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.