Hard Candy Christmas — Dolly Parton

Everyone seems to be worries that prices will never fall to affordable levels, despite the fact we are witnessing unprecedented price declines everywhere. Those of you desirous of a high-end Irvine property have not seen the price drops you would like to see, so you conclude they will never get there. If you widen your view a bit, you see properties declining in value all around us and even within Irvine at the low end.

If you are watching the high-end market, these will be the last to fall because this is where knife catchers are most active. The high-end watchers of the IHB are a microcosm of the market. Even among this group, there are people willing to jump in at different price points. Each person capable of buying has a different degree of kool aid intoxication. Each potential buyer has a different tolerance for fear of being priced out — which is still the primary motivator of knife catchers. If you only make lowball offers, you may never get filled, and you will never own. This reality gets amplified into the fear of being priced out, and through this fear, people raise their bids.

Pause for a moment… Reflect on the emotions you felt when you read, “If you only make lowball offers, you may never get filled, and you will never own.” Did you feel the fear? How strong is it? Will you act on this fear? If you are introspective enough to have these emotional awarenesses, you can gauge your own level of kool aid intoxication. We are all different, and the most fearful are the most likely to become knife catchers.

Personally, I rely on my analytical skills to keep my emotional responses under control. I have faith that market pricing will fall to levels consistent with rental parity. It is a faith backed up by market data pertaining to previous market bubbles. I also recognize that even if prices do not reach rental parity, and if I never own, I will be better off financially by renting. It is a win-win. Intellectually, I recognize this truth. Emotionally, I have to let go and trust my intellect. It isn’t always easy.

{book}

For those who have been waiting for prices to reach rental parity, there are still signs the market is heading that direction. Before we get “there,” we need to identify what “there” is. In a stable real estate market, rental parity is a general guide, but not all market segments stabilize at rental parity. The low end, composed of undesirable condos and other properties where owner-occupants are rare often trade at prices below rental parity. The less desirable it is, the closer it trades to investor cashflow levels (GRMs from 100-120). The median type property that owner occupants desire trade near rental parity. This is particularly true for “starter homes,” those nicer condos and small 3/2s. The above median properties often stabilize just above rental parity (+10%.) This happens for a number of reasons: 1. The longer ownership period of these homes justifies a higher investment premium. 2. The limited supply makes them scarce. 3. Rents are more variable at the high end as most people who can afford the higher rents generally own instead.

In the market bubble of the late 80s, the low end of the market got bid up to rental parity, and the high end was pushed well above. When prices crashed in the early 90s, the high end crashed first, then the low end got hammered. With the low end already at rental parity and within levels of affordability, it made sense for the high end to crash first. Once the more desirable properties were at rental parity, there was an exodus from the low end that caused prices there to plummet. I mention this because I believe this is how the next stages of the drop will play out.

Since the Great Housing Bubble saw an unprecedented degree of price inflation, both the low end and the high end prices became elevated far above rental parity. As the low end comes down to rental parity, it is starting to find some support. At this point, we are looking much like the market in 1991 — the low end is nearing rental parity, and the high end is still grossly overpriced. If history repeats itself, the low end may stabilize temporarily near rental parity while the high end declines. Once the high end drops to rental parity, the low end will take another drop down to investor cashflow levels. Is it going to happen that way? Who knows, but that is my best guess.

Today’s featured property is a 3/2 that appears to be at rental parity here in Irvine.

Asking Price: $360,000

Income Requirement: $90,000

Downpayment Needed: $72,000

Monthly Equity Burn: $3,000

Purchase Price: $550,000

Purchase Date: 8/2/2005

Address: 416 Monroe #166, Irvine, CA 92620

It doesn’t look like the realtor is expecting a big payday here…

This property was purchased on 8/2/2005 for $550,000. The owner used a $440,000 first mortgage, a $55,000 HELOC, and a $55,000 downpayment. Not to worry, he opened a new HELOC for $110,000 on 9/20/2005 and removed his downpayment. The owner isn’t losing anything here…

If this property sells for its asking price, the various lenders stand to lose $211,600 after a 6% commission.

This property is being offered for 35% off its 2005 purchase price.

What is it worth?

I have looked at this property from a conventional financing perspective and from the more realistic perspective of an FHA buyer. In either case, I believe this property is near rental parity.

• With the lower interest rates, I used an assumption of 6% rather than 6.5% I have been using previously. Perhaps some can find a better rate, and for some it will be worse.
• I do not believe there are Mello Roos for this property.
• Since this is a condo, I put only a 1/2% maintenance and replacement reserves. If the condo association is well managed, there should be no special assessments, and with the entire exterior being the responsibility of the association, maintenance should be minimal.
• A buyer making $90,000 is not going to see a huge tax benefit. The marginal tax rate is only 25%, and with the loss of the personal exemption, the effective tax savings rate is closer to 15%.
• The lost income from the downpayment should be an after-tax amount, so I have reduced this from 5% to 3%. There are still 5% CDs available (in those banks nearing collapse…)

• The picture is very similar for an FHA borrower. They have to pay a higher interest rate because they have to cover the FHA insurance, and since the mortgage is more than 80% of the property value, private mortgage insurance is required. These costs, plus the larger mortgage balance, increase the monthly cost of ownership.

In both scenarios, the total cost of ownership is under $2,400 per month. What do you think this would rent for? I think $2,400 is about right for a 3/2 in Irvine. Of course, that doesn’t mean rents cannot go lower, and during this recession, they probably will. However, this property seems a reasonable price given current rents and the cost of ownership. What do you think?

{book}

Hey, maybe Ill dye my hair
Maybe Ill move somewhere
Maybe Ill get a car
Maybe Ill drive so far
Theyll all lose track
Me, Ill bounce right back
Maybe Ill sleep real late
Maybe Ill lose some weight
Maybe Ill clear my junk
Maybe Ill just get drunk on apple wine
Me, Ill be just

Ill be fine and dandy
Lord its like a hard candy christmas
Im barely getting through tomorrow
But still I wont let
Sorrow get me way down

Hard Candy Christmas — Dolly Parton