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

===================================

$170,000 Average “Box” Cost

+

$40,000 Average Per lot Infrastructure Cost

===================================

$210,000 Total Average Fixed Construction Costs

Variable Costs

* 12% Profit

* 5% Marketing

* 3% Overhead

* 5% Finance

* 3% Other

===================================

28% Variable Costs Percentage

$280,000 Variable Costs Dollars

===================================

$490,000 Total Costs (Fixed Costs + Variable Costs)

$510,000 Land Residual (Finished Lot Value)

X

100 Number of Lots

===================================

$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

===================================

$392,000 Total Costs (Fixed Costs + Variable Costs)

$258,000 Land Residual (Finished Lot Value)

X

4,270 Number of Lots

===================================

$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.

Bulls have opinions; bears have opinions. How do can you tell who’s opinion is more likely to become future reality? What characteristics are exhibited by an analysis with good predictive power versus those without? How do you tell the difference between an opinion based on emotion, fantasy and wishful thinking from an opinion based on a rigorous, unbiased examination of the facts? These are the questions I wish to explore today.

As part of my job, I obtain market studies to evaluate various land uses for specific pieces of property. Based on the quality of the information in these reports, I make and implement recommendations on the purchase and development of multi-million dollar properties. If my analysis is faulty, or if I fail to recognize a faulty analysis in a report upon which my actions are based, the project’s investors will not meet their financial objectives. In short, if I mess up my analysis, people lose money.

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The easiest way to demonstrate a good analysis from a bad one is to directly compare a good one to a bad one and note the key differences. For an example of a good analysis, I will use The Anatomy of a Credit Bubble, not because it is so great, but because I know it very well. For an example of a bad analysis I will use Gary Watts Real Estate Outlook 2007 because he has achieved local fame, and because his analysis is terrible.

Accurate Data

The first thing an analysis must contain is accurate data which is verifiable. Garbage in, garbage out. For The Anatomy of a Credit Bubble I used data from the US census bureau, the local MLS, Newsweek magazine, US department o labor, and a variety of websites which used official government data sources. Basically, if you want to challenge the accuracy of the data presented in the analysis, you could go the source and verify it. I don’t have any problems with the accuracy of the data presented in the Gary Watts report, so he makes it past the first hurdle.

Direct Causation

Once you have accurate data, the analysis of this data must focus on cause and effect. There must be direct causation linking a specific set of conditions to the outcomes these conditions will produce. A good analysis demonstrates this direct causal link in a clear and unambiguous manner. When an analysis relies on indirect causation, it is weak; when an analysis relies on implied causation, it is worthless.

In The Anatomy of a Credit Bubble, I demonstrated a number of direct causal links which impact how much people pay for houses:

• House prices are directly correlated with amounts borrowed.
• Amounts borrowed are directly correlated with the interest rate offered.
• Amounts borrowed are directly correlated with the borrowers debt-to-income ratio.
• Artificially low interest rates (reset issue) and exotic financing cause foreclosures.
• Foreclosures cause higher interest rates.
• Foreclosures above a certain threshold cause house prices to decline.
• Declining house prices causes more foreclosures. (note the causally related downward spiral)
• Declining house prices and increasing foreclosures cause lenders to lower debt-to-income ratios and raise interest rates.
• Lower debt-to-income ratios and rising interest rates cause amounts borrowed to decline.
• Less amounts borrowed (in conjunction with foreclosures) causes house prices to decline.

Notice the focus is always on correlation and causation forming a chain of events leading to an inevitable conclusion. A good analysis centers the debate around the premises. If the premises are true and accurate, the conclusions cannot be denied.

In contrast, a bad analysis states a conclusion and offers support through indirect or implied causation. When you read through the Gary Watts Real Estate Outlook 2007 you find yourself asking, “How does that impact house prices?” It is a question that is never answered.

Straw Man Arguments

You know an analysis is in trouble when it starts with straw-man arguments to refute counter claims. The Gary Watts Real Estate Outlook 2007 starts its analysis with this headline,

“So Why Do You Feel So Bad? . . . Could It Be The Media? Remember all the fuss over Y2K? How about Killer Bees, West Nile Virus and the Mad Cow disease? What happened with 2005’s “serious” lack of vaccines for one of the “worst” flu seasons? Where did SARS and the Bird Flu. . . fly to?”

He left out crop circles, UFOs, Kennedy conspiracy theories, and the prophesies of Nostradamus. This is an effort to make all dissenters look like raving maniacs with no credibility. The implication is that people who believe there is a housing bubble must also have believed in these other erroneous predictions. This is a feeble attempt to increase his own credibility through linking his opponents to false predictions.

Gary Watts Real Estate Analysis

When he finally gets to real estate, he pulls out these gems:

“Housing Prices Continue to Decline!

Only the rate of appreciation is declining; home prices are still rising. The median profit earned for Orange County was $291,000 for 4 years of ownership!”

Here he conflates a rising median with rising prices for individual homes. We all know the prices of individual properties are declining. We have documented it in many, many posts. The median holds up only because sales at the bottom of the market are nearly zero and incentives and discounts are not reflected in the reported sales prices. The comment about the median profit is completely superfluous information which only documents that we had a bubble. It makes no statement as to whether house prices are currently rising or falling.

Next Mr. Watts comments on the decline in sales:

“Home Sales Decline By ____30___%!

They are measuring against 2005’s almost record year. Since 1996, the yearly average of all sales in Orange County has been 42,716. Last year our sales decline will be only 15% off our 10 year average.”

Sales are below the 10 year average, but only by 15%. Notice the attempt to make this seem insignificant? Bear markets in real estate begin with a dramatic drop in sales. This is the leading indicator everyone anticipates. He makes no mention of what this means. A good argument would have at least attempted to address the bearish argument of declining sales signaling the top of the market.

More nonsense, this time on foreclosures:

“Foreclosure Activity Rises!

They have to be up after hitting a record low! The truth is that 99% of all loans in the U.S. are not in foreclosure. The remaining 1% that were foreclosed upon had the following breakdown:

* 80% were classified by federal lenders as Professional Thieves and were turned over to the FBI.

* 20% were classified by lenders as Fraud for Property that resulted in unethical lending practices.

* Ca. Defaults: Historical 32,762 – Low: 12,145- 3Q’04 High: 59,987 – 1Q’96 Current: 37,273

* For all of ‘06, foreclosures accounted for only 1.81% of all Orange County sales, with lenders reselling those homes at an average discount of only 3.8%!”

Here he tries to make it sound as if borrowers are making their payments, and the foreclosure problem has nothing to do with the exotic loan terms. According to Gary Watts breakdown 100% of the foreclosures can be attributed to theft or fraud. Does anyone believe that? Somebody provide me a link to his supporting material concerning the breakdown of foreclosures — if it exists. I would like to see it. I suspect this is a rectal extraction. Plus, he completely ignores the implications of the trend in foreclosures which is increasing at an increasing rate. It isn’t the number of foreclosures today that is the problem, it is the number forecast for the next 5 to 7 years that is alarming.

Then Mr. Watts really pulls out all the stops,

“Affordability Index at Record Low – So Few Can Afford to Buy! Home ownership is at a record high of 70%, while the baby boomers ownership percentage is 80%! This index is archaic and does not account for how dramatically the world changed in 1979.”

Affordability is the central issue of the bubble. His drawn out attempt to make light of this problem is ridiculous. First, what does his statement about ownership percentages have to do with anything? Affordability is so low because this increase in home ownership (caused by loose lending standards) has driven up prices as buyers outbid one another for properties.

He tries to bridge to his analysis about the changing world in 1979… Basically, he says baby boomers are rich, and they will buy so much real estate that the market demand is limitless. This is silly. Baby boomers were big participants in the bubble, that is clear; however, now that these second homes are burning a financial hole in their pockets, they are not buying more, but instead selling what they have. Also, baby boomers are all moving toward the empty nest stage and into retirement. Their demand for housing space is going to decline as they downsize and abandon their McMansions.

Plus, I just have to wonder why this market altering event in 1979 didn’t prevent the last bear market from 1990 to 1996 — a bear market Gary Watts accurately predicted?

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I don’t want to rehash his entire analysis, but when you read it you see numerous examples of indirect or implied causation. Each of the facts he mentions could in some way contribute to increased buying or decreased supply, but each of them also could amount to nothing. It is the shotgun approach: maybe one or two items out of the list of 20 will have an impact, so he just lists them all hoping the cumulative impact will convince the reader prices will increase. He plays on the inability of most people to sort through the details. He doesn’t dazzle them with brilliance, he baffles them with BS.

Give yourself an out

In the final paragraph, Gary Watts does give himself an out which makes the inaccuracies of his forecast look beyond his control.

“What to Watch:

1. If the Fed sees things it does not like and raises interest rates.

2. If increases in our housing inventory push the supply past 5.5 months.

3. Un-motivated sellers still entering the market in large numbers.”

This is an obvious tactic as explained by Rich Toscano,

“This is the type of permabull revisionism that we can expect a lot more of in the months and years ahead. It goes something like this: “We were right to predict infinitely rising home prices, but who could have foreseen Factor X?” Factor X might be further mortgage defaults, employment weakness, a consumer slowdown, outmigration, or any number of other problems. It will be discussed as if it was some entirely unpredictable exogenous shock, and that the bullish analysts’ predictions would have been spot on had the X-Factor not come into play. The truth is that the X-Factor will not be some external shock as they’d have us believe, but a likely if not inevitable result of the excesses of the housing bubble.”

At the time Gary Watts wrote his analysis, there was more than 5.5 months of inventory on the market. It has only gotten worse. He built in the excuse for the failure of his analysis.

Conclusion

A good analysis uses direct causation with verifiable data, clear premises and easy to understand conclusions. A bad analysis has faulty data and utilizes indirect or implied causation to support a hazy conclusion.

People in the industry who really want a market analysis employ companies like John Burns Consulting to get something with real predictive power. Nobody who makes multi-million dollar investment decisions uses Gary Watts. Quite honestly, if a consultant I used gave me a report like Gary’s, I probably wouldn’t pay them, and I certainly wouldn’t use them again.

Gary Watts analysis is nothing to take very seriously, but it doesn’t need to be. Gary’s place in the REIC is not that of a paid analyst, he is a paid shill of local realtors. His analysis is not intended to actually forecast anything, he merely needs to make it plausible enough to help realtors convince people to buy homes. If you want to rely on him to guide you for making the purchase of a home, do so at your own risk and with the full knowledge you are a sheeple being guided to the slaughterhouse.

Why do we get so much pleasure from failed flips? I can think of no other human endeavor which has engendered so much pleasure in the misfortune of others. In my opinion, the outpouring of schadenfreude we are seeing as the housing bubble deflates is a mixture of Greek tragedy and bad karma. In short, bubble participants should have seen it coming, and they are getting what they deserve.

Schadenfreude is not a spiritually uplifting response. Most religious traditions would counsel us against it. In Buddhist teaching, people are taught to cultivate feelings of compassion for the misfortune of others — feeling empathy and sadness for the slings and arrows of outrageous fortune when they impact another. The near enemy of compassion is pity: it masquerades as compassion, but it has an element of separateness which detracts from the sense of Oneness with all things. Joy is good: Sypathetic joy, the joy in the happiness of another, is another pillar of a spiritual existence. However, joy in the misfortune of another — schadenfreude — is not a skillful behavior leading to happiness. Even knowing that, many of us feel this joy anyway. Why is that?

I recognized financing terms were creating artificially high prices early on. By 2004, I was telling people I knew this was a problem which would cause a market crash. I can’t tell you how many people looked at me like I was crazy. “Real estate always goes up,” I was told. “The government would never allow prices to crash,” I was told. “If you don’t buy now you will be priced out forever,” I was told. You know the intoxicated language of those who imbibed the kool aid. If these statements had been offered in a defensive manner of someone who is being made to realize they made a serious mistake, I could have felt sympathy for them. I would have been able to disarm their defensiveness and helped them see the light. However, what I generally got was a smug assuredness of someone who truly believed they were right and I was wrong; not just was I wrong, I was a stupid, cowardly fool who did not have the brains or the courage to take the free money being given out.

During the bubble rally, those of us who chose not to participate were labeled as “bitter renters.” We were labeled as envious of the good fortune of homeowners as their property values rose, as they took on insane amounts of debt, and as they learned to finance a lifestyle well beyond their means. This was undoubtedly true for some, but in my opinion, this is not the primary reason so many derive so much pleasure from the misfortune of those now suffering from declining property values.

These same people who chided us for being envious actually wanted us to be envious: they wanted us to know they were the winners in our competitive society; they wanted us to view them as superior. This need to feel superior is undoubtedly a manifestation of Southern California’s Cultural Pathology, but it more than that. This act of putting themselves above us created a separation which prevented us from feeling sympathetic joy for their good fortune, and it will prevent us from feeling compassion for them when they fall.

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In our collective unconscious which manifests in our dreams and our mythology, water is often symbolic of our emotions or our emotional state. Have you noticed people are often categorized as deep or shallow? If you are in debt you often feel “underwater,” etc.

Anger is much like water: if not given an outlet, it will fill a reservoir until it reaches a breaking point and is expressed in a flood of emotional rage. Each encounter with a pathologic, kool-aid drinking housing bull over the last few years has added to this reservoir, and reveling in failed flips is an outlet for this pool of toxic emotional waste.

There is an element of tragedy in every disaster, but financial bubbles are some of the most interesting because they are completely man made. They are created by the individual decisions of buyers who are motivated by greed, foolish pride, and a false sense of security. Each of these people should have known better. Many of them were warned of their impending doom and chose to go down the path to the Dark Side.

Newton’s Third Law states, “For every action, there is an equal and opposite reaction.” The Law of Karma states, “For every event that occurs, there will follow another event whose existence was caused by the first, and this second event will be pleasant or unpleasant according as its cause was skillful or unskillful.” Do you believe the behavior of buyers over the last 4 years has been skillful?

Whether it is Newton’s Third Law, Karma, or a Calvinist form of retributive justice, as this bubble deflates, all the participants in this bubble are about to experience a great deal of hardship. Like many of you, I will enjoy their suffering until my reservoir of schadenfreude is emptied. For the sake of my own personal spiritual well being, I hope this happens soon so I can get back to feeling compassion for my fellow man.

ARTIST: Dire Straits

TITLE: Money for Nothing

I want my, I want my MTV

I want my, I want my MTV

Now look at them yo-yo’s, that’s the way you do it

You play the guitar on that MTV

That ain’t workin’, that’s the way you do it

Money for nothin’ and your chicks for free

Now that ain’t workin’, that’s the way you do it

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Many people have horror stories about dealing with their local homeowners association (HOA). Hopefully, some of these people will regale us with their stories in the comments to this post.

Most of Irvine is homogeneous: this was intentional. Homeowners associations are formed to maintain facilities in common ownership, and to maintain property values in an area through the enforcement of covenants, conditions & restrictions (CCRs). It has been shown, painfully, that individuals acting without governance will allow their properties to deteriorate, appropriate public spaces, and express their individuality in ways which harms neighborhood values (anybody remember this clip from Cheech and Chong’s Next Movie?). In this post, I want to show what can happen — even in Irvine — when the HOA is weak, or does not exist at all.

The property above is located at the intersection of Fulton and Lewis in Northwood. Perhaps you find it attractive? The color scheme is well executed, but the selections would be outside the norm for an Irvine property. You would never see this in Westpark, for instance.

I am sorry you can’t get the full impact of the colors in these photos, but I can assure you that this house catches your eye when you drive on this street.

The real case to be made for HOAs in Irvine comes from this property on Ecclestone Circle. First, look at the size of this thing. Even in a neighborhood of large homes — which The Ranch is — this home stands out as being enormous. When I first saw it, I thought it was multi-family.

Do the words “starter castle” come to mind when you see this place? The property at 5 Eccelstone Circle is for sale. Do you think this house is helping or hurting its resale value?

This is the view from the neighboring street. This place dominates the scene in other neighborhoods.

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Homeowners associations have gotten a bad reputation because they are often taken over by individuals of limited competence or those with a Napoleon Complex. These criticisms aside, Homeowners associations provide a value-adding service which, in my opinion, is worth the hassles they create.