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Tuesday, June 28, 2011

Will the other shoe drop for real estate? - Published in the SB News Press in April of 2011

When I moved to California from Texas in 1993, the real estate market was just finding its bottom, after the excesses of the Savings & Loan debacle and the peak in prices around 1990/91.  Prices would stay at their lows until late in 1996, when they finally started to rebound.  I didn’t realize it at the time, but I had moved to California at the perfect time to buy real estate, with prices having just suffered such a tremendous collapse… or so I thought.  A more in-depth analysis of the conditions surrounding that 1993 price-point low, and a comparison to today’s real estate market, may shed some light on this issue, and may provide some insights into the attractiveness of real estate today.

The real estate boom of the late 1980s/early 1990s was driven, in part, by excess building, fueled by savings & loans, primarily in Texas and California, that were issuing high-yield (junk) bonds to raise the capital that they, in turn, lent to developers, speculators and buyers.  Like most bubbles that expand until they burst, this real estate cycle was driven by many factors all culminating in skyrocketing prices on the way up, and the inevitable crash we witnessed. 

Median home prices in California reached their peak in July of 1991, at around $206,000 (Santa Barbara peaked the month before at around $277,000).  By February of 1996, the California median home price had fallen to $170,000, or by about 17.5%.  In Santa Barbara, the media price declined to a low of about $170,000 in December of 1994, and was at $231,000 by February of 199, when the state hit its low, representing a 39% drop for Santa Barbara from the high to the low.

Prices in California did not surpass the $200,000 mark until May of 1998, almost two-and-a-half years after hitting bottom, and almost 7 years after the previous peak.  Santa Barbara prices surpassed the $277,000 high by June of 1996, only about one-and-a-half years after the bottom, but about 5 years after the previous peak.

What was so completely different about the current real estate bubble (that just burst) in comparison to the previous boom and bust cycle for real estate (1988 or so through 1996), is interest rates.  Even as real estate prices were rising dramatically back in 1988 and 1989, the 30-year fixed-rate mortgage rate was around 10 to 11 percent.  This contrasts sharply with rates during the 2006 and 2007 period, which were hovering around 6.5 to 7%.  In fact, even after prices began dropping, and while they continued to drop well into the 1993 through 1996 period, when real estate was hitting its lows, rates were still very high in comparison to where they are today.  Even in 1993 at the depths of the real estate declines, the 30-year fixed-rate mortgage was still running between 7 and 8 percent. 

I first moved to La Jolla from Texas in late 1993.  I was told that it was a good time to buy real estate, and that prices had just been hammered.  The first place I rented was owned by the builder, right at Wind-n-Sea Beach.  It was a 3-story duplex, which was only about one-year old.  It was about 2,000 square-feet and had a roof deck with tremendous views.  The owner was asking $385,000 at the time and no one would even look at it.  He begged me to buy it. I could not wrap my mind around paying almost $400,000 for a duplex (half of a duplex really), when in Texas, I could have bought a 5,000 square-foot house on 10 acres for that amount. 

I lived in the duplex for 2 years.  The owner lowered my rent while I was there so that I would allow him to show the unit.  No one cared.  He eventually sold it, years later, probably for substantially less than he was hoping to get in 1993. 

I am sure that place was worth $1.5 to $2 million during the latest boom.  I have always wondered if I made a huge mistake by not buying that place when I had the chance to get it cheap.  I often thought back about that place, and have felt like an idiot, knowing how much it’s worth today, even after the recent declines.
But did I really make a big mistake?  On closer examination, I am not so sure I did.  Starting in 1994, rates were climbing, and were already pushing 9 percent by the end of the year.  (Rates did come back down somewhat, to around 7.5% by the end of 1995, but went right back to around 8.5% by the middle of 1996.)     Using 8.5% as our assumed mortgage rate, and $400,000 as our loan amount, the monthly mortgage payment would have been about $3,850.  At the time (1994), I was paying $1,600 per month in rent, so the idea of assuming a $4,000 monthly mortgage payment was a bit scary to say the least (which is the key reason I didn’t buy anything).  Of course, there are some tax benefits to buying, especially in the early years of the loan, but even so, the next difference between renting and buying was still significant and therefore a huge deterrent. 

There would not have been an attractive opportunity to refinance at a lower rate until 1998 – 4 years later.  Which means that I would have been stuck making that $4,000 payment every month for at least 4 years – a pretty scary situation for a guy working on straight commission as a stockbroker at the time.  But, at least eventually I could have refinanced and brought my monthly payment down Rates dropped to about 7 percent in 1998 and 1999, and then down around 6 percent by 2002.  In 2004 and 2005, rates briefly approached 5.5 percent, ran back up, and then by 2009 had returned to the 5.5 percent area.  In 2010, the 30-year fixed got down around 4% and it is currently around the 4.4 percent area.

Looking back now at my cash flow requirements to support an 8.5 percent mortgage and the fluctuations in my income, I now feel my decision wasn’t such a bad on after all.  More importantly, I see some serious problems with the current real estate market that did not exist back in 1993 through 1996.  The most glaring is that rates are historically very low.  At first glance, this might seem like a positive, and it is as long as rates stay where they are.  But what happens if they begin to rise?  Unlike the previous situation, in which mortgage holders could eventually refinance, bringing their monthly payments down, there will be no opportunity to refinance at lower rates down the road.  What you see is what your get, for as long as you own the property, if you buy at the current rates. 

Also, if rates do start to move higher, which they certainly will once the Fed begins to raise interest rates (to fight inflation) and the entire rate structure moves up, real estate prices must adjust down further, meaning that anyone that buys now will be down on price and will not want to sell at a loss, only to buy a different house of lesser value (for the same mortgage payment) because rates are higher than they were when the first home was purchased.  With no refinancing opportunities, and the very real possibility of being forced to take a loss, should the homeowner want out, current home buyers will likely be making a very long-term purchase decision if they buy now. 

Prices ultimately are based on the affordability of the monthly payment, so the higher mortgage rates rise, the lower home prices have to move to make the payments affordable for buyers.  Rising mortgage rates could indeed be the other shoe to drop for real estate.

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