Guest post from The Decline And Fall of Western Civilization:
This factoid from Mark Hanson:
Let me frame this… in the bubble years existing sales $500k and over were common. In CA alone, from early 2005 to late 2007, the average house price was over $450k. Total sales were huge then too…over 700k nationally in many summer months.
In July 2009 there were only 460k single family (ex-condo) sales – by the way that was down from June’s 465k, but that got lost in the housing bottom headlines. Of the 460k houses sold, only 12k or roughly 2.5% had a purchase price over $500k. I don’t have inventory numbers on houses for sale over $500k but even at 5% of the total inventory that is 1.75 years of supply. Oh, and by the way in CA alone last month there was close to 12k NODs on props over $500k.
This 2.5% sales rate goes to underscore how insignificant (and ruined in many cases) the organic move-up/across buyer has become due to epidemic negative equity and absolute lack of affordability through exotic finance. Unless he can sell and re-buy he will remain gone.
But what really is negative equity? Unlike the bubble years when zero down or a 100% HELOC after the purchase in order to replenish savings was the norm, today’s buyer has to sell for enough to cover the Realtor cost and the 20% down needed to buy most mid-to-high end houses using new vintage loans. Most analysts look at the reported negative-equity figures as the tipping point — it’s not.
If homeowners can’t sell for enough to pay a Realtor 6%, extract the down on the new property, and pay for moving costs they are effectively in a negative equity position. Homeowners know this — a homeowner that has only 15% equity knows they are trapped in their house. We are still learning what this realization does to spending habits, as the focus for many becomes ‘how do I earn or save my way out of this’.
When looking at neg-equity if you move the bar down to 90%, 80%, or even 74% (6% Realtor fee + 20% down) then it changes everything. The vast majority of homeowners in the nation become stuck (see chart below). Without these existing homeowners active in the real estate market, we will never find a true bottom.
Hanson is painting a picture of a residential real estate market in a death spiral. With some states seeing a sizable majority of potential homebuyers frozen out of the housing market by negative equity, there will be effectively no (ie, net negative) move-up or organic homebuying. Folks with less than 25% equity in a house that can be sold today cannot even move laterally, much less trade up, without adding capital that (for the most part) they don’t have to spare. So mid- to high-end homes become completely illiquid assets at anything like current prices — and illiquidity will drive prices further south as supply overwhelms demand. With prices declining further, banks will tighten lending standards further — the era of the 30% down payment is already here in the blighted coastal states, and it figures to spread, moving the bar yet further away for the trapped. There is furthermore a demographic trend at work, as savings-light empty-nest baby boomers divest themselves of the grand houses that characterized their materialistic phase and move to downsize in an effort to raise capital and lower expenses in advance of old age. And so the vicious cycle perpetuates itself.
The end result will i think be a massive compression in price differentials between small and large homes. Square footage, greatrooms, stainless-and-granite professional kitchens and fourth bedrooms were at a huge premium in the boom; in the bust the functional essence of a home, the roof it provides, will likely become the focal point to the relative devaluation of all extraneous components. It would not surprise me if, in the most afflicted markets, large houses actually exchange more cheaply than mid-size units, reflecting the significant differential in operating costs and taxes.
That may seem like great news if you’re waiting out the housing bust from the sidelines and renting your way to, if not prosperity, at least smaller losses. but the effect of further significant declines in house prices on the properties to which the banks are perhaps most exposed has utterly no positive effect for credit quality and therefore the economy.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.