Movin’ on Up — Theme from the Jeffersons

Well we’re movin on up,

The conventional wisdom in California real estate is that you buy a home, and when it appreciates, you sell it and move up to a better home. There is some truth to this idea, but not in the way most people think. Let’s examine how it really works.

Let’s look at a hypothetical example. Assume market prices are stagnant, and a small starter home can be purchased for $200,000. The next level up can be purchased for $350,000, and the high end can be purchased for $500,000. The price differential required to move between these classes of housing is $150,000. In a stagnant market, the only way anyone could move up would be to save or make more money. Someone would have to either save the $150,000, or get a large enough pay raise to finance an additional $150,000 to upgrade to the next level of housing. So how does appreciation change the equation? It doesn’t.

Let’s say house prices appreciate at a rate matching the level of inflation. If so, all the properties would become more valuable, and the gap between price levels would increase at the same rate. It would still require savings outside of the house appreciation or a raise in pay to move up. Appreciation alone does not close the gap because all properties will appreciate. There is a belief in the general public that the only requirement to end up in a Mansion on the beach is to climb aboard the “equity train” and wait for the appreciation to transport you to your beachfront paradise. It doesn’t work that way.

So what happens when appreciation exceeds the rate of inflation? Nothing different. All properties will be similarly affected. The rate of appreciation does nothing to close the gap between the various rungs on the property ladder. It is important to note that excessive appreciation is a demand-push phenomenon. When the low end starts to appreciate, prices close in on the next tier of properties. If the gap closes, even by a small amount, people will move up. These move ups, cause prices to rise at higher and higher property tiers. In short, the prices at the bottom of the market push prices up all the way to the top.

Now we’re up in the big leagues,
Gettin’ our turn at bat.

In case you didn’t notice, there is a great deal of price volatility in California. There are significant periods of time where house prices will appreciate faster than incomes increase. This is purely the result of irrational exuberance and kool aid intoxication. Prices cannot rise faster than incomes on a sustained basis, but prices can certainly go up faster than incomes when we are inflating a bubble. When prices start rising faster than incomes, price change alone can serve as a precipitating factor that ignites a rally. When prices rise faster than incomes, people see that the quality of the house they can afford declines. They do not need to fear being priced out forever; they just need to see the reality that they are slowly being marginalized by the increasing prices. This often prompts people to accelerate their buying plans and get what they can today rather than wait until they are more financially capable tomorrow because if they wait, they will have to settle for less. This buying further drives up prices. The rising prices causes more people to notice their buying power is decreasing which prompts even more buying. The irrational rally is on. Once it gets started, then people start buying out of greed to profit from the transaction, and the rally really takes off.

A very similar phenomenon is at work even during our current price decline. As many have noticed, the high end is not falling as fast as the low end. This is happening for two reasons: first, the subprime loans that have already imploded were concentrated at the low end of the market, and second, the activity of prime borrowers with cash (the only people buying right now) is at the higher tiers of the market. The low end has an extreme imbalance between supply and demand while the high end does not — yet.

So why are knife catchers being active in a decline? There are two reasons: 1. They believe they are buying at the bottom (foolish but that is what they believe,) and 2. They fear being priced out of another rally. It is the second fear that is self-perpetuating. As you can see from the chart above, the low end has fallen much more than the high end. This is increasing the gap between the move-up tiers. In this circumstance, people who want to move up are seeing their buying power diminishing, and they buy before it diminishes even more. It is the same phenomenon that it witnessed in a price rally, but it is operative in the initial stages of a decline. This is one of the main motivations of knife catchers, and it explains a great deal of the foolish buying we see today.

Let’s examine the math of this. Go back to our example, and we will start at peak prices where the low end is $500,000, the next tier is $750,000, and the top tier is $1,000,000. Let’s assume each of these tiers has a $250,000 mortgage from their starter home (equity transfer and savings to move up the property ladder). Over the last few years in San Diego, the low end has dropped almost 45%. That would take a $500,000 property down to around $275,000. This would leave the owner with only $25,000 in equity for a move up. The next tier up has only dropped 33%, so the $750,000 property is still selling for $500,000, and the owner would still have $250,000 in equity. The highest tier has only dropped about 20%, so the $1,000,000 home is still selling for $800,000, so the owner still has $550,000 in equity. Despite the huge decline in prices, the gap between the tiers is still very large, and the lower tiers are losing equity faster than the upper tiers. If the price gap is increasing or only decreasing slowly, and the equity in low-end properties is declining rapidly, what money is left over for a move up? Obviously, none. The move up market is dead.

The increasing gap between properties tiers and the lack of equity at the bottom to create the move-up demand push is going to create the opposite affect: demand price pull. Falling prices at the low end is going to pull prices down at the high end. Even if the Alt-A and Prime resets were not looming, this price pulling phenomenon would be enough to clobber the high end.

There is a limit to the number of knife catchers capable of paying the extremely inflated high-end prices. The transaction volumes are very light, and any increase in supply (which is coming) at the high end will crush this segment of the market. There is no support coming from the move up market to help out high end pricing. It is only a matter of time before these market segments join their subprime brethren in the 50% off club.

The San Diego market lead Orange County by one year on the way up, to the peak, and on the way down. Watch their market to see where ours is going. We are not 45% off the peak at the low end yet, but today’s featured property is one of those low end properties getting totally hammered. It is being offered for 32% off its early 2007 purchase price.

Asking Price: $435,000

Income Requirement: $108,750

Downpayment Needed: $87,000

Monthly Equity Burn: $3,625

Purchase Price: $640,000

Purchase Date: 3/21/2007

Address: 302 Terra Bella, Irvine, CA 92602

cloet? oppertunity?

This is another property that has some very suspicious activity. Let’s take a look at the last several owners to see the full story.

Owner #1

This property was purchased on 12/22/1999 for $255,500. The owners used a $204,800 first mortgage, a $51,250 second mortgage, and a $-550 downpayment. According to the property records, these people actually cashed out at closing (unusual in 1999). I find these owners interesting because they behaved like typical irresponsible fools, but they were rewarded for it. They refinanced on 6/6/2002 for $258,000, and opened a HELOC for $47,200 a couple of months later. On 10/9/2003 they refinanced again for $297,000, and a few months later they opened a HELOC for $35,000. These people were nothing special. Just average homeowner using refis and HELOCs to fuel consumer spending. Rather than being punished by the markets, these people sold to owner #2 for a huge profit. I imagine they continued their behavior at their next property.

Owner #2

A family purchased the property on 5/31/2005 for $589,000. They used a
$471,200 first mortgage, a $58,900 second mortgage, and a $58,900
downpayment. This was a corporate relocation, and the property was purchased by a relocation service for $577,500 on 12/6/2006.

Owner #3

This is the owner who has aroused my suspicions. This relocation company found a buyer on 3/21/2007 willing to pay $640,000. Does it seem likely that this property appreciated over 10% in four months during the winter of 2007?

Owner #4

What is even more suspicious is that owner #4 defaulted almost immediately. The property was purchased at foreclosure auction 9 months later on 1/8/2008 for $545,282. The most common form of buyer fraud has the straw buyer make two payments before defaulting. The fraud is harder to prove, and after 2 payments, the penalties if convicted are less severe. The foreclosure process is 7 months if the lender meets all their deadlines. Two payments plus 7 months is 9 months.

So what do you think? Did the relocation service go find a straw buyer to avoid taking a loss? It sure looks that way to me.

{book}

Well we’re movin on up,
To the east side.
To a deluxe apartment in the sky.
Movin on up,
To the east side.
We finally got a piece of the pie.

Well we’re movin on up,
To the east side.
To a deluxe apartment in the sky.
Movin on up,
To the east side.
We finally got a piece of the pie.

Movin’ on Up — Theme from the Jefferson