Friday, July 29, 2005

Real Estate is a House of Cards

I lived in Orange County, CA for some time. It is near and dear to my heart. I know its housing market well. The Orange County Register has an article that makes the case that the housing markets in California's various "hot spots" are bubbles about to burst and predicts that a "hard landing" is the most likely result. I personally know people in Orange County who are in the real estate development business and who have sold all of their holdings except for raw, undeveloped land.

Some choice quotes:
"Are you familiar with the game Jenga, where players successively remove small wooden blocks from the bottom of a tower and place them on top, creating a progressively more unstable situation until one player causes the whole structure to tumble?"

"That's basically what's about to happen very soon in parts of California and several other "hot" housing markets around the country. Merrill Lynch recently issued a "bubble" warning for six California housing markets - San Diego, the Inland Empire, Los Angeles, San Francisco, San Jose and Sacramento, where "affordability" indexes are at historic lows. In other words, household incomes are way out-of-sync with home prices."


"Yet California housing prices adjusted for inflation have climbed 80.7 percent since 1997, the largest increase in the country, and well beyond the 45.7 percent run-up in housing prices we experienced in the period 1983-89."


"Low mortgage rates, a loosening of qualification standards and a surge in interest-only financing have certainly played a part. So has a housing demand-supply imbalance."


"But it won't take a big uptick in mortgage interest rates to trigger a slow-down or retrenchment in prices, and the argument that such high prices are justified by insufficient supply coupled with strong demand just doesn't hold water now that we have gone beyond all rationality with respect to affordability across the board."


"We're in the midst of a classic speculative bubble, and even the venerable Alan Greenspan referred to a bit of "froth" in certain housing markets in a recent speech. The UCLA Anderson Forecast, which has been warning of a break in the bubble for the past couple of years, echoed that warning again in its latest quarterly update and predicted a recession to follow even if it's a "soft landing.""


"A hard landing is more likely (where nominal prices actually fall) because houses are more overvalued than in past booms, inflation is lower and many people have been buying houses as investments."


"But the most compelling evidence of a bursting bubble to come is the divergence of home prices and rents. In the United States over the past decade the ratio of home prices to rents has increased by almost 40 percent."


"To re-calibrate to more reasonable historical levels will require rents to rise sharply, which is constrained by household income growth, or home prices will have to fall, the only other possibility."


"Japan presents the scariest boom-to-bust scenario, where home prices have declined 14 years running, representing a loss so far of 40 percent from their peak in 1991. Americans, who live on the edge of credit catastrophe anyway and who have cashed in on rising home equity to bolster their disposable incomes, are especially vulnerable to the negative consequences of flattening or declining home prices."


"Over the past four years, 90 percent of the growth in U.S. GDP was accounted for by consumer spending and residential construction. Declines in the nation's biggest housing markets are likely to trigger a major economic slowdown."
And finally, their dire prediction:
"It is not a question of whether this will happen but when, how dire will be the consequences on economic growth, and how long it will take to restack the blocks and begin again."

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