Investment Roadmap: Real Estate

You can buy a nice house in Detroit for $6,000.  Yes, a mere $6k.  You could buy a whole block in Detroit for the price of a normal house in California! Is it time to go in?  Well, since the steel industry cratered in 1979, Pittsburgh has survived but as a much smaller city.  Will Detroit come back at all, or shrink to fit the new reality?

The definitive index of housing is Case-Shiller, and it shows that we are still way above the long-term trendline and have more to fall.  We are only about half way down.  Housing has fluctuated around the trendline for 200 years, but in the Greenspan Bubble it run up 3x higher!

Given all this, what is the best play in real estate today?

In the areas which had the most egregious lending practices - new builds in California and Florida for example - the destruction of value is complete.  Story in the WSJ Tuesday: banks bulldozing houses under.  They do not expect them to be worth finishing.  Same thing happened in the Great Depression.  Time to buy into a vacant housing development?  Doubtful the maintenance and security costs will be returned, let alone value. 

News stories have rushed around, that the rate of decline is slowing, and even that housing was up between Jan and Feb!  Time to go in?  Well, the stats count foreclosures as sales, and the only reason for the positive blip is that 45% of sales in Feb were foreclosures.  What has actually happened is that the banks had delayed foreclosing, and in some States laws forced them to delay foreclosing.  As they begin to foreclose massively, the sales stats will go up!  But the buyers are gone and the people are kicked out of their homes. 

A NYT article Tuesday is telling.  The headline is Signs of a Rebound, and it paints a picture that where housing fell the most, it is now recovering.  Read the article, however, and it is clear the data does not support the headline.  Sales in March are down 7% year over year, showing the fall is continuing down.  The months-supply of unsold homes is still abnormally high, and has not changed for the past year.   Then there is this factoid:

In fact, some analysts think price declines in many markets are accelerating. First American CoreLogic, a real estate data firm, reported that “the depth and breadth of price declines continued to worsen in February.” Fitch Ratings recently revised its estimate of future declines to 12.5 percent, from 10 percent, saying the drop would extend to the end of next year.

The bank stress test came out today, and one of the most colorful commentators on the crisis had a briliant rant about it.  The government said a mere $10B would satisfy the stress in the top ten banks.  A private analysis says BofA needs $60-100B all on its own, and Citi, Wells Fargo and JP Morgan add another $150B collectively.   $200-250B, not $10B.  But it gets worse.  The banks own a massive amount of defaulted mortgages, and they are apparently sending out notices of default but NOT foreclosing yet. This enables them to hold the assets at par value.  Unfortunately for them, events are about to undo their plans. Option ARMs are soon to reset to higher interest rates and negative amortization of principal.  For many of them if the reset causes the principal to increase to more than 110% they transform from interest-only to full amortized repayment of principal, jacking up the monthly payments by 1.5 - 2x.  After them come HELOC's, second loans on houses, which will likely be a 100% write-off since the equity value is so low in these puppies  The tidal wave is estimated at $2.5T or more in losses that will overwhelm these bank balance sheets. $10B looks like a drop in a huge bucket. 

What this means for real estate is the next leg down is about to hit. 

Feel like buying a cheap condo in Vegas?  What happens if the vast majority of units stay empty, and the few lonely owners have to cover the 'special assessments' to pay for the maintenance of the whole building? 

Seems like the only two sensible options (besides staying out) are: buy in place which avoided the egregious loans, like Palo Alto; or buy apartment buildings near distressed areas to pick up all those folks who are about to be kicked out of their homes.

Comments

[Forkoholic Serge of Elliott Wave Forkology]

Yelnick, u can't post naked housong charts - put some EW count! :) and a pitchfork

[john walker]

Yelnick,

You wrote "Option ARMs are soon to reset to higher interest rates..." Is there any data to support the "soon" and "higher rates"?

In fact, current refinancing rates are substantially /lower/ than in recent years; see here for the various indexes used for ARMS:
http://mortgage-x.com/general/indexes/default.asp

If there is any hard data to support this "ARMs debacle" outlook, please tell us.

[yelnick]

john walker, option ARMs are designed to reset, usually after five years, or when deferred interest accumulates principal above 110% or 115% percent. The good news is low rates have lengthened the time of reset a bit; the bad news is that the tidal wave is nonetheless built in and coming. Here is a recent discussion: http://seekingalpha.com/article/131772-breathing-room-for-option-arms .

[john walker]

Yelnick, The resets are coming, but as of today the refinance interest rate is /lower/ than the when-issued rate, so resets are a net /benefit/ to the homeowner. For the tidal wave you describe to be harmful, nominal rates would have to rise sharply (which, I realize, you expect). My point is that the reset PER SE are not a worrisome issue, UNLESS nominal rates rise. (As per the bond thread, we disagree on the likelihood of nominal rates rising during a deflation AND economic contraction.)

[yelnick]

John walker, the option ARMs reset either when interest puts them over 110% or 115% of principal, OR when five years is up (typical time period). Low interest rates are delaying the rests but they are coming. The article on this most sites point to is

http://www.businessweek.com/lifestyle/content/apr2009/bw20090416_103126.htm?chan=top+news_top+news+index+-+temp_lifestyle

Another is at one of my fav sites, SeekingAplpha:

http://seekingalpha.com/article/113063-option-arms-the-banking-backdrop-of-2009