2008May Real Estate--Real Trouble

2008May Real Estate--Real Trouble

Real Estate: Real Trouble
By Donald Creech CFP® AIF®

The next two years will bring once in a lifetime economic events. The causative factors will be a combination of economic bubbles cycling through our global capital markets and sustained by major demographic changes. Anticipating the turning point and the outcome presents new challenges for investors.

Bubbles rotate from one sector to another due to investor perceptions about demand and profit potential. In 2000, the Tech Bubble ended. It was a bubble fueled by government intervention in the free marketplace with mandates for certain technology performance levels. The underlying assumption was that businesses were not sufficiently concerned about their survival to prepare for Y2K. Wildly optimistic expectations of investors accelerated conditions past the Fed’s initial goals. As the tech bubble crashed, investors abandoned stocks for real estate, leading to a new bubble.

Cheap money was available due to the Federal Reserve’s manipulation of the money supply and interest rates, which were attempts to shorten or soften the recession. Those actions were later classified as a mistake by their chief creator, Alan Greenspan.

In the aftermath of the stock market decline, investors opted for the myth that “real estate never goes down.” With cheap money available to acquire it, demand for speculative properties rapidly increased as buyers threw cash at real estate, and builders rushed to create new supply. Few examined the underlying real demand for real estate or denied it was changing. In fact, normal demand for owner-occupied residential real estate peaked in early 2003, based on demographic needs. The final surge in home construction and home price appreciation after 2003 was largely a result of speculation, as anyone observing at the time could attest.

Most residential real estate transactions are for starter homes with peak demand between ages 28 and 33. The boom in housing in the late 1970s through the early 1990s was largely the result of the Baby Boomers buying their first homes. Demand for starter homes should begin to turn up in the coming years, but the Y Generation will not reach its peak in starter home spending until the early 2020s!

Given the excess housing inventory that we have, we estimate five years of softening prices before demand will return pricing pressure on starter homes. Until then, it should remain a selective ‘buyers’ market.’

According to the Consumer Expenditure Survey, larger families whose incomes have grown up along with the kids and the dogs, trade up to larger homes, on average, at age 42. The number of 42 year olds in our economy is determined by the number of babies born 42 years earlier. US live births, adjusted for immigration, peaked in 1961 falling sharply afterwards with the advent of The Pill. I still use ‘old math’ and arrive at the following result: 1961 + 42 = 2003. Since 2005, when the bubble began to peak, through the end of 2007, residential real estate transactions have declined 63%! It will be fourteen years before we will have a long-term increase in families with the need to trade up into larger homes. It will take some time to absorb the current housing inventory and have sustained price appreciation in larger homes.

Baby Boomers who expect to free up home equity for retirement will likely have to reassess their retirement plans. Excepting areas with continuing strong job growth, demand will continue to weaken extending the current ‘buyer’s market’ well past 2010.

Declining values reduce homeowners’ net equity. The ability to borrow may be affected. Home equity has often been used to finance other family needs due to the favorable tax treatment of residential mortgage interest. In a marketplace compromised by sub-prime loan problems, some lifestyle purchases may be deferred or forgone completely.

Real estate taxes, on the other hand, will likely continue to rise. Assessed values lag reality by several years. When assessments begin to reflect lower sale prices, expect your county to request an increase in the tax rate. Your county still needs revenue for schools, roads, payroll and benefits. Unlike your household, government bureaucrats never consider reductions in spending when revenues fall.

Scoffers doubt significant price reductions will occur, or that they can be sustained. However, in 1990, Japan’s population demographically resembled ours today. Lacking households with teenagers and growing pets, the Japanese real estate market declined 60% from 1990 through 2006.

Scoffers fail to examine even domestic data. The 1970s Boeing recession in Seattle created a population shift as Boeing employees left the area for better opportunities. Real estate supply was high and buyers were few. Homes on Lake Washington Blvd. were available for less than $20,000 and had no offers! An acquaintance of mine gave his Mercer Island home of 20 years back to the bank. The mortgage balance was less than $12,000. Lacking buyers, real estate prices will fall.

California experienced 40%+ price declines in the late 80s when the Cold War ended. Government installations were closed. Workers vacated the greater San Francisco Bay area creating a surplus of sellers. Prices fell. Fortunately for California, our national economy was strong, and California recovered. However, we had positive demographic trends and needs in the 80’s.
As we move into the next decade, we have negative demographic trends for real estate. We will have declining demographic needs for many consumer items as Boomers prepare for retirement.

Child rearing and college expenses typically end in our late-40s. With little time to prepare for retirement, household consumption budgets that supported the children are redirected into retirement savings and debt reduction. The average 50-year old has less than $50,000 in retirement accounts. Accelerated savings is not an option but a necessity. Cashing in home equity will be less helpful as we work our way through a lengthy buyer’s market in residential real estate.

The impact of redirected consumer expenditures is a significant decline in corporate profits and an extended bear market for stocks. Expect interest rates to have a short-lived upward bias as the economy deals with resurgent inflation from the commodity bubble and the Y-generation entering the labor force.

Economic bubbles are self-deflating from marketplace distortion. They do not need a significant event to burst; they simply wear out. As we end the first decade of the 21st century, rising commodity prices should be the catalyst for our next recession. The ensuing recession will be lengthy, sustained by Boomers’ reduced consumption levels.

Major changes are required to sustain your stock market, fixed income and real estate portfolios, not to mention, your peace of mind. Within the next five years, we expect to see deflation return - punishing borrowers and rewarding fixed income investors. An economic tsunami is fast approaching. It is time for “all hands on deck.” This is not a drill.