Real Estate Recession Coming

This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

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The housing market now is increasingly a buyer’s market. One of the major builders of luxury homes reported that both its third quarter and full year earnings “would fall short of its previous forecasts as a result of slower sales.” The firm noted that “high cancellation rates on contracts in backlog that were projected to close this year, and more pronounced use of price concessions and incentives, particularly on the resale of those homes which have experienced contract cancellations.”

Some realtors and economists now argue that the decline in home prices will be modest and is nearly complete.

They are very likely to be mistaken.This decline is just beginning and will become more severe because of a recession that will be triggered by the falling home prices. This in turn will lead to a surge in unemployment and many of the newly-unemployed will no longer be able to afford their homes.

The first factor that led to the unprecedented surge in home prices of more than 50% in the last five years is that the Federal Reserve began to pursue an extremely easy money policy in 2001 to buffer the economy from the implosion of the stock price bubble of the late 1990s.

Nominal interest rates declined to 1%,and since the inflation rate bounced around 2%, real interest rates were negative. The combination of low interest rates and the ready availability of credit led to a surge in home prices that in turn led to exceptionally high levels of both new construction and remodeling — new kitchens and bathrooms. Moreover the surge in household net worth that followed from the much higher level of home prices facilitated borrowing. People used their new collateral to pay for autos, vacations, tuition, and even daily living expenses.

The second factor that drove home prices upward has been the creativity of the lenders in developing new forms of credit. Financial firms became much more creative in designing mortgages that reduced the monthly payment of the borrowers and thus enabled them to buy more expensive properties. More borrowers opted for adjustable interest rate mortgages, or ARMS. Some provided only for interest payments for five or ten years. A recent innovation was the negative amortization mortgage, sometimes called the option ARM. The interest payment that the borrowers made for three or five years was less than the amount required based on the interest rate, and the borrowers’ indebtedness increased.

The expansion of private mortgage insurance meant that many individuals could buy homes for the first time. Their purchases induced significant increase in the prices of starter homes, and the owners of these properties realized large capital gains and spectacular increases in their net worth and so they traded up to more expansive homes.

Finally tens of thousands of individuals have purchased homes and apartments in anticipation of large gains on their small investments. Condo flipping became commonplace and for several years the practice was extremely profitable.

Most of the surge in property prices has been on the Pacific and the Atlantic coasts and especially in warm weather areas; home prices in the Midwest and in Texas have not increased significantly. Prices have doubled in the southern California and south Florida.

The Federal Reserve reversed its easy money policy in the Summer of 2004 and then began to increase interest rates slowly and steadily. Interest rates on some adjustable rate mortgages are now twice as high as they were three years ago. Home foreclosures began to surge about six months ago, especially in Indiana and Ohio and other states that have experienced job losses in the automobile industry. Foreclosures also have increased in Colorado and other mountain states and in southern California.

Some impatient sellers have auctioned their properties. The sales prices often have been 20-30% below the previous asking prices. Moreover the sellers incur marketing and other costs that often are 10% of their selling prices, about twice as high as the traditional real estate sales commission.

Government regulators will require that the banks that have taken title to homes in foreclosure sell them. The prices of these properties will decline by 20-30% or more.

Moreover many of the investors who bought homes in Florida, Arizona, Las Vegas, and Southern California in anticipation of quick revaluation profits will put these properties on the market, often at prices significantly below their purchase price.

The supply of homes nationwide for sale is much higher than at any time since the early 1990s, about equal to six months’ sales. In part the increase in the inventory of unsold homes reflects a stalemate — buyers are waiting for prices to decline further while sellers are reluctant to reduce their asking prices in anticipation that there is an eager buyer just over the horizon. Most of these sellers will be disappointed. The current market value of their homes is below and in many cases significantly below their current asking prices.

In the next few months more and more of those houses on the market will reduce their asking prices, both because of the mounting costs of owning unoccupied properties and in response to the price reductions by the major home builders who will be seeking to reduce their inventories of newly built and unsold homes.

Moreover no builder is likely to put a shovel in the ground to start a new project until home prices stabilize.

Financial markets have already responded. Share prices of companies that are major home builders have declined by 30-50% in the last year.

The decline in spending that will follow from the combination of the sharp decline in new home construction and the much smaller borrowing against lower home values will lead to a sharp increase in the unemployment rate. Foreclosures and price drops will follow.

The decline in household wealth that will follow from lower home prices is likely to be comparable to the decline in 2000, 2001, and 2002 that followed from the lower stock prices. Moreover the sharp slowdown in the rate of economic growth is not good news for corporate profits.

U.S. equity prices declined by 40% in the three years after the bubble imploded. The decline in property values on average could be as large, and because of the regional character of the bubble, much larger in what had been the hot property markets.

The New York area will be sharply affected both by the decline in home prices and in stock prices. Homes in the metropolitan area will remain more costly than in most other parts of the country, but they will become much more affordable than they now.

Mr. Aliber is professor at the University of Chicago’s Graduate School of Business and president and chief investment officer of Dorchester Capital Management.


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