Our open thread this weekend contains a brief analysis of the Riverside County housing market. All of Southern California’s real estate markets are interconnected by commuters. What happens over the hill impacts pricing here in Irvine.

Here is a great article from the LA Times: HUD’s Dollar Homes falls short of mission.

I would like to share with you some interesting blog posts I read this week at The Housing Chronicles Blog,

Declines in the Case-Shiller Index not uniform

Apartment rents falling in Southern California

“Shadow inventory” of foreclosures remain hidden from the market

And related to today’s topic:

Signs of life in the hardest-hit housing markets

They say an end can be a start
Feels like I’ve been buried yet I’m still alive
It’s like a bad day that never ends
I feel the chaos around me
A thing I don’t try to deny
I’d better learn to accept that
There are things in my life that I can’t control

If I Ever Feel Better — Phoenix

Will prices ever stop falling in Riverside County? Will their real estate market in the Inland Empire rise like a Phoenix from the ashes? Prices will not rise any time soon, but there will be an increased activity among cashflow investors absorbing the inventory of foreclosures. Eventually, all of the houses from the bubble will be recycled, and the new homeowners will not have near as much debt as the previous ones. The economy will recover, and life will go on.

Cashflow Investing

Riverside County and parts of San Bernardino County are collectively known as the Inland Empire. It is a mess. Unemployment is high, house prices are already down 50%, and they are still falling. Prices will continue to fall until real estate savvy cashflow investors loaded with cash enter the market and begin absorbing the inventory. Call it opportunistic, vulture investing, value buying, or whatever term you think appropriate, but the people who invest in this manner are the ones who will create the bottom with their buying activity.

In every disaster there is opportunity. Uncertainty in any market negatively impacts pricing; however, there is a price point where investors believe they are being properly compensated for the risks they are taking on. Even now, there are properties in Riverside County that warrant serious consideration from cashflow investors.

Think about it, let’s say you find a property where the cashflow value with a 10% return is $180,000. However, you are worried that you will have difficulty finding tenants for the next two or three years. How much income might you lose? $10,000? $20,000? Discount the property to account for the difference. There is generally a price point where an investment makes sense.

Cashflow investing is a process of determining value, evaluating risks and discounting as appropriate. Whoever has the most aggressive set of assumptions will acquire a property in the open market. Those who are too aggressive will lose money, and those who are too conservative will never transact. That is how markets work.

The Inland Empire

I want to thank Boyd Martin of Market Profiles for providing the information presented today. He provides an analysis of New Home prices in various sub-markets across California. Like many in my industry, I receive his quarterly updates. I called him on Thursday to obtain his permission to reproduce his study from the 4th quarter of 2008 for the Inland Empire.

Market Profiles
714-546-3814

bmartin@marketprofilesinc.com
wscott@marketprofilesinc.com

NewHomesMatch.com

I mentioned a couple of weeks ago the BIA website NewHomesMatch.com. They have every floorplan of every new home in Southern California in their database. It is a really cool service.

All of the data presented today is accurate for new homes. These prices are not reflective of resale home prices. New home prices are a much better indicator of market strength and direction. The active builders do not live in denial because they must sell their inventory to stay alive. If that means prices must be lowered, then they will lower prices. At whatever price levels new home bottom, resale homes will bottom out even lower usually 2 or 3 years later because the less expensive new homes puts tremendous pressure on resale prices. This deep recession may put our resale market bottom back from 2011 to 2012 or 2013.

The Inland Empire’s Local Markets

Above is the grahpic from his update. I have used his graphic to provide a general overview of the Inland Empire markets:

As you might expect, the sub-markets in the Inland Empire can be broadly grouped by their proximity to Orange and LA Counties. The growth in these markets began as a “cost push” of housing as people sought less expensive homes. This still goes on today.

The first of these sub-markets is the eastern edge of Orange County and Corona. The next level is the Riverside and Lake Elsinore Markets. Further inland you arrive at Moreno Valley, Perris, and Murrieta. The extreme fringe of this market is Banning, Beaumont, San Jacinto and Hemet.

The further out on the fringe you go, the less expensive pricing becomes, and the more risk you take on as an investor. As prices crash, people migrate to the west. This leaves the eastern fringe markets with excess supply and problems with vacancy. Properties on the eastern fringe require major price reductions to compensate for the risks of vacancy and declining incomes. These are also more difficult to manage. Since the extreme eastern markets are also the markets that saw the most construction during the bubble, there is a huge turnover of homes due to foreclosures. However, this is also an opportunity; this is where you can pick up a house that is less than 5 years old for prices well under construction costs. In short, they almost are giving them away.

East OC and Corona

As you can see from the graphic, new home prices in Corona declined in price about 10% last year. They are also still building a lot of McMansions (3,409 average square footage). What do you think this does to pricing in Orange County? Some people are going to go to Corona and buy a new McMansion for $150/SF, particularly when the Irvine Company still wants to get $385/SF. (Here is one for $109/SF) There is no way OC pricing holds up when new homes are available that close for that much less. Yes, I know, none of us want to go live there, but we are the Irvine Housing Blog; we do not represent a typical market cross section. Many people will go over the hill to buy these houses. Prices there have probably not bottomed, particularly for new homes, but their market is closer to the bottom than to the top.

Riverside and Lake Elsinore

This next market segment could probably be separated into two different markets as Riverside and Lake Elsinore have very different market dynamics. Riverside has more of an economic base than Lake Elsinore does because it is a more established community. Lake Elsinore more than doubled in size during the bubble whereas Riverside saw a much smaller percentage increase in its population. That being said, I lump these together because they both represent an additional 20-30 minute drive from the OC and LA markets.

As you can see, the pricing in Lake Elsinore is getting hammered. If you really want to see carnage/opportunity, take a look at nearby Wildomar. How does $31/SF for a 2006 home grab you? (Most are near $70/SF) There isn’t a pooper-scooper big enough for some of these markets. The general pattern to look for in Riverside county is to find concentrations of houses built during the bubble, and you will find entire neighborhoods of REOs and very low prices.

I consider these markets some of the better cashflow investment opportunities. Even though the current inventory is high, it will be easier to attract and keep renters here because you have two other markets even farther to the east you can attract renters away from. These markets will be less damaged by the westward migration than will the extreme fringe markets.

Moreno Valley, Perris and Murrieta

The third level inland is a high-risk market. There is little economic activity out there because it is dependent upon real estate. Market conditions will get worse here, and coditions will stay bad for quite some time. There are cheap houses here too. This one is $45/SF. However, based on current pricing across the area, this is the market slice I find least attractive. IMO, prices not low enough to compensate investors for the risk. I foresee continued downward pressure on prices across this entire market swath.

You can already see the brutal beating the Moreno Valley market is getting. Prices are down 20% YOY there.

Banning, Beaumont, Hemet and San Jacinto

This last market is utter chaos. When Jim Cramer talked about “plowing under the Inland Empire,” this is the area he was talking about. The sleepy little communities in this area exploded with housing developments from 2003-2006. Everything out there is new. Now, with the collapsing prices to the west, everyone is abandoning their homes and moving closer to work and cutting their housing costs in half. This area is a disaster zone. It will be the last to recover. However, for those with a long-term market view and a lot of nerve, this is where the home-runs will be hit. There will likely be many properties less than 5 years old transacting near $40/SF. Here is one at $42/SF. At those prices, you could almost let it sit empty for three years and just factor in the vacancy loss to your calculations (maybe not that long, but you get my point). There is a price point where these properties become attractive. Anyone thinking about investing out there needs to be fully aware of the risk. There is a reason the prices are so low.

Notice that in none of this discussion did I mention appreciation. These properties are cashflow investments; appreciation is not a consideration. Sure, if California blows up another massive housing bubble some of these properties may provide a convenient exit point by offloading it to some fool caught up in a financial mania. But realistically, prices are not going up in Riverside County for a very long time. If you want to buy an “investment” property in these markets because you think pricing is going to recover soon, you are a fool.

Bull or Bear?

For those of you that want the IHB to remain permanently bearish, I am sorry, but I am not a permabear. I am still very bearish on Irvine and most of Orange County. I am still somewhat bearish on pricing in the Inland Empire, but price levels in many areas do cashflow. This is a fact. There are risks in this market: (1) prices might drop further, (2) rents may decline, (3) jobs might disappear, and (4) incomes may go down. But an objective analysis of many properties in Riverside County shows that buying them and renting them out currently provides returns superior to other investment classes. It is what it is.

Does reporting this fact make me bullish? No, it makes me a reporter of market conditions. Only an investor who weighs the risks and rewards and has an accurate idea of what they want can determine whether they are bearish or bullish on any given asset class. Some people will look at these properties and conclude prices must drop further; others may not. No investment is without risk–a fact that escaped everyone who was speculating on the sure thing during the bubble.

Sometimes important lessons can come from unusual locations. The experience of the US Forest Service has much to teach the Federal Reserve. Will they learn the lesson?

Our featured property is a three-bedroom property in Irvine for under $250,000. How the mighty have fallen…

Asking Price: $247,900

Address: 46 Eagle Point #25, Irvine, CA 92604

{book1}

Burning Down The House — Talking Heads

Hold tight wait till the party’s over
Hold tight were in for nasty weather
There has got to be a way
Burning down the house

Outwardly, the Federal Reserve and the US Forest Service seem to have little in common. The Federal Reserve manages our currency and banking system while the US Forest Service manages public lands in national forests and grasslands, which encompass 193 million acres, according to their website. Nevertheless, they both manage complex systems and the outcomes of their choices are commonly obscured for many years.

Our economy, which is the responsibility of the Federal Reserve, is a collection of interrelated individuals and entities whose behavior impact the system. These participants are also reacting to the system, and thereby they are impacted by it. Our forest ecosystem, which is the responsibility of the US Forest Service, is a collection of interrelated plants and animals that both impact the system and are impacted by it.

Both complex systems under management by these two agencies are unpredictable and difficult to manage effectively. Oftentimes the results of management practices are not fully realized until decades after policies are put in place. The similarities between the missions of these two agencies and the nature of the problems they face make them analogous. Lessons learned by one agency can often be extrapolated to the other, and given the long timeframes in their system’s lifecycles, it is important to review and learn these lessons when they are presented.

What Lesson Did the Forest Service Learn?

For years the US Forest Service was dominated by timber production interests. It was a classic example of regulatory capture. The US Forest Service’s primary objective, and thereby its land management policies, favored timber production. Forest Fires were seen as an obvious threat to timber production, so policies of fire suppression were absolute: put out all fires as quickly as possible, and do not let anything burn. This was forest service policy for several decades.

To its chagrin, the US Forest Service discovered its policy was flawed. By not allowing small fires to burn, leaf litter and other combustible natural growth accumulated. In unmanaged forests, periodic fires eliminate this source of fire fuel. In managed forests this accumulation of fuel fosters fires that get out of control (think Yellowstone).

To combat the accumulation of fire fuel, the US Forest Service changed its policies. Now, small fires in the understory are permitted to burn. By eliminating the excess fuel, the more dangerous and costly canopy fires are avoided. A few trees may get damaged in the small fires, but the forest survives.

What Can The Federal Reserve Learn from the Forest Service?

The interests of the timber industry to the US Forest Service are similar to the interests of Wall Street and other financial market participants to the Federal Reserve. The policy of the Federal Reserve is to stimulate the economy—to put out the fire with lower interest rates—every time there is an economic slowdown.

This policy became known as the “Greenspan Put” during the 20 years of Alan Greenspan’s tenure as Federal Reserve Chairman. This policy pleases business interests, and for many decades, it can look like a sensible policy.

There is a major problem with the “Greenspan Put” policy of stimulating the economy through artificially lowering interest rates. Just like the accumulation of fire fuel on the forest floor, our economy accumulates unsound business plans, Ponzi Scheme financing arrangements, idiotic investment strategies, and behavioral moral hazards. Recessions are supposed to be the small fires that destroy these destructive agents, but when the Federal Reserve manipulates interest rates and stimulates the economy, recessions are not allowed to serve their purpose, and the economic problems pile up.

Many have written that there is an 80-year cycle of economic activity that results in depression-like conditions. They speak of this as if it were a law of nature like the orbital period of Pluto. This is nonsense. The cycle of depressions—if we are to believe there is such a thing—is merely a calendar coincidence. There is no identifiable cause and effect between the passage of 80 years and the cause of an economic catastrophe.

It is my opinion that our problems are caused, albeit indirectly, by the manipulation of our financial system by the Federal Reserve. When our entire financial system gets out of control due to the build-up of unsound business practices—an accumulation caused by Federal Reserve policy—there is a tipping point where monetary policy cannot save the day. The fire burns down the financial house.

One of the functions of the Federal Reserve is to maintain stable prices and promote economic growth. It was formed out of a perceived need to smooth out the extreme economic cycles of boom and bust of the 19th century. Like it or not, it is probably not going away (although many would like it to.) The question they are going to have to wrestle with is how to smooth out the ups and downs without creating the conditions that send the economy careening out of control like it is now. I am not qualified to provide those answers, but in their quest for solutions, I hope the brain trust at the Federal Reserve looks at how the US Forest Service manages a similar problem. They may find guidance in this unlikely location.

{book3}

BTW, did any of you watch the interview with Ben Bernanke on 60 Minutes last night? (part 2 is here) It was very interesting.

I watch the new show Lie To Me on Fox too much. When I watched Bernanke talking, I kept seeing this nervous twitch in his face and lips. Maybe he was nervous because he was on 60 Minutes, but he is in the public eye, so he has been on camera before. Rather than fill me with confidence, it really frightened me to see our Federal Reserve Chairman so edgy when discussing our economy.

Today’s featured property is a crappy condo, but at $228/SF, it is the least expensive way to own a 3 bedroom unit in Woodbridge.

Asking Price: $247,900

Income Requirement: $61,975

Downpayment Needed: $49,580

Monthly Equity Burn: $2,065

Purchase Price: $402,000

Purchase Date: 9/30/2005

Address: 46 Eagle Point #25, Irvine, CA 92604

Beds:	3
Baths:	2
Sq. Ft.:	1,088
$/Sq. Ft.:	$228
Lot Size:	–
Property Type:	Condominium
Style:	Contemporary
Year Built:	1978
Stories:	1
Floor:	1
Area:	Woodbridge
County:	Orange
MLS#:	S567144
Source:	SoCalMLS
Status:	Active
On Redfin:	1 day
New Listing (24 hours) Fixer-upper

3 bedroom, 1 1/4 bath fixer upper. This end unit condo features newer
appliances, large patio and inside laundry hookups. Located in the
master planned community of Woodbridge you can take advantage of the 22
pools, 24 tennis courts, and 19 park areas or relax by one of the 2
lakes and lagoons. Close to shopping, restaurants, and excellent
schools.

Check out the shadow on the inside photo. Did you see the biceps on the realtor? That dude is pumped up.

Notice this unit is not being pumped as light and bright…

This unit has all the appeal of owning your own apartment–which is none.

This property is a good example of how the lenders are getting clobbered. The dollar amounts involved are small because this unit is low end; however, the magnitude of the loss is tremendous. It is foreshadowing losses to come on nicer properties.

The property was purchased on 9/30/2005 for $402,000. The owner used a $321,600 first mortgage, a $80,400 second mortgage, and a $0 downpayment. Now that values have cratered, it is not surprising that she walked.

When the lender went to the foreclosure auction, they only bid $239,250, which is 25% off the amount of the first mortgage, and they still got the property. Nobody wanted it. The auction price is 40% off, and the current asking price is 38% off the original purchase price. We haven’t seen many 40% discounts in Irvine to date. We will see more.

{book2}

Watch out
You might get what you’re after
Cool babies
Strange but not a stranger
Im an ordinary guy
Burning down the house

Hold tight wait till the party’s over
Hold tight were in for nasty weather
There has got to be a way
Burning down the house

Burning Down The House — Talking Heads