone into the market so they can get out. At some point, instead of the lower prices being attractive to people, it panics them. The public didn't anticipate losing. Their expectations are very high with very little toleration for disappointment. The only reason they got in was because it was a sure thing. When the public starts to sell, it starts a stampede.
Again, people will ascribe their actions to some rational reason because nobody wants to be thought of as irrational and panic stricken. The real reason why people panicked and the prices fell is simply because prices didn't keep on going up.
Do you see the parallels between the behavior of our housing market and the description above?
The valuation of land used for residential housing is mysterious and often misunderstood. The purpose of this post is to explain how residential land is valued. Once the forces governing land value are understood, it becomes obvious why the Irvine Company is so protective of house prices in Irvine, and why the Irvine Company wants to maximize salable density on its land holdings.
The equations which govern the valuations of large parcels are very similar those which determine the value of an individual lot; therefore, to better understand the valuation of large parcels, one should fully understand how to evaluate an individual lot.
Individual Lots
The market value of a individual lot is equal to the revenue it could generate minus the cost of creating that revenue. Sounds simple enough, but what is the potential revenue and what are the costs?
Sales revenue will largely be determined by what can be built on the lot and how much that house would sell for in the market. The dimensions of the lot, building codes, and the local zoning ordinances will all create constraints on what can be built. Most often there will be some variety in choices available to construct on a given lot. Each of these options will have a potential revenue and an estimated cost. The combination which yields the greatest profit is the product that should be built.
Imagine a 6,000 Square Foot lot that is 60' wide by 100' deep. A typical lot such as this would have a front setback of 20', side setbacks of 5', and a rear setback of 30' leaving a 50' wide by 50' deep envelope for the house foundation. This site could comfortably accommodate a 2,000 SF house (some area is lost by not making the house a perfect rectangle.) For the sake of making the calculations easy, let's say this house could sell for $1,000,000 (peak prices).
An individual speculator would be paying retail prices for house construction. This would be upwards of $150 SF. The cost of construction would be around $300,000 (2000 * 150 = $300,000.) There would be a 6% sales commission (1,000,000 * 0.06 = $60,000), plus financing costs, overhead costs, and other miscellaneous costs which will add up to about 10% of the project cost (1,000,000 * 0.1 = $100,000.)
Therefore, your revenue minus expenses would be $1,000,000 - $60,000 - $100,000 - $300,000 = $540,000. This is how much money would be available to pay for a lot at the breakeven point. Since a speculator would want to make a profit, the lot is discounted from $540,000 until an amount is reached to compensate for the risk and the headaches that go along with the project.
Perhaps the speculator would want to make $120,000 (approximately 12% of sales price) in order to do this work? If so, the speculator would be able to offer $420,000 ($540,000 - $120,000 = $420,000) for the lot. If they are the highest bidder, they get the lot, and the project is theirs. (BTW, this same basic calculation also works for tear-down projects -- often called "scrapers.")
Multiple Lots
Production homebuilders control the price of larger parcels with multiple lots because they can bid higher than individuals and still make a healthy profit (and they have the larger sums required to complete the purchase). They have a much lower construction cost than any individual because they are geared up for mass production. They have the buying power to squeeze costs down far lower than any individual working on their own or with a custom home builder. Production builders costs in today's market average around $85 SF.
A note about the numbers: Part of the process when you sell a large parcel to a production homebuilder is to come to an agreement as to the costs to complete the infrastructure of the project. In order to facilitate this negotiation, both parties often turn to a neutral third party to establish costs. In Southern California, many cost estimates are handled by Developers Research. A real cost estimate is much more detailed than what I am presenting in this post, but the numbers are reflective of a typical situation. As for the builders cost structure, this comes from my experience from sitting on both sides of the table at different points in my career and another source whom unfortunately I can't reveal because it would give away my identity.
So let's look at how a production builder would analyze a 100-lot subdivision in which they believe they can sell homes for an average of $1,000,000 per unit.
$1,000,000 Sales Price
Fixed Costs
2,000 Average Square Footage
X
$85.00 Average Cost Per SF
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$170,000 Average "Box" Cost
+
$40,000 Average Per lot Infrastructure Cost
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$210,000 Total Average Fixed Construction Costs
Variable Costs
* 12% Profit
* 5% Marketing
* 3% Overhead
* 5% Finance
* 3% Other
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28% Variable Costs Percentage
$280,000 Variable Costs Dollars
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$490,000 Total Costs (Fixed Costs + Variable Costs)
$510,000 Land Residual (Finished Lot Value)
X
100 Number of Lots
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$51,000,000 Finished Lot Land Value
The production builder can pay more for each lot because of their advantage in construction costs. Noticed the very large dollar amount builders were paying for finished lots during the peak of the bubble. Lately many of the builders have been taking "impairment" write-offs. Basically, they are admitting they over paid for land, and the asset on their books is not worth what they paid for it. Later in this post, we will examine the sensitivity of land price to changes in house price, and we will see why the homebuilders have been taking such huge hits to their balance sheets.
Land Price as a Residual Value
As you may have noted above, the value of a piece of land is whatever is "left over" after all the other costs of production are subtracted from revenue. This is a key point. If revenue increases -- like in a bubble -- the value of land increases; however, it revenue decreases -- like after a bubble -- the value of land decreases. If production costs increase, the value of land decreases, and visa versa.
The value of a piece of land used for residential housing is directly tied to the revenues and costs of production homebuilders.
Density and the Value of an Acre of Land
A builder is going to bid for the land based on the number of units. They don't care if this is on a single acre or on a thousand acres: Builders pay for lots, not land. Therefore, if you are a seller of land -- like the Irvine Company -- you want to maximize salable density. In other words, you want to get the highest number of units per acre that you possibly can sell.
Once this point is understood, it becomes obvious why the Irvine Company is constantly trying to innovate with its high-density product, and why the density keeps increasing as they go along.
House Price and the Value of an Acre of Land
To fully understand why the Irvine Company is obsessed with maintaining high home prices, an understanding of how changes in home prices impact the value of land is required. Examine the above equation carefully, and notice that the variable costs are only 28% of the total.
This is another very important point: Land value is very sensitive to changes in house prices.
How sensitive? Let's take a look at an example to which we can all relate: Irvine's Woodbury.
Woodbury
Woodbury is one of the Irvine Companies newest communities. It is listed as 4,270 units. As this Village is constructed on a 1 mile square, it sits on 640 acres for a density of 6.67 dwelling units per acre (DU/AC).
Based on the equation above, we can estimate the total land value of the residential portion of the Woodbury Village:
$650,000 Sales Price
Fixed Costs
2,000 Average Square Footage
X
$85.00 Average Cost Per SF
===================================
$170,000 Average "Box" Cost
+
$40,000 Average Per lot Infrastructure Cost
===================================
$210,000 Average Fixed Construction Costs
Variable Costs
* 12% Profit
* 5% Marketing
* 3% Overhead
* 5% Finance
* 3% Other
===================================
28% Variable Costs Percentage
$182,000 Variable Costs Dollars
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$392,000 Total Costs (Fixed Costs + Variable Costs)
$258,000 Land Residual (Finished Lot Value)
X
4,270 Number of Lots
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$1,101,660,000 Finished Lot Land Value
$1.1 Billion dollars worth of land -- that is Billion with a "B." If the Irvine Company can build out this village for an average home sales price of $650,000, that is how much they stand to make (their land cost is almost zero).
Now lets look at another scenario: the housing bubble crash scenario:
$325,000 Sales Price (50% decline)
Fixed Costs
2,000 Average Square Footage
x
$85.00 Average Cost Per SF
===================================
$170,000 Average "Box" Cost
+
$40,000 Average Per lot Infrastructure Cost
===================================
$210,000 Average Fixed Construction Costs
Variable Costs
* 12% Profit
* 5% Marketing
* 3% Overhead
* 5% Finance
* 3% Other
===================================
28% Variable Costs Percentage
$91,000 Variable Costs Dollars
===================================
$301,000 Total Costs (Fixed Costs + Variable Costs)
$24,000 Land Residual (Finished Lot Value)
X
4270 Number of Lots
===================================
$102,480,000 Finished Lot Land Value
$102 Million dollars worth of land -- That is million with an "M."
Is that right? Does a 50% reduction in home prices really reduce the land value 90%?
Yes, it does.
Can you see why the Irvine Company is so protective of home prices?
Why is land value so sensitive to home prices?
As discussed previously, variable costs are only 28% of the home sales price. Remember, land value is a residual calculation, that means everything which isn't a cost falls to land value.
Therefore, 72% of any increase or decrease in the price of a home flows directly to land value.
In essence, this makes land an extremely leveraged commodity. If the value of a house changes by $10,000, the value of the lot it sits on changes $7,200. Multiply that times the 6.67 units per acre, and you can see how each $10,000 change in the value of a house changes the value of an acre of land in Woodbury by $48,024. Since Woodbury sits on 640 acres, the total value of Woodbury changes by $30,735,360 for each $10,000 change in the sales price of a home. (If you want to see a really mind-blowing number compute this for all the land in the Irvine Company's holdings.)
The Irvine Company will capitulate.
In the end, the Irvine Company will lose its battle to prop up the market. They don't control the market, they only control the "ask." Potential buyers determine the "bid." If the bids don't reach the ask, there is no sale (which is what is happening in Portola Springs.) If there are no sales, the Irvine Company has no revenue, and without revenue, they will cease to exist. They have more holding power than most organizations, which is why The Irvine Company has not been cutting prices and offering incentives like all the homebuilders, but the Irvine Company still must sell its holdings in order to survive. If they didn't, they could just decide all houses in Irvine must sell for $10,000,000. In 300 years when those prices may be reasonable, they will start selling homes again. Do you see the absurdity of the Irvine Company holding to peak prices forever?
Conclusion
This is my world: I work for a company that develops raw land. The people who were actively investing in land development during the bubble made more money than you can possibly imagine. The extreme sensitivity of these investments to changes in home sales price resulted in properties obtaining sales multiples of 10 times or greater in just a few years.
As an example, I did some consulting work on a property in 2003 which was purchased by a land developer as raw, unentitled land for $2.4 million dollars cash. When they received their entitlements in 2005, they sold the land in three phases to a production builder for a total of $100 million dollars (4x for the entitlements and 10x for the bubble rally.)
If you thought the bubble rally was a good time to be a homeowner or a homebuilder, you were missing out on where the real action was: land development.
A great many people like it when houses go up in price. During a rally the bulls become intoxicated with greed and obsessed with owning real estate as an investment. However, once houses become an investment, the prices of houses begin to behave like an investment, and volatility is introduced into the system. You do not want houses to trade with the volatility of a commodities market. It causes more harm than good.
Price volatility is a very disruptive feature in a housing market: the upswings are euphoric, and the downswings are devastating -- and there are downswings. Declining house prices are emotionally and financially draining both to individuals and to the economy as a whole. The upswings create massive amounts of unsustainable borrowing and spending, and the downswings create economic contraction, foreclosures and personal bankruptcy. Is the ecstasy of the rally worth the despair of a crash? I think not, but we shall see.
There are technical reasons for a market crash (foreclosures, credit tightening, etc.) and I have discussed those in great detail in earlier analysis posts; however, market psychology plays a large roll in how and why it all plays out. The technical factors cause shifts in psychology among the market participants which exacerbate market moves. Today I will examine the psychology of market bubbles drawing parallels between the commodity futures market and the real estate market. In this post want to clearly illustrate how and why the psychology of market participants will facilitate the ongoing price crash.
Commodities Trading
In a commodities or securities market, you simply cannot have a rally, unsupported by valuation measures, without a crash back to fundamental value. It is very clear the rally in house prices was not caused by a rally in the fundamental valuation measures of rent or income. This was documented in How Inflated are House Prices? and The Anatomy of a Credit Bubble. Many people forgot the primary purpose of a house is to provide shelter -- something which can be obtained without ownership by renting. Ownership ceased to be about providing shelter and instead became a way to access one of the worlds largest and most highly leveraged commodity markets: residential real estate.
Trading is a very difficult endeavor. The vast majority of active traders lose money, and most don't last very long. I paid my dues to the market, but I am one of the survivors. In the process, I spent many, many hours looking at charts and watching the chaotic gyrations of market prices in real time. I have also become keenly aware of my own emotional reactions and those of other market participants. It was these experiences, more than anything else, that kept me from participating in the real estate bubble. I have learned (painfully at times) that traders who "chase the market" lose money. I was not going to chase the real estate market.
The Psychology of the Bubble
The above graph is an excellent depiction of the psychological stages of a market bubble. It is fairly easy to put timeframes to each of these stages as displayed by our local housing market:
- Take off: 1998-1999
- First Sell Off: 2000
- Media Attention: 2001-2002
- Enthusiasm: 2003
- Greed: 2004-2005
- Delusion: 2006
- Denial: 2007
- Fear: 2008
- Capitulation: 2009-2010
- Despair: 2011-2013
- Return to the Mean: 2014
Obviously, the past is easier to document than the future, so we may reach future stages sooner or later than shown above, but we will reach them. I have made my opinions on timing and depth of the decline known in Predictions for the Irvine Housing Market.
The Stages of Grief
Markets are the collective actions of individuals, and the psychology of the markets can be broken down to the psychology of the individual participants who make it up.
When prices first drop and the market enters the denial stage, the individual market participants feel confusion and attempt to avoid the truth. This is motivated by fear they may have been wrong to purchase when they did, and they might lose money. They seek ways to quell these fears through drinking even more kool aid. Bulls in the denial stage will not come to a blog like this one because we will not feed their denial. Some will stop by, try to convince us we are wrong, and move on. The only person they are really trying to convince is themselves.
When the markets enter the fear stage, the little voice inside of each buyer gets louder and louder. This boils over into anger, frustration, anxiety, etc. The individual desperately is seeking ways to maintain denial -- perhaps they read Gary Watts Real Estate Outlook 2007 -- but reality becomes stronger than denial. As a mechanism to break down the denial they imagine the possibility that reality they are trying to deny is the truth. This leads to depression and detachment as reality is too painful to accept.
Finally, "as the going gets tough, the tough get going," and the individual seeks ways to get out of the problem through emotional bargaining. Some will take action. Perhaps it is lowering an asking price, taking the property off the market and doing some renovations to "add value." Some will not take action, and they lapse back into denial because the market is "coming back soon." Note that these psychological stages all occur in the fear stage of the market. Those owners who chose to lower their price as part of their bargaining may get out with minimal losses (assuming they lower it enough to actually sell.) Those that chose other courses of action, lose much more money.
Each individual only reaches acceptance when they sell their house. This is when we enter the stage of market capitulation. Collectively, everyone in the market accepts prices are going to drop further, and they need to get out: Now! Of course when everyone knows prices are going to drop, and everyone is trying to sell, there are no buyers. This puts prices into free-fall until buyers are ready to buy again.
Since buyers in the aftermath of a bubble tend to be the risk adverse who did not participate in it, they will make cautiously low offers on properties. This cautious buying together with desperate sellers causes the market to drop below normal valuation standards. The market enters the despair stage. Here the market participants think nobody wants the asset, and nobody ever will again. Of course, nothing could be farther from the truth as those who recognize the fundamental value of the asset are buying it in preparation for the next cycle.
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Why does it happen this way?
Now that we know what happens, the next logical question is why does it happen. To fully understand this, one must look into the mind of the market participants at key stages in the process, examine their circumstances and see the decisions they must make. While we go through this exercise, I am going to compare and contrast the thought process of a trader with that of the general public.
The first and most obvious difference between traders and the general public is their holding time. Traders buy with intention to sell for a profit at a later date. Traders know why they are entering a trade, and they have a well thought out plan for their exit. The general public adopts a "buy and hold" mentality where assets are accumulated with a supposed eye to the long term. Everyone wants to be the next Warren Buffet. In reality this buy-and-hold strategy is often a "buy and hope" strategy -- a greed induced emotional purchase without proper analysis or any exit strategy. Since they have no exit strategy, and since they are ruled by their emotions, they will end up selling only when the pain of loss compels them. In short, it is an investment method guaranteed to be a disaster.
A bubble rally is usually kicked off by some exogenous event. In a securities market, it may be a very large order hitting the trading floor, and in a real estate market it can be a dramatic lowering of interest rates. Whatever the cause, a series of events is set in motion which repeats with a remarkable consistency. It repeats on multiple timeframes in all financial markets.
Enthusiasm Stage
At the beginning of the enthusiasm stage, prices are already inflated, so there is cautious buying from traders looking for trends and momentum. Prices rise steadily and more attention is drawn to the market. The market sentiment turns very bullish. Buyers are everywhere and sellers are scarce. The general public takes notice and begins to participate in larger numbers.
Greed Stage
In the greed stage, the bullish sentiment reaches a feverish pitch and prices rise very rapidly. Everyone in the market is making money and everyone believes it will go on forever. The greed stage is where the behavior of traders and the general public really start to diverge. Traders recognize it isn't going to go on forever because prices are unsupported by fundamentals: They sell. The general public is convinced prices can rise forever: They buy -- from the traders. (If you don't think this happens in the housing market, I suggest you read Still Renting from Pimco trader Mark Kiesel.)
Think about this for a moment: most people who are bullish already own the asset, but for prices to continue to rise, there must be more buying. For buying to occur, someone who was either bearish or ignorant of the rally must be convinced to buy. In other words, a greater fool must be found. (Remember the National Association of Realtors $40M add campaign?) Once everyone is made aware of the market rally and is convinced to buy, you simply run out of new buyers. Once there are no more potential buyers, prices can only go down.
Denial Stage
Right now, we are in the denial stage. Prices have not dropped enough to cause real fear. Denial is apparent in polls like this one: Out of touch with realty reality where 85 percent believe their home will rise in value during the next five years, and 63 percent believe a house is a good investment. That is serious denial.
It is also apparent in the number of homes purchased during the greed stage that are held for sale at breakeven prices -- even if this is above market. When the inventory is large, and houses stay on the market for a long time, prices are too high. Sellers who refuse to lower their prices to take a small loss are in denial about the current state of the market. They believe bids will increase and some buyer will come along and pay their price -- after all, that is the way it was just 2 years ago.
Buyers who bought in the enthusiasm stage are still ahead, so they feel no urgency to sell. They have made good money already and they will hold on with hopes of making a little more. Since they believe the asset will appreciate again (and they have no exit strategy), this group of buyers does not sell.
In contrast, the few traders who still hold positions liquidate and go back into cash. Successful traders recognize denial as a signal to exit their positions to lock in profits or prevent further damage.
So why can't prices rally here? There are two reasons: First, the pool of buyers is depleted as discussed above, and second, the excesses of the bubble are causing a contraction in credit terms. There are fewer buyers, and those who might want to buy can't borrow the large sums needed to push prices higher. Market psychology hasn't really turned yet, but technical factors are getting in the way. This same phenomenon occurred in our last credit induced financial bubble which resulted in the savings and loan fiasco of the 1980's and it helped facilitate the decline of the early 90's. What is Past is Prologue.
Fear Stage
This fall and winter, we are likely to see a liquidation of bank held inventory. Banks will try to get their wishing prices through the prime selling season, but by the end of the year, there will be pressure to get these non-performing assets off their books. The fire sale of bank foreclosures and the continued tightening of credit will drive prices down an additional 5% to 10%. This will cause some major problems for owners of residential real estate.
At this point, successful traders have all exited the market, although a few knife-catchers jump back in during the bull trap and become bagholders. Greed stage buyers are now seriously underwater. Comps are selling for 10% less than their breakeven price, and there is little hope that prices will rally. Some will sell at this point and take a loss, but most will not.
People who bought in the enthusiasm stage come up to their breakeven price and face the same decision our greed stage buyers faced earlier: sell now or hold out for a rally. Even though there is reason to fear, most will not sell here. They will regret it later, but they will hold on.
- The most important psychological change in the market as we enter the fear stage is the belief that the rally is over. Price rallies are self-sustaining: prices go up because rising prices induces people to buy which in turn drives prices even higher. Once it is widely believed that the rally is over, it is over. Market participants who once only cared about rising prices now become concerned about valuations. Since prices are far above fundamental values and prices are not rising, there is little incentive to buy. The rally is dead.
- Another major psychological change occurs in this stage after people accept the rally is dead: People reassess and change their relationship to debt. During the rally, debt became a means to take a position in the housing commodity market. Nobody cared how much they were borrowing because they never intended to pay off the loan through payments from their wage income. Everyone believed they would pay off whatever they borrowed in the future when they sold the house for more than they paid. Once prices stop going up, people realize they are simply renting from the bank, and the only way to get ahead and build equity is to pay off a mortgage. The desire to borrow 10 times income diminishes rapidly as people realize they could never pay off such a large sum. What started in the denial stage as an involuntary contraction of credit, in the fear stage becomes a voluntary contraction of credit as people simply do not want to borrow such large sums.
So why can't prices rally here? There are even fewer buyers in the market and a reduced appetite for debt due to the change in market psychology. There are more and more sellers are either choosing to sell or being forced to sell. Since there are more sellers than buyers, prices continue to drop.
During the fear stage, a majority of buyers during the rally go underwater on their mortgage. Most will endure the pain and stress. In the past, since the bubbles of the 80's and 90's were built on conventional mortgages, people just held on. In this bubble, people used exotic loan financing terms, and they simply cannot afford to make the payments. They will borrow from other sources until finally the entire system reaches a breaking point and they implode in foreclosure and bankruptcy.
Capitulation Stage
The transition from the fear stage to the capitulation stage is caused by the infectious belief that the rally is over. There is a tipping point where a critical mass of market participants either decide to sell or are forced to sell. Once this point is reached, selling causes prices to decline further. This convinces even more people the rally is over which begets even more selling: a downward spiral. The capitulation stage is the counterpart of the greed stage. Sellers are everywhere and buyers are scarce.
In securities trading, the mechanism for compelling people to sell at a loss is anxiety and emotional distress, and the mechanism for force is a stoploss or a broker's margin call. In residential real estate, people are also compelled to sell by anxiety, and the mechanism for force is foreclosure. We know foreclosures are going to be particularly bad in this bubble due to the exotic financing and adjustable rate mortgage resets.
Each market participant has a different threshold for pain. Some give up early; some give up later; some stubbornly try to hold on, but in the end, by choice or by force, everyone sells out and capitulates to the forces of the market.
Despair Stage
From a perspective of market psychology, it is difficult to tell when the capitulation stage ends and the despair stage begins. Both stages have an extremely negative bearish sentiment. The general public is still selling. What makes the despair stage different is that buyers who focus on fundamentals like rental savings or positive cashflow return to the market and begin buying (Remember Rent Savers and Cashflow Investors from How Inflated are House Prices? ) These buyers are not concerned with appreciation, they simply want an asset which provides a cash return on their investment. They are not frightened by falling prices because their financial returns are independent of the asset's market valuation. It is the return of these people to the market which creates a bottom.
Conclusion
Houses should not be viewed as a commodity to trade. Most people lack the financial sophistication to successfully trade in commodity markets. Buying and hoping prices go up is not a successful strategy (as a great many are about to find out). Volatility in housing prices is harmful to the community as the financial and emotional costs of the inevitable price crash are just too great. Everyone pays a price. Renters like myself who chose not to participate are forced to wait to obtain the security of home ownership at an affordable price, and buyers who endure the crash... well, their pain is obvious.
I don't know how to solve this problem, but I suspect government intervention will only make it worse. Part of the problem is embedded into the local culture (remember Southern California’s Cultural Pathology?) Perhaps after the pain we are about to witness is over, people will learn their lessons and break the cycle; however, human nature being what it is, I doubt it.
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Epilogue
People have commented on the confidence I have in my analysis of the market. To be very honest, most of the analysis came later. Early in this bubble I witnessed inflated prices begin to rise. My years of experience trading the markets told me it was a beginning of a financial bubble. I didn't know exactly what was causing it, I didn't know how high it would go or how long it would last; I just knew it would prove to be a bad time to buy. Even after watching prices go up significantly from there, I knew it wasn't going to last. I had seen the cycle too many times before. I was witness to the insanity as it unfolded, but it has only been in the last year that I became more interested and really researched the details of causes of this bubble. I have greatly increased my depth of understanding of this phenomenon, but I have never doubted my initial instinct; I still don't.
