The Real Estate Speculator’s Hangover

According to the chief economist of the National Association of Realtors (NAR), the housing market is now transitioning from an “unsustainable boom” to a “permanently high plateau.” According to an October 25 NAR press release:

“David Lereah, NAR’s chief economist, said stabilizing sales should build confidence in the housing market. ‘Considering that existing-home sales are based on closed transactions, this is a lagging indicator and the worst is behind us as far as a market correction – this is likely the trough for sales,’ he said. ‘When consumers recognize that home sales are stabilizing, we’ll see the buyers who’ve been on the sidelines get back into the market, and sales will be at more normal levels in the wake of the unsustainable boom that we saw last year.’ He noted sales already are improving in some areas.

“Total housing inventory levels fell 2.4 percent at the end of September to 3.75 million existing homes available for sale, which represents a 7.3-month supply at the current sales pace.”

Housing inventory levels can certainly continue falling, but don’t make the mistake of concluding that this will automatically lead to the return of a “tight” market. Over the past year, inventories were given an extra kick as many existing homeowners merely tested the waters of the market; these homeowners hoped to extract big equity gains in 2006 via the analytically complex process of slapping an “ask” price closely resembling their neighbor’s sale price from last year. From there, they expected to sit back and wait for multiple “bids” above their ask price, ultimately selling to the highest bidder.

Trouble is, buyers have finally wised up to the realization that housing runs in cycles – and the top of this cycle has been the most overextended in history. Irrationally exuberant psychology extended the topping process, as buyers clearly feared being left behind by the home equity gravy train. This was very reminiscent of the tech bubble psychology that caused an already-overvalued NASDAQ to double yet again from spring 1999 to spring 2000 before crashing.

The hangover in the housing market will clearly not be as severe as it was in the case of the NASDAQ’s 78% peak to trough decline, because houses (generally) have more durable, tangible value than stock certificates. But by no means is housing about to turn around and rocket upward once again. Buyers’ lowball bids are reflecting this, and sellers can either withdraw their listing or hit lower bids if they must move out of necessity.

As I wrote in August of this year, too many pundits (who in fact must remain cheerleaders as part of their job description) are treating the housing market as if it were similar to the stock market:

“…about 9-10% of the housing market turns over every year. Compare this low turnover with volume in the stock market. The typical S&P 500 stock has about 150% turnover per year, so you can be reasonably sure that the stock sitting in your portfolio is worth within a fraction of a percent of the last tick. The low housing transaction volume makes aggregate national housing value statistics misleading. The near-term value of your house is completely dependent on what current shoppers are willing and able to pay for your house. The ‘willing’ part is psychological, and psychology has morphed from ‘my house will appreciate 15-20% per year’ to ‘my house will appreciate 8% per year.’ The ‘able’ part is dependent on global liquidity and mortgage financing aggressiveness.”

The data coming out over the past few months indicate that while homeowner psychology may have worsened to “my house will appreciate 2% per year,” the mortgage liquidity spigots remains on full blast. Those desperate to sell should be able to sell by hitting lower bids in this low-rate, high-liquidity environment, while those buying are doing so because they want to raise a family in a home – not because they are deluded into thinking they will become millionaires without lifting a finger.

But the bond market merits our attention, particularly after what we saw there last Friday.

If yields spike back above the June highs, the buying support under the housing market could quickly falter, making the “landing” far more perilous than it currently appears.

It’s a big analytical mistake to extrapolate the prices of a 9-10% turnover market onto the entire housing stock. But this mistake has convinced many millions that housing inflation equals “wealth creation.” Thus far, this mistake has not proven to be very costly, since credit availability appears to have no rational limit.

But those who have been planning under the assumption that last year’s housing market was the status quo are waking up to an ugly reality. An article in the November 3 Wall Street Journal entitled “The New Word in Home Sales: ‘Canceled,'” provides an anecdote:

“Cancellations by buyers of existing homes are up as well. Although no formal measures exist, historically they have been in the 2% range, according to the National Association of Realtors. In September, however, nearly half of the 454 agents responding to an online NAR survey said they had recently experienced cancellation rates higher than that.

“Sean Shallis, senior real-estate strategist for the Shallis Team of Re/Max Villa Realtors in Jersey City, N.J., says that roughly 22% of his sales have fallen apart before closing this year because the buyers backed out, up from 10% last year. With the market cooling, buyers have decided they can buy a similar property for less. For others, adjustable-rate mortgages have gotten more expensive, making a home purchase too costly, Mr. Shallis says. To reduce the chances of cancellation, he is advising his clients to close their deals as quickly as possible after the offer is accepted, and to put fewer contingencies in the contract. ‘The longer your property is under contract, the longer the buyer has to talk and think about it and watch the market change.’

“Mr. Shallis himself is among the would-be buyers with cold feet. Late last year, he agreed to pay $595,000 for a new two-bedroom condominium in Jersey City for his in-laws. He pulled the plug on the deal this summer after his father-in-law’s illness scotched the planned move. ‘My exit strategy was if they didn’t move into it, we could sell it or rent it,’ Mr. Shallis says. But that plan made less sense after the price of similar properties dropped to as low as $529,000. At the same time, higher short-term interest rates made it unlikely that he would be able to cover his mortgage payments and other costs if he found a renter. Instead, Mr. Shallis walked away from the contract and lost his $30,000 deposit.”

The huge number of people who bought investment properties in recent years cannot all rent them out. For those who can, their after-tax, after-expense yield is practically negative. Without the fundamental support provided by yield, the “second house” market rests on the speculation that prices can continue to irrationally inflate. As the WSJ story shows, even “senior real estate strategists” are beginning to grasp this concept.

Best Regards,

Dan Amoss, CFA
for Markets and Money

P.S.: The hangover for real estate speculators is likely to continue worsening. Upon the first hint of “deflationary” fears, global central banks tasked with destroying paper money at a “measurable” pace will unleash their next campaign of rate cuts and liquidity injections. At that point, the “good” inflation in the stock and real estate markets can quickly morph into the “bad” inflation of rising CPI levels, gold, and commodities.

Dan Amoss

Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

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