The California Real Estate Market in Perspective 2008-2012

The California Real Estate Market in Perspective: 2008-2012 by Brent Wilson Reochronicle.com/blog

In many places, the California real estate market could be described in one word: bad.

Prices haven't collapsed everywhere, but even where they haven't, sales numbers are way off.

Nothing goes straight up forever, and it looks like gravity has come into play in a big way. Prices in many areas are down to 2004 levels, and some foreclosures are back to 2002-3 levels, or below.

California was the poster child for wild lending and crazy mortgages. There are several reasons why prices haven't collapsed completely, but one is that prices went up so high so fast that many people still have a lot of equity, and thus have options besides foreclosure when they have a problem. As prices continue to fall and their equity collapses, things could become very ugly, since many people will no longer be able to sell, having no equity.

I'm going to go out on a limb and talk about what seems likely to happen over the next few years or so, based on how things look now, and on how similar bubbles and busts have played out in the past.

Lender Weakness

It became obvious over the last year that many lenders couldn't continue lending recklessly, since they could no longer sell weak mortgages, subprime or otherwise.

The simple fact of the crazy lending going away cut prices over 30% in many areas, in one year. This is even before IndyMac failed, before the Fannie Mae/Freddie Mac "bailout".

Many large banks, mortgage companies, and thrifts are badly overexposed in California, and are already choking on a huge inventory of foreclosed property. Lenders are backed into a corner since they must also continue to lend somewhat inflated amounts on properties in order to keep the market from collapsing completely.

If many lenders were to decide that prices were still too high in California and that consequently they should be more conservative in lending, based on the estimated lower future value of their collateral (houses), there could be a real rout in prices very quickly.

Where the problem arises is that lenders MUST become more conservative in lending in California. Otherwise they would likely be dragged down that much more quickly. When they do become more conservative in lending, it reduces the value of their collateral (houses), since houses are worth what you can borrow against them, and more conservative lending generally equals lower prices. Catch 22.

Inland Areas Leading the Rout

Up to this point (July 2008) inland areas have led prices down, for the most part. Coastal population centers are off as well, but not to the same extent.

It seems likely that this is just a lag effect, since real estate is somewhat local, but also everywhere influenced by the availability of financing. Given another year or so, most coastal areas will likely begin to experience drops in value similar to those which have already happened in Sacramento and Riverside.

In most areas with prices fundamentally out of whack with incomes, prices seem likely to fall. One source of data on local median incomes is City Data, http://www.citydata.com.

Most areas with house prices above four to five times local median family income are very vulnerable to a steep drop in prices. In many coastal cities, prices are still over seven or more times median family income. Without enough income to qualify for more conservative loans, higher interest rate mortgages, and failing lenders, how are prices supposed to stay at such a high level? Even with collapsing prices, it's still MUCH cheaper to rent in most parts of California. But in a few more years, it may be cheaper to buy than rent as prices continue to fall.

These figures from the City Data web site (although a bit dated, from 2005) indicate how far out of sync incomes and house prices were in Los Angeles and California at the time. How could a household in Los Angeles with the median income pay 12 times their income for a house? Answer: insane financing.

Estimated median household income in 2005: $42,667 (it was $36,687 in 2000) Los Angeles� �$42,667 California:� �$53,629

Estimated median house/condo value in 2005: $513,800 (it was $221,600 in 2000) Los Angeles� �$513,800

In the old days (back when lenders held loans on their books for 30 years) it was common to pay two to three times your annual income for a house. The absurd house prices we've seen are a direct result of a decade or more of reckless lending, with ever-falling standards, until the end saw no-doc loans, with no qualifying. This was nothing more than a pyramid scheme, with the least-qualified buyers at the end paying the highest prices, using the most insane financing.

As lenders become weaker and more fail, it will be a miracle if prices in coastal cities hold up in California.

Back To Where We Started

In many busts which follow bubbles, it's common for prices to end up below where they started before the bubble began. The key difference in the case of the housing bubble is that the speculation was done with mostly borrowed money, and the object of speculation was the roof over people's heads. Lenders competed to offer ever more insane financing, just as buyers competed to pay ever more insane prices.

What this means is that, unlike during the dot com bubble, a fairly large part of the banking system will eventually be wiped out. After the bottom is reached, it could be a long time before property values rise significantly, simply because there will be relatively few strong lenders able to do more than very conservative lending.

Rising real estate prices are completely dependent on lenders strong enough to make loans to support the rising prices. Once lenders become sufficiently weakened and enough bank-owned properties accumulate, prices will have nowhere to go but down. When the recovery comes, it's unlikely that prices will go up even 10% a year.

Most economists seem to have a built-in bias toward optimism, probably because bad news doesn't sell. There are also few if any economists who have lived through a long nationwide real estate bust--the last real one was in the 1930s. So they lack experience, apart from observing the regional real estate bust in the early 1990s.

Widespread foreclosures tend to destroy a market, whereas scattered foreclosures are usually absorbed by the market more easily. Anytime foreclosure sales rise to a high level, above 30-40% of all home sales, it tends to drag the market down very quickly, since the sales prices of the foreclosures set the overall market price. Lenders can sell much more cheaply than homeowners, and often compete with each other, as well as cut prices drastically to move slow selling properties. In some markets with many foreclosures, the market prices are being set by different lenders competing with each other to capture buyers.

Lenders competing with each other to capture buyers is a whole different dynamic. The average homeowner who can't sell will take their home off the market, but the lender MUST sell, so they will continue to drop the price until a buyer is found. One large lender with a big inventory will sometimes drag the entire market down with them as they try to move their properties.

Lenders can't help but move down prices as they sell their properties. As they do this, they reduce the entire value of all houses in the market, which means that the value of their collateral goes down. It also makes other homeowners that much more likely to lose their homes, since more people will end up owing more than their houses are worth.

This sort of thing has never happened in California before, but now it's here and nobody has any experience in dealing with a problem of this magnitude.

My Crystal Ball

To summarize, prices will continue to fall in California because:

(1) Lenders are weak and can no longer lend in a careless way (2) Weaker buyers have mostly left the market, since they can't get financing (3) The Federal government has finally stepped in and mandated more conservative lending (4) More conservative lending equals lower prices (5) A huge number of bank-owned houses makes for too many homes on the market. Prices would have dropped anyway, but selling of foreclosures will make the drop worse (6) Lenders are competing against each other to capture buyers, pulling the market down with them (7) Some homeowners who need to sell are unable to compete with foreclosure sales, so many who could have sold in the past will end up in foreclosure as well (8) Many homeowners with adequate income but no equity will find that they can rent a comparable property for far less than their house payments, and will throw in the towel and let their properties go back to the bank (9) Mortgage interest rates will have to rise, since more foreclosures equals more risk, and lenders have to charge higher interest rates to compensate for the risk.

For those of you who want a number, my estimate is that prices will fall in most areas to early 1990s prices, and below that in the hardest hit areas. Look for many inland areas to reach some sort of low level by 2010--there may be further falls, but it's likely that most of the pain will be over by then.

Coastal areas seem likely to follow, with prices at a low level by 2011-2012 in most places. The most desirable areas may be more protected from the worst falls, but there will be plenty of pain to go around for everyone.

This might sound excessively pessimistic to some, but, based on all the above factors, it seems inevitable.

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