Thursday, February 21, 2019

Real Estate in Los Angeles - crash or soft landing?

by Dan Maier (writer), Hollywood, November 06, 2006

I was speaking with a gentleman today who was employing a form of logic that can only be described as well, circular. He believes the housing market will not “crash”. He has to. He purchased a home in LA within the last five years; he can’t afford to be wrong. There seems to be two camps in America today; the camp that believes the housing market is overbought, overvalued and unsustainable and those who believe that the recent boom in housing prices is “business as usual” or normal. I am not in the camp that subscribes to the later opinion.

Let’s look at housing prices and what they are and / or represent. As I understand it, housing prices typically reflect a ratio of median income to interest rates. If incomes don’t increase, but interest rates move lower, one can typically afford to spend more on the principal of a mortgage as the interest fees on the loan will balance out the total you would pay over the life of the loan and vice versa. Basically, you would spend roughly the same for a mortgage of $100K at 6% interest as you would for a mortgage of $140K at 3% interest. Typically, the rule of thumb is that you aim to spend on a home between 3 – 4 times your gross annual income or no more than 25% of your gross monthly income on a mortgage payment. This rule may gain some sway depending on your geographic location. For instance you may have to spend 5 – 6 times your income in popular cities like Los Angeles, San Francisco or New York where, coincidentally, some people are currently paying up to 90% of their monthly income on a mortgage payment with the rationale that the increase they are paying for their mortgage will be offset by the increase in equity they will receive via the current aggressive appreciation provided by the current asset bubble. This is skewed logic as it requires an insane belief that housing prices will always rise and dismisses the fact that you should build equity through paying down the principal on your debt and not rely on achieving equity through asset appreciation alone.

According to 2000 US Census bureau data, the median income in Los Angeles for a household was $42K, for single males $36K and single females were at $31K. The median housing price was $210K. As a ratio of income to housing prices, this translates to 5::1, 6::1 and 7::1 respectively. As you can see from these figures, the housing market was just slightly out of reach for the average, single male or female, but for those in households, the housing market was at or near equilibrium. (A note on the term Household. This term was popularized and brought into common usage in modern economics as two-income households became more popular and thusly, most economic measures in America are weighted against household income. In my opinion, this is an abstraction.) According to the data available from the BLS and BEA today, the median income remains largely unchanged though the median housing price stands at $550K in Los Angeles. This yields the following ratios of income to housing prices, 13::1 for households, 15::1 for single males and 18::1 for single females. These ratios grew very large in a small amount of time. This qualifies as a bubble. But what about interest rates? Yes, interest rates did fall to historical lows right about the time we needed to fund a war in Iraq and coincidentally, the start of the housing bubble (thanks Mr. Greenspan!). Just prior to 9/11, interest rates were fairly stable at about 5.75% - 6.25% from 1994 through 2000. Just after 9/11, interest rates fell to about 1%, the lowest they’d been since the year 1958. Combine historically low interest rates with irresponsible lending by banks (Option ARMs / interest only, reverse-amortization / stated income loans) and you can see the why and how housing costs grew out of control in certain pockets of the country like Los Angeles. Unbridled money creation. Believe it or not, there are still places in America where the median income is around $50K and the median housing price is around $100K (Indianapolis).

So, how was the gentleman I was speaking with using circular logic? The gentleman, I will call him Larry, believed that the housing market in LA was just fine. Like I wrote earlier, Larry has to believe that the housing market is fine because a contrary belief would not boast a good forecast. Larry told me that he purchased his home in ’04 for a price of $500K. Larry said that his home had appreciated to $650K during a year period from ’04 to ’05. Well, that certainly sounds good for Larry as he appears to have earned an extra $150K that year! Woohoo! Good for Larry. Larry was disappointed because, in the year period from ’05 to ’06 his home had lost $17K ($650 - $633). Larry believes that the worst of his real estate depreciation woes are behind him. I guess Larry believes that he deserves an easy $150K for doing absolutely nothing, but to lose any of it is just too much; after all it is a house isn’t it? Don’t housing prices always go up? No, they don’t, but more on that later. Larry’s logic in believing that housing prices are done “correcting” lie in his belief that if the economy is truly slowing, and that the Fed will cut interest rates to help the slowing economy. If the Fed cuts interest rates to bolster the slowing, recession-like economy, that will protect those real estate owners who overextended themselves with hybrid loan products when $1.5 Trillion worth of those loans reset in 2007. So I mention to Larry that if the Fed is going to drop interest rates because our economy is slowing then it should be a good time to get into real estate as you could probably “flip” a couple of properties for some handsome profits once the interest rates actually do drop because when they do, housing prices should start rising again. But Larry had a different opinion. He advised against investing in real estate at this time as property values were just too high. Too High? Hmmm, does Larry actually want to lose more of his “profits”? Does he want his home to depreciate? Is Larry just not happy making money? Or is Larry just a plain, average, run-of-the-mill, uninformed American investor who bought a house in 2004 because he didn’t want to miss his last chance to own a home before prices got too out of control. I guess I’ll never really know for sure what Larry was really thinking. When I encounter people like Larry I make a beeline for the door. I couldn’t be bothered engaging him much further.

Apparently there is no doubt now in the mainstream media that we’ve had a housing bubble and that prices are starting to correct. Will the real estate correction be a soft landing or a hard crash and what’s the difference? In my opinion, I think there will be somewhat of a crash although it is difficult to tell with real estate as the market does not tend to move as quickly as the equity markets do. Whatever will occur will definitely take some time to run its course and therefore, depending on the timeline used to spin the story could be perceived as “slower than usual asset appreciation”. I am a firm believer in regression to the mean. The problem with this is that regression often overshoots its target, which may translate into a crash-like scenario. A crash is a correction of greater than 30% to the downside in a market. So, if the ratio of income to home price increased by a dramatic near 300% from an otherwise point of equilibrium, then we should at least expect a 50 – 75% retraction in prices before the price corrects back upward to the mean. This would be a crash. Of course real estate could maintain its current loftiness if wages increased by a paltry 300% and stayed in step with real estate and interest rates, but I’d rather not bet on that.

If you are like me and chose not to engage in this market silliness then you are probably sitting on the sideline waiting for sanity to show itself before you start buying up repossession properties which the banks will be selling for pennies on the dollar. If you don’t believe that real estate can retract by such a large percentage, just tell that to Ben Stein. Ben recently wrote a piece about his experience with the southern California housing market. Apparently, in the early 90’s, Ben purchased a home in Malibu for approximately $600K. He said that within a year of his purchase, the housing market had fallen to where he couldn’t sell his house for $350K even if he tried; there just simply weren’t any buyers. Nowadays his house is worth approx $1.8M, but our friend Ben is willing to bet that these lofty prices, because they are not supported by increases in income and sustainable low interest rates, have the absolute real possibility of a correction of 50% or more.

About the Writer

Dan Maier is a writer for BrooWaha. For more information, visit the writer's website.
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2 comments on Real Estate in Los Angeles - crash or soft landing?

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By Annonymous on November 06, 2006 at 10:46 am
very well researched article, great job
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By Beowulf on November 10, 2006 at 12:20 pm
The bubble will burst.
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