The State of the Real Estate Market and Prospects for a New Reality

PAR Economic Report, December 2007

Dr. Austin J. Jaffe:

PAR Consulting Economist,

Penn State University, University Park, PA

The State of the Real Estate Market and Prospects for a New Reality

PAR Economic Report, December 2007

Introduction

On a recent television broadcast, consumer advocate and guru, Suze Orman, received a call from a viewer who had a difficult real estate question. He was a first-time real estate investor who purchased a single-family home as an investment and now he wanted to sell the property. However, with the recent decline in house prices around the country, the caller wondered if it wouldn’t be better to simply offer the deed in lieu of foreclosure. In effect, someone had told the caller that it might be better to just walk away from the property rather than continue to maintain his newly adjusted mortgage payments (as well as other expenditures on the never-rented rental property).

Orman asked a few questions: Was it rented? (No.) What type of mortgage was involved? (An ARM with a recent reset.) How much was the monthly payment? (Sizable.) The host’s instincts were to avoid the destruction of his credit score if he defaulted and simply walked away from the deal. However, Orman’s concern about his credit history is not what is important about this example. What came next is a microcosm of all of the problems with the current residential real estate market.

The investor revealed that he certainly expected to make money on this investment and he was disappointed about how things were turning out. Orman asked what he had paid for the property two years earlier and he reported something around $255,000. She then asked at what price was the property listed? He replied $305,000 but there wasn’t any interest from prospective buyers and few, if any, showings to date. Yet every month, he faced another hefty mortgage payment.

Quite properly, Orman seized upon the fact that his price expectations appeared to be way out of line. She didn’t know anything about the market and the competition but she didn’t need to know these facts. This was a case of a naive investor who failed to come to grips with the new real estate market.

This is a market in which price reductions are increasingly common and that the myth of a continuously upward spiral of real estate prices was a mere fantasy. Economists speak of sticky prices moving downward; in this case, it proves to be an investment disaster since the investor believed that prices had to be sufficiently high enough to earn even a small capital gain.

The residential (and commercial) markets in Pennsylvania and most of the rest of the country have been shocked into a new reality. Prices, sales, housing starts and new construction are in rapid decline. After several years of moderate-to-high appreciation (with a few pauses along the way) in many cities, housing markets are in a state of decline. It is also increasingly apparent that a major correction is underway in the real estate industry. It will take several months and perhaps a few years to recover to the market peak of 2005-06. To the extent that the caller’s attitude is wide-spread, the real estate market will take a long time to re-price its assets.

Overview of the Leading Issues

This section surveys several of the important areas of the residential real estate market. Attention is directed to the evidence and experience in Pennsylvania markets where possible.

A. Falling House Prices

Not so long ago, most observers refused to believe that house prices would ever fall and if some did, somewhere, sometime, it was argued to be an anomaly. In effect, many laymen and professionals in the real estate business anticipated that prices would rise each and every year, if not each and every month.

Beginning in early 2006, median house prices began to slip. In October 2006, it was reported that the 2.5 percent price reduction in median prices was the biggest year-over-year price decline in records going back nearly four decades. (AP, October 25, 2006).

The National Association of REALTORS® (NAR) predicted that the worst is behind us as far as a market correction - this is likely the trough for sales. However, there was an abundance of evidence that markets had not yet bottomed out. The Commerce Department reported that new construction prices had dropped some 9.7 percent from a year earlier (AP, October 26, 2006). The end of the boom had begun in earnest.

CNN.com reported that most REALTORS® had never seen a bear market and that there was a lot to be learned from industry veterans. (CNNMoney.com, November 7, 2006).

Over time, prices continued to fall and the market psychology was quickly turning against the optimists. By February 2007, one writer noted that economic history suggests that the recovery of housing is years away with more than a 3 percent decline in median prices over the previous year. (CNNMoney.com, March 9, 2007). Despite extreme optimism in some quarters, the beginnings of the credit crunch were upon us.

Wall Street was beginning to get nervous by March 2007. After record earnings from mortgage-backed securities (MBS) and structured investment vehicles (SIV) for several years, the subprime lenders began to warn of troubles ahead. It hit the largest and most respected investment and commercial banks immediately and significantly.

By April 2007, NAR reported the prospects of significant home price declines nationwide for the first time since the 1930s. It was apparent that some regional markets were in steeper decline than others (Los Angeles, Florida, Phoenix, and Las Vegas). These were several of the hottest markets in the previous years. These were also havens for much of the subprime lending and for the use of so-called aggressive mortgages, (those with interest-only or very low teaser rates in ARMs and promised adjustments, called resets, to come in 2-3 years). Many borrowers never expected to have to reset their mortgages since their idea was to trade-up before the adjustments kicked in.

By September 2007, it was common to hear about double-digit price reductions. One report estimated that 75 percent of the nation’s housing markets should expect such declines over the next few years. A study by Moody’s Economy.com predicted declines to exceed 10 percent in 86 of the 379 largest housing markets, with 290 of the housing markets to experience some decline. (CNNMoney.com, September 19, 2007). Some markets were forecasted to decline from peak-to-bottom (over 2-3 years, generally 2006-2008 or 2009) down as much as 25 percent. No median house price in any city in the 100 largest metropolitan areas was forecasted to increase.

In a very recent report (October 2007), it was estimated that the average home price had fallen four percent from the housing peak in early 2006. One observer predicted an average total drop of 11 percent should be expected. (AP, October 27, 2007). No experience in history exceeds these declines except for the “Great Depression” when home prices fell by about one-third. Yet, the overall economy has been strong, unemployment has not risen and economic growth continues at a moderate pace. These are indications of how different this decline has been compared with other downturns.

It is true that housing is weak in northern Ohio and Indiana and in parts of Michigan. These areas have also witnessed the rise of subprime borrowing and lending practices much like in the former high appreciation cities mentioned above. However, for the most part, the bursting of the housing bubble stems from the mortgage finance problems rather than fundamental economic slowdowns, unlike in the upper Midwest.

Pennsylvania is traditionally a follower of market trends rather than a leader. Many local markets continued to hold their own and even rose in typical prices while other cities were experiencing slowing market conditions, increasing inventories and price declines. Eventually, Pennsylvania cities began to follow the trend, as expected, and although the declines in prices are lower than in the more volatile markets, many Pennsylvania cities are experiencing the same market conditions now as others felt several months ago. It is as if Pennsylvania markets are lagging behind about six to nine months.

B. Slowing Sales Activities

Another indication of problems in residential real estate is a reduction or decline in transactions. The industry uses sales activities as a measure of market strength since the industry is transaction oriented. Prices matter but sales figures matter more.

By July 2006, housing markets were slowing down such that The Wall Street Journal reported inventories were accumulating in 26 markets throughout the country. (WSJ, July 20, 2006). The numbers were astronomical as well: five times the number of homes were on the market in Orlando compared with only a year earlier, four times the amount in Phoenix and Tampa and triple the number of units in Washington, DC. In the larger markets this meant tens of thousands of homes were sitting on the market. In addition as subprime mortgage borrowers defaulted, these actions added to the inventory; yet, mortgage money was becoming scarcer, especially for subprime and even slightly better borrowers.

By September 2007, NAR estimated annual sales figures were trimmed to the rate of 6.54 million units, a 7.6 percent reduction from the previous year. Only a month earlier, the estimate was at the rate of 6.61 million. (CNNMoney.com, September 7, 2007). By the end of the month, NAR reported the estimate for the year was down to the rate of 6.30 million units. (AP, September 25, 2006) The decline continued as NAR reported reduction in sales activities for the sixth consecutive month, now down to the rate of 6.18 million units. (AP, October 26, 2006). At the same time, the inventory of unsold homes was at an all-time high with condominiums even weaker than single-family homes.

With the December sales figures, it was acknowledged that sales activities showed the biggest drop in 24 years, a reduction of 8.4 percent during 2006 or about 6.48 million units down from over 7 million the year before. (CNNMoney.com, January 25, 2007). Homebuilders had even steeper reductions in sales activities.

By March 2007, the sales fell to a rate of 6.12 million or an 8.4 percent decrease from the month before. (WSJ, April 24, 2007). This was the largest one-month decline since January 1989. Interestingly, the decline was attributed to poor weather although subprime woes were increasingly acknowledged. (AP, April 24, 2007). One economist observed that potential homebuyers are staying on the sidelines because the continued bad news in the press gave them the jitters.

“It is a market a lot of consumers are frightened to enter,” noted Philip Neuhart, an economist with Wachovia (CNNMoney.com, April 24, 2007). Their instincts were correct: markets continued downward and inventories continued to grow.

By September 2007, the demand slid further. NAR reported sales at an annual rate of only 5.04 million units, the lowest in 10 years. (WSJ, October 24, 2007). By now, subprime delinquencies and defaults were in play and mortgage financing was increasingly tight. Inventories by the end of September were up to 4.40 million homes available for sale.

New home sales hit a seven-year low according to a Census Bureau study. (CNNMoney.com, September 27, 2007). Existing home sales were at the lowest level in five years. Increasingly the focus shifted to the drying up of financing. Even jumbo loans (those over $417,000) were not immune and because Fannie Mae and Freddie Mac could not purchase them (they were non-conforming loans), the interest-rate grew dramatically so that the market for jumbos ground to a halt. The subprime woes had spread to prime borrowers and even to loans for expensive homes in many markets.

 

Given credit unavailability and the fear of further declines in house prices, recent reports indicated that the nation’s supply of single-family homes was at its highest level since February 1988. (WSJ, October 25, 2007) In addition, the supply was added to with the rising number of defaults and foreclosures and with the inability of subprime borrowers to find any financing.

In Pennsylvania, sales activity has slowed considerably. A review of recent data reveals that even the stronger markets are now showing the same signs of the national slowdown. As before, the Pennsylvania experience is likely to be a more modest reduction in sales activities compared with more volatile markets but there are some markets with extensive subprime exposure. The tightening of credit conditions throughout the Commonwealth is likely to increase the slowdown in Pennsylvania as it has elsewhere, too.

C. Defaults and Foreclosures

For years, mortgage default (the formal decision to cease payment of the mortgage note) and foreclosure (the legal proceeding to regain the lender’s interest and move to sell the asset to recover the outstanding loan balance), have been a very small part of modern real estate finance. Some of the reduction has been due to the adoption of successful underwriting methods and the modern evaluation of default risk. Default rates were always a fraction of one percent and foreclosure rates were less, as lenders sought workouts and other remedies given the often costly nature of the legal procedure.

Today, defaults and foreclosures have more than doubled compared to only a few years ago (but are still less than two-percent of the market). There are several reasons: declining home prices, the reduction or elimination of home equity, the economic hardship in some parts of the country which led to traditional failures to produce sufficient income to maintain one’s credit obligations. However, in this case, there is a new culprit: the use of aggressive mortgages, especially interest-only or adjustable-rate loans at high loan-to-value ratios with low teaser rates and no asset price appreciation. Many borrowers anticipated selling or refinancing within months of purchase at considerably higher asset prices.

It is apparent that the financial risk inherent in risky mortgage instruments was neglected by thousands of borrowers who anticipated windfalls in what they anticipated to be hot real estate markets. Major investment banks participated who packed these loans into securitized instruments and sold them throughout the world.

The use of teaser rates in ARMs were not viewed as controversial until recently. This is likely due to the fact that affordability issues did not matter much whenever home prices continued to surge. All parties were protected with higher prices bailing out affordability problems. Even if a sale did not take place, the option to refinance at favorable terms compared with returns to the assets masked the difficulties.

As early as October 2006, ARMs with teaser rates were coming to the attention of the media. Foreclosures were up 42 percent during 2006, (CNNMoney.com, January 25, 2007), amounting to one out of every 92 households. A typical case began with a monthly payment of $1500, using the teaser rate to help affordability. Some borrowers may have thought this rate was fixed, others knew there would be an adjustment sometime out in the future. Others never imagined they would be in the same house when the adjustment month was scheduled to occur. Interest rates rose a bit but the terms of their mortgages were set even if rates remained constant and the adjustments were sizable, increasing to $2500 or $3000 per month. Given that the households may have purchased too much housing for their incomes, there was no way they could pay the new monthly mortgage. They began to fall behind, could not refinance and found themselves in financial trouble. Many never imagined that they would get into trouble in the presumed, safe real estate market. Some purchased several homes as speculative investment vehicles as well.

In early 2006, it was reported that 39 percent of new mortgages were non-traditional, meaning not using a fixed-rate mortgage. (MSNBC.com, October 25, 2006). New foreclosures were predicted to be 1.3 million by the end of the year.

What is now on the minds of millions, who likely counted on flipping these assets or refinancing them prior to the reset date, is the number of resets scheduled over the next several months. At least $1.5 million in ARMs were reset in 2006 and as many as $2.5 million more are ready to be reset in the next few years. Many of these borrowers will not be able to maintain their payment schedules for these reset loans.

During March 2007, foreclosures on US homes reached almost 150,000, which was up 47 percent from the previous year. (CNNMoney.com, April 18, 2007) Estimates for the year extended from 1.2 million to 1.8 million according to various sources. One expert expects as many as 2.4 million homes to be lost over the next few years. (CNNMoney.com, April 25, 2007). It is also clear that home ownership rates were slipping from their all-time highs as perhaps as many as one million households were being forced to drop out of the home ownership market and return to the rental sector.

The data showed that most of the foreclosures were in areas with high subprime usage: California, Florida, and in a few other formerly hot housing markets. In addition, in the upper Midwest markets, subprime borrowers accounted for a majority of the foreclosure cases due to declines in manufacturing and the auto industry. These economic problems led to financial difficulties for many households. Recent research shows that subprime mortgages did not cause the problems but certainly were associated with many of the defaults and foreclosures.

Each state reported differing experiences with foreclosure rates. By early 2007, there was one foreclosure for every 264 households nationwide. In Nevada, the rate was one in every 75 households and in Colorado it was one in every 111 households. California had more than any other state (80,595 total) and accounted for one of every five in the country. Florida was up substantially from the previous year as well. (CNNMoney.com, April 25, 2007).

 

Almost all observers expect foreclosures to continue to rise throughout 2007 and into 2008. The reset dates are prescribed and given the unavailability of mortgage finance, especially for risky borrowers, there is an inevitability and finality to the situation.

For investment property, walking away from the obligation and the foreclosure proceeding which follows, is now viewed as an investment option. Despite the high cost of a slashed credit score and the vulnerability of losing personal assets, conditions are bad in many real estate markets. Workout loans are frequently suggested as a less painful strategy. (WSJ, October 18, 2007). One of the unfortunate facts is that the record number of foreclosures increases the supply of units on the market precisely when the relative supply of units is at its highest level since the 1930s.

Calls for assistance from Federal and State governments have grown in recent weeks. There are many bills in Congress and in state legislatures across the country designed to try and bail out over-extended borrowers as well as borrowers who may have been unaware of the consequences of the financial instruments they used. These measures are controversial and complicated. We will most likely hear more about this in weeks ahead.

Pennsylvania has not been immune to the rise of foreclosures due to this mortgage crisis. A very recent study reported that some 45,500 homes are estimated to be subprime foreclosures in the state. (AP, October 27, 2007). In September 2007, the foreclosure rate in Pennsylvania rose 22 percent from a year ago with the greatest increase in Philadelphia with an increase of 53 percent.

D. The Rise of Subprime Lending

There is no question that the rise of subprime lending practices has led to the mortgage crisis. The market was ready as soon as house prices stopped appreciating. Further, problems in the subprime mortgage sector have spilled over into quality loans as well as other economic sectors. While in the beginning of the crisis, it was thought to be a series of small, risky loans which were proving to be poor risks, no one doubts the seriousness of the impact now. Subprime lending practices may result in weak economic growth and recession. According to some observers, there are other issues as well, credit crunch problems for all mortgage borrowers; problems for the Federal Reserve Bank, in terms of providing sufficient liquidity for the overall economy, enormous losses for investment banks and their customers (may have already been reported) and issues for regulators who are about to engage in a series of hearings to develop new rules governing the financial system and real estate securitization.

 

As for the subprime crisis, everyone is pointing fingers at someone else.

A typical list includes:

a) Mortgage brokers (who allegedly steered borrowers toward more expensive homes than they can afford).

b) Real estate appraisers (who allegedly inflated house estimates in order for borrowers to get the maximum financing they desired).

c) The Federal Reserve Bank (who allegedly made cheap money available for a long time in the beginning of the decade, often at negative real interest rates, so as to stimulate the housing market).

d) Other government agencies (who allegedly failed to regulate the new player the mortgage broker -- who have taken over a majority of mortgage lending from traditional savings and loans).

e) Mortgage lenders (who allegedly relaxed lending standards for risky borrowers).

f) Wall Street investors (who bought securitized instruments seeking high returns allegedly without knowing their contents and risk levels).

g) Real estate agents (who allegedly encouraged households to buy more housing than they could afford).

h) Borrowers (who, after all, generally need to be held responsible for their own actions). (CNNMoney.com, April 24, 2007).

In such a crisis, there is plenty of blame to go around.

In March 2007, ex-FED chair, Alan Greenspan worried that the subprime problems could easily affect other sectors and it has now begun. (CNNMoney, March 15, 2007). He also cautioned that high house prices were the main problem rather than defects in the mortgage market. Very recently, Greenspan emphasized that problems in the financial system were plagued by excessive inventories of homes. He estimated that the financial system would be strengthened with the sales (and elimination) of 200,000 to 300,000 housing units now on the market. (CNNMoney.com, November 6, 2007).

The subprime mortgage crisis is also taking its toll on the banking industry. Massive layoffs have begun as banks trim their staffs and in some cases, close down mortgage divisions. The reported losses are enormous, led by Merrill Lynch ($8.4 billion and 13 percent of its market capitalization), Citigroup ($3.5 billion), UBS ($3.4 billion), Deutsche Bank ($3.1 billion), Morgan Stanley ($2.4 billion), Bank of America ($1.6 billion), JP Morgan Chase ($1.6 billion), Lehman Brothers (.7 billion) and Bear Stearns (.7 billion) (WSJ, October 23, 2007). Several of the CEOs have been forced out or have recently resigned and there are reports hat more losses will be forthcoming.

A recent Joint Economic Committee study estimated the subprime losses at $103 billion over the next two years. (AP, October 27, 2007). If one considers the secondary effects and further surprises, since the crisis has not yet bottomed out, estimates are that the losses will be as much as $200-$250 billion.

This is a serious and important reminder of how important the housing sector is to the financial system in the US. The same study reports that the subprime mortgage crisis will cost Pennsylvania about $2.45 billion. This includes lower home and neighborhood values as well as lost property taxes via foreclosures.

Five Lessons for the Real Estate Market

In this section, we offer a few lessons that may be useful for participants in the real estate market.

1) Real estate is a long-term, consumer durable with unique features and characteristics.

We have lived through a period in which we forgot that housing provides shelter and user benefits for households. Rampant price appreciation caused us to think houses were investment commodities that continuously appreciated in value at high rates of return. The next several years suggest our concept of housing will return to a more traditional view of housing as a consumer good (with some investment characteristics) and not solely as a vehicle for appreciation potential.

2) There is an extremely important link between housing markets and mortgage finance.

Housing and financing are closely interwoven. As a result of the current financing crisis, we need to have a better appreciation for this interrelationship. While deregulation of the mortgage market in 1981 opened up a variety of innovative mortgage instruments and led to the rise of mortgage-backed securities, the market’s recent experience demonstrates the power of financing and the possibilities of abuse and misunderstanding of financial instruments and investment strategies.

The link between housing markets and mortgage finance has traditionally been neglected by the real estate brokerage industry and others. The brokerage business hasn’t focused nearly enough on teaching real estate professionals about the variety of new mortgage instruments. There is an enormous need for education on real estate finance for both REALTORS® and consumers.

3) Real estate sales professionals need to develop additional expertise in real estate finance.

The old days of going to the broker to calculate a client’s standard mortgage payment are over, Jaffe believes. Today, REALTORS® need to understand and manage financial transactions for their clients and themselves.

The real estate professional of the future will be expected to be more in tune with modern real estate finance as never before. The real estate profession needs to focus on educating the consumer about the entire financial process of purchasing a home.

Consumers thought appreciation would bail them out and greed took over. Now they are getting caught with 100-percent financed loans and depreciating values. There is a collision coming every month as these adjustable-rate mortgages reset and their mortgage rates continue to rise.

4) We may be at the beginning of a special period in the history of U.S. real estate markets.

It appears we may be entering an era where the financial returns on housing are quite low, yet, after the fallout from the current crisis settles, we will see new and innovative instruments available for mortgage finance. Real estate professionals will operate in markets with considerably more information and work with better-informed clients who are in tune with market trends and information

This kind of market may feel like real estate markets felt 50 or more years ago with all parties operating with an added benefit of a multitude of data sources and greater knowledge on the part of consumers.

The strategy of consumers having hardly any savings, barely any financial assets and a huge house is foolish and vulnerable. The thinking that more real estate is always better is not necessarily true and people need to put their household portfolios and budgets into proper perspective. Always assuming that a larger house is better than a smaller one is a faulty way of looking at things.

5) The long-term future for the real estate industry is very bright and exciting

The prospects for medium and long-term economic growth throughout the U.S. continue to be outstanding. The demand for housing will “remain strong and perhaps even increase” as incomes rise and households seek better quality housing in the future. As the country continues to grow, so will its demand for housing. The demand for real estate in the long run, over the next 10 to 15 years, looks like it will return to a normal pace.

The returns to the real estate industry will be very positive in the long run and in the future there will be a market for new, innovative, quality construction. People who have been in the real estate industry for a long time have seen this type of downturn before. As long as we continue to see economic growth, the demand for housing will remain strong.

Prospects For 2008

A new Fortune Magazine study identifies 25 real estate markets poised to fall (Fortune, November 7, 2007). The focus is over the next five years based upon differences in the house price-to-rent ratio today compared with the previous 15-year average. The city with the predicted largest reduction is Orlando, Florida (-34.2 percent over five years). Its current price-to-rent ratio is 23.8 percent and historically the ratio is 14.9 percent. For each of the cities, the current ratio is significantly higher than its long-term average. The result is that prices are forecast to drop significantly in order to get back to normal ratios.

Other cities expected to show large declines include:

Miami: -32.3 percent

Tampa: -28 percent

Baltimore: -27.8 percent

Las Vegas: -26.4 percent

Sacramento: -26 percent

Los Angeles: -24.1 percent

San Diego: -23.5 percent

Phoenix: -23.5 percent

Charlotte: -22.9 percent

Richmond: -22.3 percent

Seattle: -19.5 percent

Only Philadelphia is on the list of Pennsylvania cities and housing in the City of Brotherly Love is forecasted to decline by 21.6 percent over the next five years.

What about 2008? It is not likely that the decline in house prices and drop off in sales have reached its bottom yet. Most observers do not see the end to the declines in the near future. It is expected that there will be announcements of additional losses in mortgage securities, especially in Europe and Asia. Real estate markets are likely to continue to struggle well into 2008. Pessimists argue that recovery will not take place until 2009 or 2010. A more reasonable guess is that real estate markets may stabilize in late 2008 but much depends on the overall economy and on demographics. The bottom line is that this downturn is likely to be as serious of a housing decline as was the drop in the early 1980s even if the reasons are much different. If the decline continues, it could be the worst era for housing since the 1930s.

The Federal Reserve Bank seems determined to manage the credit crunch to help the overall economy. This observation suggests continuing assistance to lower financing costs via occasional reductions in the discount rate. Such actions will continue to result in a lower value for the dollar in international exchange markets, already at all-time lows against many major currencies. It will also mean a shift toward worrying about economic growth rather than inflation in the months ahead.

For real estate professionals 2008 will continue to be as challenging as it has been in 2007. Since Pennsylvania housing markets are less volatile than other markets, the impacts of various shocks from Federal Reserve policy to national mortgage finance issues will likely be considerably less. There is no reason to expect Pennsylvania housing markets to behave like the highly-charged markets on the decline when they did not behave like them on the upside.

Real estate in Pennsylvania will survive and homeowners will prosper over time, especially as we return to the view of housing as a long-term durable asset with moderate rates of appreciation potential and numerous subsidies by favorable federal and state tax authorities. No other industry can point to such important elements in their products.

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