The Volatile California Housing Market – 10 Reasons why there will be no Recovery in 2010. The Seamless Short Sale and Renting back in Vogue.

The California housing bubble will go down in history books right along the Florida real estate bubble of the 1920s where speculators flipped swampland contracts over a nice lunch.  The unique aspect of the California housing bubble is that it engulfed the entire nation and to a large degree, other cities in the world.  This was the first global housing bubble.  Much of this was possible because of banking globalization and people being able to trade and buy across boarders with greater simplicity.  The open nature of the market allowed the California dream to become the global real estate dream.

Now California has taken a large brunt of the decline on the chin.  The economy is stumbling trying to maintain balance, the state budget seems to be in perpetual deficit, and housing prices seem to be falling into an abyss.  Yet after a statewide drop in the median price of 50 percent, it does seem that prices are stabilizing.  Much of this course is due to the large number of foreclosure re-sales occurring in more depressed areas.  Of the 45,000 homes sold last month in the state 43 percent were distressed properties.  Even in light of this, the median price ticked up to $250,000 when in the previous month it had been $246,000.  The California housing market is so enormous that to paint with a broad brush misses the nuanced complexities of the actual market.

In this article, I want to show why the California housing market will see no recovery in 2010.  Yet the dynamics of the market are going to be different from what many expect.  We are already seeing some creative methods of keeping distressed homeowners in their home while banks halt off writing down any losses.  Seamless short sales and rent-backs are creeping into the system.  Our government has already made it abundantly clear that they will bailout banks to sums much larger than many would expect.  So recovery is off the table for California housing in 2010.  But whether the market crashes further or stabilizes is yet to be seen.

Chart #1 – Number of Agents and Brokers

California sure loves its real estate.  In 1997/98 there were 297,000 licensed agents and brokers in the market.  By the peak in 2006/07 the number was up to 537,000 showing an increase of 80 percent in a little under a decade.  In July of 1997 the state had 32 million people and by July of 2007 the state had 36 million people.  This population increased by 12.5 percent while those that were real estate agents and brokers expanded by 80 percent.  Now of course much of this was brought on by housing mania and the aspiration for real estate wealth glory.  Many achieved high incomes during the bubble yet much of it was squandered in conspicuous spending.

To a large degree, that is why California is seeing a double hit to its economy.  First, a large number of people making good pay in real estate no longer have that income.  The industry has scaled back from its heights.  Even with all the negative news regarding California housing, we still have 521,000 licensed agents and brokers.  I imagine many more have left the industry and the statistics simply do not reflect those leaving the industry.  Over the next couple of years, you will see many not renewing their license.

Chart #2 – Pent up Inventory with Alt-A Loans

One item that sticks out to me regarding California is the number of Alt-A loans in the state.  This seems to be the wildcard.  Will these loans implode and send an avalanche of inventory or will lenders simply hold loans off the books for years to come?  Whatever the outcome, California has 28 percent of the 2.5 million active Alt-A loans in the country.  Many of these loans are scheduled to hit recast dates, that is the loan will amortize over a much quicker period and the payment will jump, starting in 2010.  Some will point to a low interest rates but the issue is more prominent with the actual change with a recast.

Now Alt-A loans were nefarious in pushing the California bubble upwards.  Part of the Alt-A loan was the much disgraced option ARM product.  These loans allowed borrowers four payment option choices:

-1.  30 year fixed payment

-2.  15 year fixed payment

-3.  Interest only payment

-4.  Negative amortization minimum payment

Unfortunately, data shows that 80 percent of option ARM holders elected to go with selection number 4.  Recent data on these loans show default rates starting to rival those of the more dubious subprime loans.  Yet how this will impact inventory in 2010 is yet to be seen since much of these loans seem to be held off the books by banks. 

If you think like a bank, it does make sense.  Why flood the market and depress prices if the government is willing to bail you out with additional taxpayer money?  If you think of the big pushers of these loans like Wachovia, Washington Mutual, and Countrywide Financial they are now owned by the too big to fail banks of JP Morgan/Chase, Wells Fargo, and Bank of America.  If the banks had to write-down loans to current values their equity would render many obsolete.

Chart #3 – Competitive Rental Market

California has always had a large renting population.  Many people in areas like San Francisco and Los Angeles choose to rent either by choice or because of economic reasons.  With a lax lending environment many decided to take the plunge and buy a home.  Many are now realizing they got in over their heads.  Yet recent trends are also showing interesting housing patterns.

For example, we are seeing college students move back home after unsuccessfully trying to find work in this tough job market.  Some people are doubling up and what was a Great Depression throwback, some are taking in people as renters.  This was common during that time and now we are seeing people doing what they can to stay afloat:

“(San Francisco Chronicle) Facing layoffs, pay cuts and furloughs, more people have turned to shared housing to help make ends meet. Craigslist … says that its roommate-wanted postings over the past 12 months are up 60 percent for the Bay Area, and up 85 percent within San Francisco.

While young singles sharing digs to save money is nothing new, this new brand of “recession roommates” includes more families and couples who are sacrificing their privacy as a way to cope with the economic downturn.

The Census Bureau’s American Community Survey showed a jump in cohabiting in 2007, the most recent survey year. In California, the number of “family households” with a roommate stood at 228,500 in 2007, up 9.6 percent from 2006. In “nonfamily households,” 674,000 reported having roommates in 2007, a 9.4 percent increase from the previous year.”

People will do what they can to stay afloat and taking in roommates is no exception.  This might play with the numbers for 2010.  Most assumptions were based on families and potential buyers looking to move back in.  Some, for example people short on money are out of the market completely.  If you look at Chart #3 you will see the rental vacancy rate shooting up to 8.9 percent from last year.  That is why in many areas rent prices are coming down or remaining stagnant.

The idea of homeownership for all is coming into question as well.

“WASHINGTON – The Obama administration, in a major shift on housing policy, is abandoning George W. Bush’s vision of creating an “ownership society’’ and instead plans to pump $4.25 billion of economic stimulus money into creating tens of thousands of federally subsidized rental units in American cities.”

A couple of things I will say about this.  The problem wasn’t that we didn’t build enough housing during the boom.  In fact, we over built.  But the over building occurred in larger than life sized homes.  Little was focused on high density affordable housing.  Why?  Well during bubbles, people will chase the speculative fervor and sustainability is only an after thought.  Here in California, the lack of affordability is still big.  In some lower income regions like the Central Valley builders would have done well to look at the income of their local population.  Instead, they built 2,500 square foot mansions for households that make $35,000 to $40,000 a year.  Those are the markets with the biggest and deepest pain.

Chart #4 – Homeownership Rate

It should come as little surprise that we are now heading back down to a homeownership rate from the pre-bubble days.  But what the chart above shows, is that from the early 1990s home ownership in California has followed a strong trend upwards.  This is partly due to our two bubbles.  The 1990s with technology and the 2000s with real estate.  Both of those are now popped so the bottom is harder to predict since we are trying to remove two decades of bubbles to a more sustainable view of homeownership for the state.  Let us look at some average rates:

From 1984 to 2007 average 56.1 percent

From 1984 to 2000 average 54.9 percent

Current at 58.3 percent

So these are good levels.  If we include the bubble years in our average, we can expect a more sustainable level at 56.1 percent.  Removing this decade real estate bubble, we can see the homeownership rate dip to 54.9 percent.  I tend to see this as a more accurate measure.

Chart #5 – Unemployment

Source:  Doctor Housing Bubble

What is probably more solid evidence in seeing no housing recovery for California in 2010 is the unemployment rate.  The above chart clearly depicts a troubled economy.  The latest unemployment rate shows the state at 11.9 percent.  If we are to include part-time workers looking for full-time work and those who have given up our rate jumps up to 22 percent.  This data also does not include the tens of thousands of state employees now furloughed for 2 or 3 days a month.

There have been a couple of reports stating that the unemployment rate will peak at 13 to 14 percent.  This is more reason to believe in a weak housing market for 2010.  Without a job buying a home becomes secondary to financial survival.  It is hard to see what industry is big enough to compensate for the lost jobs in real estate, finance, and construction.  Or more specifically, what industry can produce the volume of high paying jobs seen during the bubble?

Chart #6 – 30 Year Fixed Mortgages

Subprime loans and Alt-A loans are now largely absent from the market.  These were the bread and butter for the California housing bubble.  Take for example this data.  Last year in Southern California 19.7 percent of home loans taken out were government insured FHA financing.  Today, these loans which go in larger part to first time buyers make up 37.2 percent of the market.

30 year mortgages are now the market.  If we look at average rates over 40 years of data we find that the average rate comes in at 9.05 percent.  Today the average rate is at 5.22 percent.  Now this is troubling because we are already at the bottom of the rung in terms of mortgage rates.  The only way to go is up.  And take for example the median $250,000 California home and run both rates:

$250,000 Loan 10% down

Principal and Interest at 5.22% = $1,238

Principal and Interest at 9.05% = $1,818

The payment difference is enormous.  We have a 46 percent jump if rates go back to their 40 year historical average.  Now rates are artificially low because the Federal Reserve has been purchasing mortgage backed securities in large numbers but also mentioned they will be winding down.  The amount of securities on their books is being brought into question and with the amount of debt outstanding, is hard to see how much longer this can go.  Should rates spike, it might push the housing market into a second downspin.

Chart (Idea) #7 – Psychology

The above needs no chart.  Consumer psychology has shifted.  No other investment class has taken a hit to its untarnished record like real estate.  Very few people now argue that real estate will never go down.  That mantra created a lot of buying pressure and now given how widespread prices are falling, many are questioning whether owning real estate is the right move.

In this landscape, California will see additional pressure in 2010 to combat.  The old marketing pamphlets will need updating to convince people why real estate is a good purchase.  A large number of buyers are investors in this market.  The move up buyer is a small portion of the market.  If you were buying a distressed property for $100,000 then this might be a good buy but in many areas of California, homes are still largely over valued.  Without the creative financing of option ARMs or other mortgage products, buying a $500,000 home may not work even for a couple making a good amount of income.

Some people now realize that with renting, they might have more flexibility.  No maintenance costs, no taxes, no insurance, and the ability to pick up and leave when your lease is finished.  These might be luxuries to someone that is underwater and is unable to sell.  The psychology has shifted and this will have an impact on the market in 2010.

Chart #8 – Massive Amounts of Debt

Consumers are maxed out.  Without big incentives like cash for clunkers people are reluctant to buy big ticket items.  There is no bigger ticket item than a home.  The first time homebuyer tax break is running out.  Will Congress renew this?  Who really can tell but at a certain point consumers are now more reluctant to take on more debt even if there is access provided.

Our country debt is simply enormous.  The numbers are jaw dropping.  When we look at the chart above for U.S. households, we realize an inflection point has been reached.  Households simply cannot take on further debt burdens on top of the debt already on the balance sheet.  At a certain point, the debt cannot be managed and that is what we are seeing with the enormous amount of foreclosures, a large number in California.

Now a big part of the market is being driven by foreclosure re-sales and investors.  Next year, we’ll see if this trend can continue.  Given the amount of debt and the weak employment sector for the state, it is hard to see how in 2010 we see housing recover for California. 

Chart #9 – Local Area Incomes

Per capita incomes has been falling right in line with the housing bubble popping.  With lower incomes, prices have to reflect more modest incomes from the local population.  If 30 year fixed mortgages are the rule, many now have to fall within certain guidelines.  I have talked with many sellers and agents that have seen potential homes fall out of escrow because once it came down to vetting for a loan, the buyer simply did not qualify.
That is to be expected.  With rising unemployment I would expect that per capita income to decline.  Furloughs for 200,000 state workers basically pushed per capita incomes down by 15 percent.  And how many others have left their high paying finance and real estate jobs for more modest pay in other sectors?  These people are still considered part of the fully employed.

Chart (Idea) #10 Shadow Inventory

The shadow inventory argument is probably the most crucial in determining what happens to housing in California for 2010.  Does the inventory flood the market or is it slowly leaked out.  A couple of trends are emerging.  Rent-backs and seamless short sales:

“(LA Times) How does this square with my assessment that the stock of homes returned to normal in May? One answer is that the recession is increasing the number of occupants per home, calling for programs that will encourage renters to buy. Another answer is that we built single-family homes in certain locations when what we needed were multifamily homes in other places. Greatly reduced lending standards allowed a large number of moderate-income Americans to buy homes in so-called exurbs, such as the far reaches of Southern California’s Inland Empire. The building that occurred there created homes for a class of buyers that no longer exists because the subprime mortgage market is gone for good. Going forward, these homes will find their best use as rental properties, rented to the very families who now occupy them as owners but don’t have the income to do the debt service. In these cases, we don’t want to stop the foreclosures. Instead, we should facilitate the change in status of the home from owner-occupant to rental, ideally rented to the same families who live there now.”

Mind you this is one of the people who missed the housing bubble and wants us to build again (wrong) but the point about renting distressed homes to current owners is now taking hold.  Some of the shadow inventory might be held off from future write-downs by banks taking in some cash flow from current distressed borrowers.  This isn’t necessarily a bad idea so long as no additional funding is given to banks.  Yet with the amount of shadow inventory reportedly out there, will banks now become the biggest landlords in California?

This is something that is already on the table:

“(WaPo) Before leaving for their August break, Democrats and Republicans in the House took a rare, unanimous stand on both questions by passing the Neighborhood Preservation Act by voice vote. The bill was co-sponsored by Reps. Gary G. Miller (R-Calif.) and Joe Donnelly (D-Ind.).

The bill would remove legal impediments blocking federally regulated banks from entering into long-term leases — up to five years — with the former owners of foreclosed houses. It would also allow banks to negotiate option-to-purchase agreements permitting former owners to buy back their houses.”

Now this is interesting.  Many investors do lease-options when buying real estate.  You buy a home, lease it out to a tenant under an option for them to buy the place at a set amount in 2,3, or even 5 years.  5 years seems long but it does happen.  The benefit as an investor is you have a set price in the future and a locked in buyer.  As a potential buyer, you know what prices to expect in the future.  It isn’t such a seamless process but it is an option that is out there.

Some examples of seamless short sales are emerging and might have a big impact on California:

“Hackman and Huerta already are doing seamless short-sale transactions. Here is one moving toward escrow: A family purchased a house for $725,000 with 20 percent down in 2005, then made substantial improvements with the help of an equity line of $72,500. The house now is valued around $500,000, but is saddled with $625,000 in mortgage debts.

Enter the seamless short sale: Hackman has brought in a private investor who is willing to buy the house at current value, all cash. As part of the deal, the investor has agreed to lease back the house at $25,000 a year, triple net. In three years, assuming they’ve been good tenants, the original owners have the option to buy back the property for $550,000.

Hackman says the internal rate of return to investors can be raised or lowered based on rents and the buyback price, but typically are in the 8 percent to 10 percent range.”

Now this is a fascinating example because many of the Alt-A loans are products with an average balance of $443,000 in California.  Will banks simply lease these homes out to current borrowers?  That is a good question.  Borrowers of course are under no obligation to lease the place back.  Many will strategically default especially those who were looking to flip for a quick profit.  But I would imagine that many would take this offer up.  First, you are assured housing at market rent levels.  Second, you can buy back your home at a later date for a reduced value.

How well will this work?  Hard to say.  But all these 10 points and charts signify that there will be no housing recovery for California in 2010.  Beyond that point we will need to revisit but with high unemployment, pent up foreclosures, declining incomes, and fewer mortgage products California housing has a long road ahead.

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