February 15, 2007

Are you a Don Quixote or Hamlet of Housing?

Reading housing bull blogs and reading housing bubble blogs presents an interesting insight into the psychology of the current housing market. Most folks are moderate regarding the housing situation meaning they want to purchase but are fundamentally torn apart because they realize prices are just too expensive. These people understand that in order to be wealthy one must own some sort of real estate. Renting unfortunately is not a long-term strategy to success; however over paying is a guarantee of struggling both mentally and economically in a declining market. Just imagine buying a home at peak price only to see your home lose $100,000 or $200,000 in a matter of a few short years; think this isn’t possible? I’ll give you an example of an area in Southern California later in the article to show how this is possible and occurring.

Don Quixotes of Housing

So back to the topic of the dual psychology of the housing market. We have the interesting phenomenon of the Don Quixotes and Hamlets of housing. Don Quixote is exhubrant, one-dimensional, dogmatic, and totally immersed in his vision of the world. Even if reality is otherwise, Don Quixote is adamant about his belief and he is a person of action. These folks are your typical perma-housing bulls. Even if the Walls of Jericho are crumbling they are blissfully happy chanting their mantra of year-on-year appreciation. Don’t underestimate the Quixote’s of the market, they take action and do not sit on the sidelines. They practice the philosophy of shoot, fire, aim. These people have kept the market afloat in times of economic nonsense. The subprime market is overflowing with these people. The history of action, the history of decision making belongs to the Don Quixotes.

Hamlets of Housing

Then we have the Hamlets of housing; the over-analytic and multi-dimensional folks that examine every nugget of the market. They spew data as if water falls came out of their mouths. Each housing head that has a comment is quickly refuted with thorough data and is usually left speechless. They provide soliloquies on the nature of housing and what has fueled the bubble as if Socrates was their mentor. Yet many of these folks are stuck in the analysis paralysis stage. They believe so much in their data and are driven by analysis that it is highly unlikely that they will ever buy, even if prices tumble as they will. These folks will ponder housing as a life and death matter and fail to realize that time is also a key ingredient in making successful business decisions. At times these folks are criticized for sitting on the fence and never making a move; and there is some truth in this. Unfortunately, not taking action is just as dangerous as making rash decisions. They follow the mantra of aim, aim, and well what does the meaning of “aim” mean anyways?

The Two Polarize the Market

These two different characters have incredibly polarized the markets; their extreme action on the housing market has created a place where moderates cannot and will not invest. And those that do take the plunge find themselves questioning their decision since housing has become such an expensive proposition. When two forces with dogmatic views push on a market as necessary as housing, there can only be one outcome and that is what we are seeing. Yet the tide has shifted; even looking at the hits on housing bubble pages has increased in the last few months. I noticed people landing on my page searching for “housing crash 2007”, “housing market decline”, “real estate bust”, and “why is housing going down 2007” and these searches have replaced more optimistic queries such as “real estate investing” and “real estate boom.” What we have left is a market were prices went so out of control that exotic financing products needed to be introduced into the market like Quixotes battle with the windmills.

Orange County Drops $42,000 in 1 Month

Reality and perception changes at the margins. Most moderate housing followers expected the current state of the housing market, this is no surprise. It comes as no shock then that last month in Orange County median price dropped $42,000 in one-month as reported by DataQuick. Keep in mind that this is approximately the national family median income and a large metro area has decreased this amount in one month. When prices go up as they have they can go down just as quickly; this is based on the fact that leverage is a double-edged sword. When things are good they are extra good; when things go bad, well we can picture Hamlet pondering life with a skull in his left hand.

What Does this Mean?

For the past two months the rhetoric has now changed in the mainstream media. I’ve noticed that these are the following words that you are seeing:

Stalemate
Stalling
Waiting
Holding-Firm


The Hamlets and the Quixotes are waging a sitting war while the moderate middle is playing a different game; REOs, short-sales, and banks trying to unload property from sellers that can no longer afford to play this game. Many of the Quixotes believe they will get peak prices because in their reality they can do no wrong, the one-dimensional belief system will keep a stranglehold on them until they are forced by an invisible hand to take further action. The Hamlets see that blood is beginning to spill on the streets only reinforcing their belief that housing is a bad investment decision. But the majority of people looking to buy in the middle ground will patiently wait and purchase when the time is right both economically and mentally; they need to have the analytical skills of a Hamlet but must be ready to swing the sword quickly as a Quixote when the time is right.

12 Comments:

hemorrhoidforhousing said...

Wow! Awesome insight. I guess I fall into the Hamlet group. Here in the Bay Area I was totally turned off by the reality of paying too much for too little. An identical house 2 doors down from the one we rent just sold after sitting on the market for over 3 months. It started out listed at 839,000 for a 4 bed 2 bath 1900 sq ft 40 year-old tract house. The sellers reduced to 809,000 and it sat for another month after that. I will be interested to find out what it actually sold for. But when you consider we rent the house we live in for 2,150 and with a possible sales price of 795,000 with 20% down at 6.5% the monthly payment with a 30 year fixed is 4,019 a month. Let's factor in tax and insurance the monthly cost is close to $5,000 a month. That is twice what we pay to live on the same street. We don't pay maintenance, taxes or insurance.

Now the only question is.....To buy or not to buy? Whether it is nobler to continue to rent or charge the windmill mortgage in hand remains to be seen

Dr Housing Bubble said...

hemorrhoidforhousing:

“Now the only question is.....To buy or not to buy? Whether it is nobler to continue to rent or charge the windmill mortgage in hand remains to be seen”

It just happens to be that we are living in Wonderland. I hate to say it but the Bay Area is nuttier than Southern California in terms of prices, and this says a lot. From what you mention, it seems that renting is the logical and economic choice right now for you. But as we know, the mystical draw of owning a home goes beyond numbers so hence our interest in housing. Hence those folks with subprime mortgages have already charged the windmill; not only have they charged but they bought another windmill with an interest only negative amortization suicide loan.

For those that think I’m a perma-bear I own investment property but out of state. Somehow, folks think that just because I feel California is in a mega bubble means that I’m anti housing. This is incorrect but I do purchase property in terms of cash-flow and the rental income that the said area can generate. Not only that, but you need to analyze the community you are buying; schools, growth, jobs, income, you know, the things that we consider life.

Something is rotten in the state of California

wannabuy said...

Good article. For at some time it will be time to buy again.


But I know dozens of people who bought right before the last peak (1989, 1990) who were trapped in what they bought until this peak. So it says don't buy near the peaks.

The last bottom was in 1995 to 1996... four to five year slide with slow appreciation after the slide.

So when its overvalued... its better to wait. That said, I expect to buy in 18 to 24 months. Yes, below the price bottom.

Why? At some time the tax deduction outweights the potential losses. But that also depends on one's expected apprciation rate. Since the expected appreciation for 2007 and 2008 are both negative... and price to rent is absurd...

Rent.

Maybe I'm a Hamlet. But once its a more rational market, I'll probably catch "the falling knife" and life happily. :)

But first, this message from your sub-prime lender. ;) Serously, I'm going to wait until Downey bank gets liquidated. Only after that happens will the rate of home deflation be slow enough to risk buying again. Huge portfolio of "prime" neg-am loans. In other words, the very homes I would want to buy. Until that inventory is at least partially liberated... its best to wait. There loan loss reserves seem to be going quick...

Got popcorn?
Neil

IrvineRenter said...

Dr. Housing Bubble,

The Hamlet's of your description do not participate in the market if they never make a purchase. Analyzing without participating is a complete waste of time (a bit like art critics, wouldn't you say?)

I think most of us who are watching with an eye toward purchasing are waiting for a reason to purchase. To me the vagaries to house price movement do not provide a rationale for purchase. IMO, speculation on appreciation is a losing proposition in housing: the risks brought about by extreme leverage is simply too high. I think a lot of flippers are going to discover this fact shortly.

Just so you don't think I am opposed to speculation in general, I will share with you that I speculate in the stock market using an automated trading strategy with Tradestation.com. None of my stock trading activity is concerned with cashflow analysis. I just look at real estate differently, particularly for a primary residence.

IMO, if you see a 20%-30% nominal drop, and this price level is still above fundamental values, the asset is still overpriced and may decline further. Everyone who buys this decline with a vision of resumed appreciation will get hurt just like tech stock buyers in 2001.

Back to your analysis: I think all the fence sitters are market participants because they all will ultimately buy. Each person will evaluate for themselves what risks they are willing to take and how much they are willing to pay. The "moderate housing followers," which I assume is the group with which you identify, will jump in earlier and will be guaranteed to participate. The more extreme the bearish view, the more risk there is of getting left behind by the market and not getting filled at the price you desire.

From our exchanges, I believe I am more bearish than you are. Above all, I am a realist, and if market conditions change to reflect a long-term bullish move, I will likely buy even if prices are not as low as I would like. Guesses about the depth of the drop are just that: guesses. After prices have dropped 20%-30% it will be interesting to see evaluate the status of the credit markets, the rates of foreclosures, and market inventory to see if it looks like a bottom or just a signpost along the journey down.

Dr Housing Bubble said...

Wannabuy,

“So when its overvalued... its better to wait. That said, I expect to buy in 18 to 24 months. Yes, below the price bottom.”

You are not a Hamlet because you are ready to take action in a few years when prices are more reasonable. A “true” Hamlet of housing will see that renting is still cheaper and even if prices are reasonable, they will still be on the sidelines. If anything, you seem more of a moderate.

And you are correct regarding sub-prime mortgages; the unfortunate case is that these so called operations do not know how to deal with a falling market. They are accustomed to the last seven years of constant appreciation. Now that we have a stalling and dropping market, some secondary holders are kicking these mortgages back; take a look at New Century Financial and see what happens when loans get kicked back.

Dr Housing Bubble said...

Irvinerenter:

“The Hamlet's of your description do not participate in the market if they never make a purchase. Analyzing without participating is a complete waste of time (a bit like art critics, wouldn't you say?) The Hamlet's of your description do not participate in the market if they never make a purchase. Analyzing without participating is a complete waste of time (a bit like art critics, wouldn't you say?)”

Precisely, but they do have a lot of clout. At times these are the forever renters. They will never buy and even though they may not actively participate in the market, they have an effect on market sentiment.

Irvinerenter you should be excited about the news pushed out of DataQuick yesterday. Orange County median prices dropped $42,000 in one month; it went from $642,000 to $600,000, a drop of 6.5% in one month! If anything I may be shifting to your camp of more drastic drops. It is definitely starting to seem like a housing crash is imminent and no “soft landing” is in sight. Have you seen the stats in Florida? They are having an absolute blood bath there; a perfect live case example of what happens when these speculators get slaughtered.

The fence sitters are the moderates in my view. They will participate but not now. They will move in when the market is a full fledged buyers market. Those on the sidelines are the folks that skew the numbers; the perma-bulls buying no matter what and the perma-bears that wouldn’t buy if the house was given to them.

Moderates make up the majority of the market but as we all know, housing prices are set at the margin.

IrvineRenter said...

"Irvinerenter you should be excited about the news pushed out of DataQuick yesterday. Orange County median prices dropped $42,000 in one month; it went from $642,000 to $600,000, a drop of 6.5% in one month! If anything I may be shifting to your camp of more drastic drops. It is definitely starting to seem like a housing crash is imminent and no “soft landing” is in sight."

I saw that. I remember when the December numbers came out, I thought they were inflated by a push of new homes with high incentives. Right after the new year, the builders reduced prices in Irvine to try to jump start sales. Portola Springs prices dropped a whopping 15%. The inflated December number makes for jaw-dropping decline in January. Further, since the median rose the first 6 months of 2006, and since those numbers will serve as the baseline for YOY calculations, the median in OC will look pretty bad come this June. My sense is we will be down more than 10% YOY in June, and with the REO's that will be hitting the market in the latter half of the year, 2007 is shaping up to be a disaster.

Nice to hear you are getting more bearish.

"Have you seen the stats in Florida? They are having an absolute blood bath there; a perfect live case example of what happens when these speculators get slaughtered."

I started my career in Florida (there was no market here in 92). They have few barriers to market entry so every time prices surge a flood of supply hits the market. This latest surge went on so long and the prices went so high that the supply overbuild is amazing. They will be years working off that inventory. Prices may actually dip down to or below 2000 prices there.

Jessica said...

Hello IrvineRenter. You mentioned you were going to hold off on purchasing a home until the payments on a 30 year mortgage were as much as rental payments on the same house. Has this ever been the case? If so, why would anyone rent? I always thought that rent was approximately 30% less than mortgage payments on a similar property? (Dr. Housing Bubble, please feel free to answer the same question if you like).

Dr. Housing Bubble, I am very interested in learning more about investing in real estate and creating passive income. I was in the local bookstore the other day looking for information on the topic and was surprised to see just how many books there are on the education of real estate investing, real estate market economics, etc. Could you, or anyone else for that matter, recommend the best books from which to learn?

A very appreciative,
Jessica

IrvineRenter said...

Jessica,

It doesn't happen very often in Southern California. Last time was in and around 1997. It tends to happen at market bottoms; in fact, it is one of the reasons a bottom forms.

The main reason some people still rent in that environment is because renters generally lack the downpayment that used to be required to buy. The downpayment requirement used to be a barrier to home ownership, and as such, tended to keep prices a bit lower. Once the 80/20 combo loan because common, this barrier was removed, and home ownership went from about 62% to about 70%. It is also one of the reasons this bubble took off.

As Dr. Housing Bubble pointed out in his post, if you wait for rents to align with payments, you may never buy because it might not happen. Generally it does at market bottoms, but it doesn't have to. It didn't in the Bay area market during the 90's downturn.


Personally, I think it will this time because the flood of foreclosures to come should drive prices down pretty low. It may even overshoot the rent/own breakeven point in favor of ownership. There is another level of support where rent actually provides a positive cashflow for investors. This is a very durable support level that is never breached for very long.

Also, keep in mind that the rent/own breakeven price point probably will not be reached until 2010 to 2012. IMO we will have strong declines for 2-3 years lowering prices 30% or more. After that we will probably have another 2-3 years where prices drift down slowly until a durable bottom is formed at prices about 40% below today. I believe it will take that long and go that low because all these exotic mortgage products with 3, 5, and 7 year terms utilized over the last 5 years will need to reset and force an underwater homeowner to sell. Until all these timebombs have detonated, I think it unlikely that prices will appreciate. If you are buying because you are looking for appreciation and you want to catch the next wave, you will probably be disappointed.

Dr Housing Bubble said...

Jessica,

There are three books that you should read:

Automatic Wealth by Michael Masterson
Life 2.0 by Rich Karlgaard
The Millionaire Real Estate Investor by Gary Keller

These books should offer you a balanced approach to real estate and evaluating real estate. Life 2.0 will help explore the larger issues of living in a place you love and factoring price as well. Automatic Wealth focuses on building wealth by increasing your income from working hard in your profession, investing in some real estate, stock investing, and having your own business.

If anything, I enjoy and have gotten a lot out of these books because they focus on real estate as a part of your portfolio and not a get rich quick scheme. No Hawaiian shirt tanned man selling you $20,000 per month simply by following their program. As someone who owns rental property I realize that the most important thing in purchasing real estate is understanding the financing behind it – the Millionaire Real Estate Investor should give you some solid ideas on getting the price of a property…a simple hint, not one property in California will work with their numbers.

Cheers,

Dr. Housing Bubble

Jessica said...

Excellent. Thank you! I can't wait to read these books.

What? You mean to tell me I can't believe that tanned man in the late night infomercials trying to sell me a package for three "easy" payments of $99.95 that will allow me to net $20,000 cash flow a month? Darn, I knew it was too good to be true. :)

Jessica.

wannabuy said...

The fence sitters are the moderates in my view. They will participate but not now. They will move in when the market is a full fledged buyers market. Those on the sidelines are the folks that skew the numbers; the perma-bulls buying no matter what and the perma-bears that wouldn’t buy if the house was given to them.

Moderates make up the majority of the market but as we all know, housing prices are set at the margin.


Well said.
Now, prices are set at the margin... if moderates "withhold their vote" pushing prices down... it delays their buying.

Again, I'll buy before prices hit bottom (partially for tax reasons, partially as I put a higher utilization value on a house than the average bear). But for now... its only sensible to wait.

I like the strategy my fiancee proposed; we're going to live from our May wedding on (well... after the honeymoon) as if we just bought a $850k home. (Tax, mortgage, insurance, and other assumptions apply. The "difference" to real income goes into investments managed by her.) You see, we have a $100k disagreement on what price of home we can afford. If she is right... we get a $850k home. If I'm right, we'll buy a $700 to $750k home. :)

Oh... the added savings aren't for the down payment. Its for "play and furniture money" so that the first few years of home ownership isn't as financially ugly as it might be. :)

So I guess this is a moderate strategy. I simply accept that home prices where I want to live will never hit 3X income. Cest la vie. But 11.4X?!? Every cycle they've dropped to 6X (from 8X).

So wait... see... watch inventory... incomes, etc. But I plan to buy when the downside risk is only $100k. (I currently estimate a $250k to $500k risk on the properties that I like.) Yes... buy before a clear bottom.

But my spreadsheet with reasonable home appreciation assumptions, etc. needs to stop screaming sell and instead say "buying isn't so stupid." (Again, a $100k of risk is not going to kill me. But $500k... yikes!)

Got popcorn?
Neil

ps
I've lurked on this blog a bit.