In August 2006, I predicted U.S. real estate and economy news for 2007. I made some shocking predictions.
Perhaps the most interesting prediction I made was comparing Fannie Mae and Freddie Mac to Enron. I thought then, and still do believe, that this will make Enron look like chump change. In the August 2006 post, I wrote:
“(Fannie and Freddie) are allowed to borrow money at interest rates lower than any private company due to the assumption that they will be bailed out by the U.S. government if they go under. The problem is that this implicit (NOT explicit — Fannie/Freddie loans do have a disclaimer stating that the government does not guarantee their loans) assumption has allowed corruption to reign supreme. Earnings were ridiculously overstated. Then the executive management paid themselves huge bonuses based on the fraudulent earnings. This has ‘Enron’ written all over it.”
I have to say I missed that prediction, only because I was too early — the Fannie/Freddie bust did not happen until a few months ago.
What this should show you is that this corruption was known at many levels years before it became headline news. In fact, Warren Buffett stopped investing in Freddie in 2001, “when it became apparent the company wasn’t being run well.”
Apartment Complexes and Commercial Real Estate Buildings Fall Into Foreclosure
As I theorized in 2006, headlines make the financial news section when they have interesting numbers, but they don’t make the front page of the newspaper or media service until they affect people. Once you read the financial news on a regular basis (I read it every day), you start to get a sense for what will eventually affect people, and what will never gain traction because it is theory or policy.
Here’s a great example of an article that will make front-page news next year or in early 2010. Some very large New York City apartment complexes are on the verge of default. Why hasn’t it made front-page news yet? Simple: The residents haven’t yet been affected. But soon the owners will have no choice: tenants will either have their rents doubled, causing a mass exodus and protests (front-page news for the New York Times), or the owners will default and the bank(s) holding the loans will put these large apartment complexes up for sale (also front-page news, since very few of these defaults have happened in the past few years.)
But for now, it’s relegated to the business section. There are some shocking numbers in the article:
“Savoy Park… was refinanced a few months before the credit markets stalled last summer. Credit Suisse pooled the main or senior $210 million loan with other mortgages and sold it to Wall Street investors as a commercial mortgage-backed security. The owners secured four additional loans, bringing the total debt on the property to $367.5 million, with a loan-to-value ratio of 88 percent, according to Realpoint.”
That means the owners had debt totaling 88 percent of the property’s value — and this was at the height of the market, meaning the owners are now likely underwater.
The interesting thing is that, using the article’s numbers, you can actually predict when it is likely that this apartment complex will fail. “There is no evidence that the owners are having trouble covering their debt service of nearly $2 million a month,” the article says. Then: “The building’s annual net cash flow was only $4.3 million at the end of last year.” And finally: “The landlords have a… generous reserve fund… to cover the shortfall on their senior debt — $30 million.”
$2 million a month x $12 = $24 million, minus the $4.3 million cash flow = $20 million. Reserve funds: $30 million. Doing a bit of back-of-the-envelope calculation, the building will likely fall into foreclosure in approximately 18 months.
Why Commercial Real Estate Failures Matter to You
Why does it matter to you? Because thousands of large apartment complexes and office buildings were financed in this way during the boom. Something you may not know is that I considered buying some commercial property here in San Jose a couple of years ago for my hosting company. I looked into several buildings — nearly all of which had recently changed hands to a “private equity” firm. Many of them were selling “office condos” (commercial property) at double the monthly price it would have cost my company to rent the same amount of space.
Needless to say, we ended up renting.
The fortunate thing for the renters in this particular apartment complex is that it is rent controlled. I’m dead set against rent control since it raises prices and reduces available supply, but in this particular case, it’s the only thing that is keeping this story from heading to the front page.
“Subprime” Disappears from the Headlines
What else is going to happen in 2009? The word “subprime” is going to disappear from the news. Here is the mortgage rate reset chart. By mid-2009, the vast majority of subprime loans will have finished resetting, which means that by mid-2011, the majority of subprime foreclosures will be over.
Instead, in 2009, “prime” foreclosures will become the new front-page news. It turns out that prime loans were just about as rotten as subprime.
I posted a link recently from CNN showing that 1 in 25 “prime” jumbo home loans (loans greater than $417,000) are now in default. A friend asked me: “What does that actually indicate?” Great question. It means that 4% of all those who purchased a home with a loan greater than $417,000 are now past-due by at least 90 days on their mortgage. At least 80% of these loans will go into foreclosure.
61.9% of the loans in the Bay Area in January-June 2007 were prime jumbo (also called “non-conforming”) loans.
This means a substantial percentage of “prime” loans on higher-priced houses in California are headed into foreclosure.
And that means this snowball of lower house prices has just started for the higher-end properties here in California.
Avalanche of Foreclosures Means House Prices Continue to Fall
Another tidbit for 2009: Foreclosures will start to outnumber homes being sold in many areas of the country. Realtors are crowing about home sales being up, even though prices are down. But when you look at two pieces of data for the same month: number of foreclosures, and number of homes sold — a different picture emerges.
View from Silicon Valley did some excellent research. Taking the total number of home sales for June in Santa Clara County, and subtracting out the number of foreclosures, the net number of homes sold in this county was just 433.
Don’t let this data mislead you; it doesn’t imply that all but 433 homes sold were foreclosures. It’s intended to point out that while Realtors trumpet high sales, they’re fighting a losing battle. The number of foreclosures coming on the market means that even the higher sales numbers won’t make prices go up anytime soon.
When Should You Consider Buying a House?
In fact, you have plenty of time to wait if you want a good deal on a house. Mish of Global Economic Trend Analysis says you have 15-20 more years to wait until prices return to their ‘04-’06 levels. He uses data for Southern California, but I have been tracking both NorCal and SoCal markets and I see no difference in price deflation between the two.
In August 2006, I said that late 2010 would be the best time to buy a house. I’m sticking with that. If you want to buy a house, put the money you would pay for a mortgage payment (since even with 30%+ drops, it’s still more money to own a house in most parts of California than it is to rent) in a savings account. There’s absolutely nothing wrong with waiting this out for a few more years and getting a better deal. Use those years to live frugally, pay off your debt, and build a substantial piggy bank instead of taking on more debt.
When you are ready to buy, calculate the monthly rent for a comparable place using craigslist or local classified ads, and multiply that rent price by 150. If that number is lower than the price of the house you want to buy, I’d recommend waiting. For lower-income areas (the ones hit hardest by subprime foreclosures), multiply by 80 instead to avoid continued deflation.
A Summary of my Headlines for 2009
- Apartment complexes, office buildings, and other commercial real estate bought at the peak will go into foreclosure in the next 12-18 months, or will be forced to raise rents substantially to stay in business. Since customers won’t take the rent increase nicely, this will likely make for some interesting headlines, and potentially lawsuits. This likely won’t happen until late 2009 and will continue for several more years.
- “Subprime” will disappear from the headlines and will be replaced by “prime” — particularly jumbo prime loans (those greater than $417,000.) Those jumbo prime loans will be much harder to get, and prime mortgages will default at a heretofore-unbelievable rate, bringing house prices on the high end down significantly.
- More waves of foreclosures will mean housing inventory, despite strong sales on the low end, does not decline significantly. Therefore, prices will continue to drop.
- It still won’t be a great time to buy a nice house. Wait until 2010 and use the 80-150x rent calculation to decide for yourself. In the meantime, stop taking on additional debt and start saving for a down payment — you’re going to need it, especially if you intend to buy a nice house.
What are you seeing in your local area? What are your real estate predictions for 2009? I’d love to hear from you in the comments.
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September 3rd, 2008 at 7:23 am
I’m in the process of buying a new single family house at the moment. We’re also in a very expensive market (Washington DC metro area - outside the beltway). We’re getting a jumbo non-conforming loan *and* a second mortgage. However, the total monthly payments are well within what we find comfortable and the 2nd mortgage will be paid off once our existing townhouse sells (and both are fixed rate loans). What we’ve seen going through this process is that it’s difficult to find a lender willing to give a second mortgage, and that at least in the DC area, jumbo non-conforming rates are not much higher than conforming rates. (And the sad part is - we’re putting down 20%)
I’ve noticed that the documentation requirements are much stricter than they were when I applied for my current mortgage in 2003. However, I’m not sure how much of that is because I just changed my name when we got married vs how much is now “standard”.
September 3rd, 2008 at 11:03 am
Erica: Thanks for the plug!
We plan to update those charts monthly, similar to the price tables published monthly, the latest of which is:
http://www.viewfromsiliconvalley.com/id440.html
And similar to weekly Santa Clara Co. data at:
http://www.viewfromsiliconvalley.com/id125.html
September 3rd, 2008 at 6:32 pm
What I hear: “Cain’t happen here!”
What I read: Roche pulling out of San Jose, 300 jobs lost.
2010 sounds about right.
September 3rd, 2008 at 10:20 pm
Erica,
This post is quite timely. I have been researching the purchase of an apartment building (5-8 units) both in my local area (SoCal) and out of state. I am partial to the method advocated by Tyler Hicks, that is, buying from motivated sellers and having a lender front the cash for the deal (given that the property is worth more than I am buying it for and the rents cover the ~80% acquisition cost). Your article suggests that these types of opportunities will increase.
My questions are:
What timeframe do you see these opportunities arriving? (this assumes you agree!)
Given the steady nature of their cash flow, will lenders finance this type of transaction?
How do you suggest I maximize the potential for finding these deals?
(Disclaimer: I do not own any property yet.)
Thanks for your past, present and future (blogging) insight!
Chris
September 3rd, 2008 at 11:53 pm
Hi Erica, thanks for stopping by my website, yep Peggy is like a second mother to me, haha! I’ve subscribed to your blog and will have to look you up next time I’m in the bay area. Thanks!
Brian
September 4th, 2008 at 12:27 am
Erica, with the new “housing rescue law” wouldn’t the government intend to refinance those who took exotic loans between 2004-07 and are on the brink of foreclosure when the loan reset?
would this affect your prediction?
September 4th, 2008 at 3:31 am
Reading some of the comments above, I still can’t believe people are willing stepping up to hang themselves financially. In my part of California (north coast along the Oregon border) prices have barely fallen and people are in complete denial about the housing bust. This thing is a long way from over. And to Tal above, the “rescue” law for irresponsible borrowers and bankers won’t stop the waves of foreclosures. Too much fraud, too little ability to pay, and too little interest amongst the fraudsters (AKA “borrowers”) to stay in a house that will have depreciated 50% or more, so they will just walk. Remember “subprime is contained” from our heads of state? These bailouts just postpone the inevitable and make it more messy and costly for taxpayers. But, the fundamental problem is prices remain too high, salaries too little, and now with higher documentation requirements and the advent of downpayments, the potential buying pool is now a quarter of what it was–say goodbye to your home equity!! Ha Ha.
September 4th, 2008 at 4:58 am
How about this for a headline next year:
“FDIC Bankrupt - Federal Bailout Coming.”
September 4th, 2008 at 6:41 am
Erica,
The main reason those NY apartments fell into default on their mortgage was inordinately high assumptions by the buyers of the buildings that they would be able to raise rents significantly in a short period of time. They can’t. Why? NY rent stabilization and rent control laws. They will also protect the tenants from both disposition and rent increases during a foreclosure.
And one of the reasons the CRE world has not seen more foreclosures and problems in this cycle (vs the 1989-1992 cycle which was primarily a CRE downturn) is that CRE financing in the “generic” product (low mortgage dollar, non-trophy sector) was relatively constrained by underwriting in the CMBS world. It really was difficult to get financing for LTV’s much above 80% and what was really king was debt coverage–120% - 125% debt coverage was the norm. Once you start to look at the mega-trophy market (e.g. GM building, the Claass-A buildings in prime market like NY, LA and CHCG) you start to see the financial excesses the press is writing about.
September 4th, 2008 at 9:28 am
I am looking to buy retirement property in the Santa Cruz area but I am in no hurry. Can you kindly provide your take on that area and whether its wise to wait, say, 2-3 years?
September 4th, 2008 at 10:41 am
Vinnie,
I am a Santa Cruz resident and trust me, there are WAY better places to live. It’s expensive and the quality of the area has gone down dramatically. If you like to hang out in dirty, unsafe down town areas, then it may be just right for you. Personally, I am leaving the area early next year and can’t wait! Bye SC!
September 4th, 2008 at 4:15 pm
I have seen variations of this before:
“When you are ready to buy, calculate the monthly rent for a comparable place [..] and multiply that rent price by 150. If that number is lower than the price of the house you want to buy, I’d recommend waiting. For lower-income areas [..] multiply by 80 instead to avoid continued deflation.”
and tend to agree, but this means where I rent prices are about DOUBLE what they should be. I rent for what I consider an exhorbinant amount (more than $2500/mo) but comps continue to be listed above $800,000, some in the $1 million-plus range.
Needless to say I have been watching this bubble process since about 2005 with great interest. I absolutely refused to get a toxic loan when everyone (including so called finance experts) were telling me I was a fool not to ‘jump in any way you can’. I do feel vindicated, but wonder if my area (SF peninnsula) will ever drop like it should in comparison to these fundamentals.
We’ve had the debates on patrick.net but clearly certain areas have more than simple fundamental numbers driving price.
September 4th, 2008 at 5:49 pm
Just because you made a correct prediction in the past doesn’t mean that your future predictions will be correct. Not that I’m saying your future corrections will not be correct, either.
September 4th, 2008 at 10:12 pm
“I’m dead set against rent control since it raises prices and reduces available supply, but in this particular case, it’s the only thing that is keeping this story from heading to the front page.”
I’m dead set in favor of rent control, since it moderates the insane runup in rents we’ve seen in this bubble.
Here in Pacifica, where I remember you said you thought about living, reality is setting in, but only slowly.
We have a local realtor trying to shore up the decline by commenting how much it costs to rent versus buying. What say you?
September 4th, 2008 at 11:21 pm
Hi all,
Thank you for your comments!
I wanted to respond first to several of you who have emailed and commented. The most common message I have received is: “I live in an expensive area of California. Your 150x rent calculation means house prices would have to drop by 50% for them to be in line with this calculation! Do you really think this is possible?”
My answer: YES. Not only is this possible, it’s probable.
For the reasoning why, refer to my earlier real estate post: “When Should You Buy Real Estate?”
http://www.erica.biz/2008/when-should-you-buy-real-estate-and-when-is-it-better-to-rent/
There is a section there titled “When will higher-priced houses fall?” Basically, foreclosure sales are driving the market. Subprime loans reset to higher rates first, so there are more foreclosures in subprime areas right now. Later on (starting mid-2009), as prime loans reset, foreclosures will start to hit the higher-priced homes, and they will fall, too.
Here’s the chart: http://bp3.blogger.com/_pMscxxELHEg/RxzD0s_7EYI/AAAAAAAABB4/ljDSXZhMG3o/s1600-h/IMFresets.jpg
As you can see, the biggest first lump of prime resets hits in March-July 2009. You can expect a foreclosure wave about 6-8 months behind that, and prices to have their biggest crash 8-12 months behind the resets — as prime properties get put back on the market at low prices.
In other words, be patient. It WILL happen, and it could end up being worse than subprime, since prime loans are a higher percentage of loans made — but it hasn’t happened yet. Look for some very nice bargains starting late 2009 from the early resets, and some super-sweet deals in late 2010 as the second wave of foreclosures goes on the market.
I plan to buy a million-dollar home at a 40-50% discount off its peak price. Don’t think it can happen? Just be patient. You have nothing to lose by waiting a year or two before you buy.
@Chris: Regarding rental property… I, too, may end up buying some at the bottom. You can use the same 100x rent metric for it. If it’s a multi-family property, just tally up the total gross rent and multiply by 100. I’ve done MFH total rent x100 calculations in the Bay Area, Orange County, San Diego, Houston, Tampa, and Miami — and that metric works in all of those locations.
Use rent x 80 for a subprime market, as those are likely to have higher costs due to flaky renters and they may need repairs. Use rent x 120 for a really prime property. Don’t go above 120 — at that point, the cashflow isn’t worth it.
I think the subprime market should have some good opportunities at the end of next year or even August of next year at the earliest. Prime will be another couple of years after that — 2010-2012 seem good thus far. I will continue to update on that front.
@Tal: The government program requires lenders to mark their property values down to below market value. Lenders have been reticent to acknowledge the bust, since many of them hold mortgages for amounts over 100% of the value of the property.
See, there’s a nice loophole in the bank regulations — and others can explain it better than I can, but I’ll explain by example. Let’s say a bank holds a $500,000 mortgage on a property. The market busts and the property is now worth $300,000. The loophole is that as long as the bank doesn’t intend to sell the mortgage to another company, it can continue to hold that mortgage at its “book value” of $500,000. Banks depend on this sort of “equity” because it’s money they can lend against, as well as shareholder value.
To take advantage of the government program, the bank has to mark the mortgage down to less than $300,000. This erases a huge amount of shareholder equity and significantly reduces the capital the bank has to lend with. Now you start to see where the problem is. The credit crisis is happening because banks are not acknowledging reality. They figure if they don’t have to sell their mortgages, they can still pretend they’re worth the full amount.
So no bank in their right mind is going to agree to mark these mortgages down, because it will cause (at the least) their stock value to plummet. Many of these lending institutions had only the bare minimum of about 2% of total capital on hand to cover loan losses. That means that even if all their loans were only marked down by 3%, they’d be out of money and thus out of business. When you’re that leveraged, “marking to market” (marking the mortgages down to market value) might as well be a bankruptcy notice.
So the government order will probably do nothing, except that some banks may knock a couple token mortgages down for publicity.
@DaveZ: I’m puzzled as to why the companies that bought these apartment buildings didn’t figure out that a law would prevent them from raising prices. Maybe they just assumed they’d “hire” a couple politicians and get the law changed? It’s bizarre to me.
I get the feeling from reading these articles that these companies were made up of a bunch of people who didn’t give a rat’s *** about whether their project actually made money, as long as they got paid their salary and bonus. Nice work, if you can get it.
By the way, I was offered several 97/3 (3% down — and they’d get an SBA loan for you for the 3% through a different program) mortgages for office real estate in the 2004-2005 timeframe. So there was plenty of crap floating around in the commercial real estate industry, too. Guess I should have saved some of that junk mail.
@pacificapatriot: Read the link about rent control in my post.
I came out publicly on my blog in 2003 saying condos were too expensive in Pacifica:
http://www.erica.biz/2003/why-i-rent-alternate-title-why-the-bay-area-sucks/
I still have that saved search set up on ZipRealty, and the same condo model that sold for $342,500 in 2003 just sold last month for $330,000.
I won that round, and I’m pretty confident we still have more price drops to go. Send the Realtor over here — we can have some fun.
-Erica
September 5th, 2008 at 6:07 am
Erica,
What’s amazing is not that the buyer’s thought they could force turnover in those apartment complexes (RE borrowers conform to Barnum’s first law, there really are an infinite supply of sucker borrower/developers out there), but that they found lenders will to loan them hundreds of millions of dollars on that story (i.e. that the new owners would put 25 - 40% tenant turnover on the table). Well soon those lenders will own those buildings (there is no way in h*** that kind of turnover will occur). The chance of the foreclosers turning those buildings over at 50% of what they lent on them is slim.
With respect to 97/3 deals in the CRE world, they certainly existed, but mostly in the very small dollar market (i.e. $500K to $1.5MM). Once you got above that you were either looking at conduit financing that had the parameters I discussed before or local bank financing (typically floating rate/full recourse financing).
September 5th, 2008 at 11:58 am
Erica, again, there are many good points in this post. Those looking to take advantage of this market can learn a lot from the information you\’re sharing.
For current owners it should be stated, however, if you own a home now, but have no plans on selling it in the next 5+ years, don\’t worry about its value. Home values only matter to buyers and sellers, not owners. You\’ve lost nothing except maybe some equity you didn\’t pay for in the first place. Calm down. A lot of owners are letting their homes go because of their values, and no other reason.
Yes, it is true some people fell for the \”boom\” a couple years ago and their values have dropped tremendously, but if you\’re going to stay in that home for many years to come, you have nothing to worry about. Don\’t let the fears of buyers and sellers get in your way as an owner. I own a home in Colorado (bought in 2004), and it\’s down about $10k in value since I purchased it, but I don\’t care. I have no immediate plans to sell, and my tenants are paying my mortgage. So, who cares what the value is?
Always look at the bigger picture.
September 9th, 2008 at 4:48 am
Interesting.. I don’t know about you, but prices in NYC, Queens County had only dropped less than 10% of the asking price.. yet people are still buying. This includes multifamily and single family and condos. The co-ops are still staying at the same level. I’m only talking about the regions where there is a huge amount of asians. In fact there there area near the main street, the prices did not drop. Some 2 and 3 family was selling for 750k, and got bid up to 920k. A similar was - 899k to 920k. It got sold, and this is just this year May 2008.
An explanation I can give is because people use their money from China and transfer it into here. Just the other day, I indirectly know someone who just transferred 1 million US dollars from China to this area and bought a house here… this year 2008.
Another explanation is that most asian here earn cash.. they cannot put into sleezy money market account or anything so the only way is to buy asset of Real Estate. Somehow they are able to turn the Cash into checks and buy houses. So you go figure.
But yes, there is a slowdown now, but that is because of the news (psychology..but this is a minor issue) and also because the stricter lending requirement since the cash buyer does not have income documentation. If they can somehow bypass that in a way, this Queens area where the asians are abundant will not see a drop in prices.
September 15th, 2008 at 3:12 pm
Hi bwc,
We’re just starting to see foreclosures on the high end. Especially in NYC, the traditional boom that comes at the end of the year with Wall St. bonuses will not happen this year. I think next year is the year that will get really “interesting” for NYC real estate.
-Erica
September 24th, 2008 at 8:13 am
I live in the Silicon Valley. The housing here didn’t drop a lot, esp the good school district like Cupertino, Mission San Jose, etc. With the recent $700B bailout plan, do you think the housing bottom is set right now? Should I still wait or buy a house right now while the interest rate is still low?
January 1st, 2009 at 10:25 am
Hi Erica,
I am happy to have found your web site. I live in Coronado CA and we rent, I have said for about a year now that prices here have to go way down before we buy. People that own here have told us no, prices will always stay high here. That we should buy before the prices go higher. Based on what you say the prices will go down and we will not go wrong to wait. I am staying a renter and holding out for price drops. Thanks for making it so clear.