Desire — U2
The last line of defense for the housing bulls is the fallacy of pent-up demand. Belief in this fallacy relies on people’s inability to distinguish between desire and demand.
Most people want a house. About 65% of Orange County residents own their homes, but probably 95% of residents wish they did. The desire for housing always exceeds the supply because there is always some segment of the market who is unable to obtain home ownership due to the cost of housing and a lack of available credit. True demand is the amount of money those with the desire for housing can raise to put toward the purchase of real estate. If those with the desire for real estate do not have savings and if they cannot qualify for a loan, they create no measurable demand. When realtors make the assertion that there is pent up demand, they are correctly surmising that there is an increasing number of people who want real estate who cannot obtain it, they are totally incorrect in their idea that this demand is merely sitting on the fence waiting to enter the market at a time of their choosing.
California’s residential real estate market is completely controlled by loan terms and the availability of credit. I first discussed this phenomenon in the posts Your Buyer’s Loan Terms and The Anatomy of a Credit Bubble. When credit terms are restrictive, when 30-year fixed-rate conventionally-amortized mortgages are the only available financing product, prices reflect the amounts of money people’s incomes can finance under those terms (as they were before the bubble). When credit terms are loose, when stated-income, Option ARMs, low interest rates, high DTIs and other terms and conditions allow people the ability to borrow two or three times the amounts available under restrictive terms, prices in the residential real estate market will be reflective of those terms (as they were in the bubble). Local supply and demand issues may temporarily halt the rise and fall to a new equilibrium level, but supply analysis alone completely fails to predict this new equilibrium or explain how prices got there.
Analyzing supply and calculating the time on the market is one method of trying to predict future price movements. The theory is that when inventory is low and sales volumes are high that prices must rise, and visa versa. This market snapshot of the balance between supply and demand can be useful, but it is notoriously unreliable because it does not examine the cause of the demand and it falsely assumes that demand is ever increasing. When you look at the chart below showing months of inventory from 2002-2007, you see a false spike in 2004. This signal would ordinarily foretell the collapse of market pricing, but since demand was stimulated in 2004 through the widespread sales of Option ARMs and the near elimination of lending standards, the inventory was quickly absorbed and prices continued higher. Similarly, right now in our market, inventory is down from the peak, and months on the market has fallen below 6 months. This would ordinarily be a signal of a price stabilization or future price increases. However, since credit is continuing to tighten and loan terms are becoming more restrictive, demand, as properly measured by dollars, will continue to weaken, and prices will continue to fall.
California has had a chronic housing shortage for many years. The
mechanisms for bringing supply to the market are slow and cumbersome,
and many local municipalities restrict the ability of developers to
bring new supply to the market or outright forbid it. It is not
uncommon in California for price points to favor the construction of
new dwelling units and for municipalities to forbid its construction.
In these circumstances, the normal mechanism for rebalancing supply and
demand do not function. In most states, when there is a demand for
housing, homebuilders will go to work and provide dwelling units to
meet this demand. The increase in supply blunts the price impact
greater demand has on market prices. This is why many states where
there are fewer land-use controls, they experience much less volatility in
their housing markets.
Of course, this is one other factor that contributes to the wild
volatility in California’s residential real estate market: irrational
exuberance (kool aid intoxication). In California’s markets, when
prices start to rise, fear and greed creates a positive feedback loop
that compels people to buy more (if credit is available) and drive
prices even higher. In other markets rising prices creates a negative
feedback loop that causes people to shun higher prices and not buy real
estate. This psychological reaction to market price fluctuations is
different for each market. Because supply delivery mechanisms are
dysfunctional in California, it is easier for Californian’s to drive
prices higher quicker than it is in other markets. This feeds the local
psychology and creates even more volatility.
Prices have already dropped 20%-25% in Irvine from their peak in
2006. This initial price drop did not occur because of foreclosures or
supply issues. It occurred because tightening credit has stopped market
participants, those desirous of real estate, from bidding prices as
high as they could in the past. The rate of decline is certainly
impacted by foreclosures and inventory problems, but the overall price
levels are determined by incomes and the amount of money people can
borrow based upon it. Credit will continue to tighten, and the amounts
people will be able to borrow will continue to decline. We have already
witnessed a spike in jumbo interest rates as risk premiums are being
priced in to the loans that are not backed by the GSEs. As the
repricing of risk continues, interest rates will continue to rise. This phenomenon will be most noticeable for jumbo loans (the high end is doomed). Also, as the
recession begins to impact incomes, the borrowing power of potential
buyers will be reduced even further. Currently, there are still many
5-year and 10-year ARMs being used to purchase real estate with very
high DTIs. As these products become less common (they are just dragging
out the foreclosure problem,) and as DTIs continue to decrease, bids
will decline, and prices will decline with them.
Some of the people I know that purchased in this market did so
because they saw the tightening credit as something that was going to
take away their ability to finance the sums large enough to buy real
estate. In short, they thought they would be priced out forever. This
reasoning puts the cart before the horse. The tightening of credit
terms is going to cause prices to fall because it directly determines
the market bids. Right now, the high end market is characterized by
very large bid/ask spreads. Sellers are holding out for wishing prices
while buyers are seeing their bids get smaller and smaller due to
tightening credit. Transaction volumes are very low, and while sellers
hold to their fantasies, there will be very few transactions. This will
not change until the Alt-A and Prime ARM resets force asking prices
lower. We have seen this phenomenon before. The low end of the market
in the areas most decimated by subprime ARMs is already at rental
parity, and there may be overshoot in these areas. The bid/ask spreads
in these submarkets are tight because there are few sellers bothering
with wishing prices, and sales are dominated by REOs.
In the post Houses Should Not Be a Commodity, I went into some detail on the stages of market psychology and buyer behavior. In this first stage of the decline, there are still people who are willing to extend themselves to the maximum to obtain real estate because they believe they must. The bubble psychology has not really changed, but the technical factors of credit availability and terms have begun to limit bids. This is why prices have only corrected about half way to date. In the next stage, people will start voluntarily reducing their debt-to-income ratios because they don’t want to stretch themselves to buy what is obviously a depreciating asset. I discussed that phenomenon in more detail in Our Changing Relationship to Debt. The next phase in the drop is going to be characterized by a reluctance to purchase exacerbated by even more stringent financing terms.
If you really want to understand the real estate cycle in California, you need to understand the credit cycle. The changing availability of credit and the fluctuations in the amounts of money financed with people’s incomes are the key determinants to price levels in our residential real estate markets. Right now, we are in a tightening cycle, and this will cause prices to continue to drop. Someday, long after our current credit crisis has passed and the credit markets recover, we will see a loosening of credit, and we may build another residential real estate bubble. Perhaps lenders and borrowers alike have learned the painful lessons of the Great Housing Bubble, or perhaps not. Greed springs eternal.
Lover, I’m on the street
Gonna go where the bright lights
And the big city meet
With a red guitar…on fire
She’s a candle burning in my room
Yeah I’m like the needle, needle and spoon
Over the counter with a shotgun
Pretty soon everybody got one
And the fever when I’m beside her
And the fever, getting higher
She’s the dollars
She’s my protection
Yeah she’s a promise
In the year of election
Oh sister, I can’t let you go
Like a preacher stealing hearts
At a traveling show
For love or money money money
money money money money money
money money money
And the fever, getting higher
Desire, desire, desire, desire
Desire — U2