Wednesday, June 3, 2009

Residential Real Estate Declines Become Quite Large … And Are Still Growing

The value of residential real estate held by households totaled $22.5 trillion in 2007. By comparison, the market capitalization of domestic equities was $19.9 trillion, and $29.7 trillion for domestic stocks and bonds, respectively. The decline in the value of residential real estate remains ominous. Because comparisons in the value of real estate is more difficult than securities traded in public markets, and because many statistics involving real estate do not account for a changing mix of properties, the true extent of residential real estate decline is not as widely known.

The following chart shows relative real estate values over time. All information is indexed at 100 as of January 2000. The chart contains 4 lines, as follows:

1. 10-city index, as described below

2. 20-city index, as described below

3. Los Angeles

4. 4% inflation

The chart provides the following insights:

1. Over the 20+ years covered by this chart, real estate values have fared not much better than 4% inflation. This is poor performance for any buy-and-hold investment asset class. However, in the price cycles within this same period, real estate has fared much better and much worse than inflation. Those making money in real estate depend upon an ability to time the market.

2. Los Angeles real estate fluctuates more (both up and down) more than other major U.S. cities. In the 20+ years shown by this chart, Los Angeles real estate has fared slightly better than most other U.S. areas.

The following chart is based on the same data as shown above, but this presentation shows percentage changes from the prior twelve month data (i.e., data 13 months old is disregarded in the calculation of percentage change):

In this chart, it is easier to see residential real estate's (i) annual volatility, and (ii) the long-term cycle on both the up and downside.

The chart also shows the still massive decreases that real estate is suffering. Recently, a few real estate optimists proclaimed that the worst is over. While it is true that the last few months had smaller percentage declines, the declines were still continuing and severe. While a 20% is better than a 25% decline, both declines are severe. In the above chart, real estate declines continue until the graphed lines increase back to the 0% line. Until this occurs, real estate values are still declining.

The following chart looks at the percentage price decline that each of the cities shown suffered from the peak real estate values. The date of the peak varies by city, but is generally sometime in the second half of 2006.

With the exception of Detroit, the largest percentage-decline locations are in sun-belt states. Generally, these same locations benefited from the largest price increases during the late 1990s through 2006. We looked at the possibility that the price declines were strongly correlated with unemployment rates. Again, with the exception of Detroit, the price declines are only weakly explained by unemployment. For example, Charlotte and Portland have unemployment rates among the highest, yet have price declines that are in the lower half. Conversely, Miami has lower unemployment than most of this group, yet is suffering one of the largest price declines.

The underlying data for the above charts comes from the Case-Shiller Home Price Index, which is maintained by Standard & Poors. Because of the manner in which the data is accumulated, this index is a more reliable measure of real estate values. S&P describes the statistics as follows:

"The S&P/Case-Shiller Home Price Indices began as a research project in the 1980's when Karl E. Case and Robert J. Shiller began to construct a methodology to measure housing price movement. They developed the repeat sales pricing technique, still considered the most accurate way to measure this asset class. The methodology measures the movement in price of single-family homes in certain regions. This is done by collecting data on sale prices of specific single-family homes in the region. Each sale price is considered a data point. When a specific home is resold, months or years later, the new sale price is matched to the home's first sale price. These two data points are called a "sale pair." The difference in the sale pair is measured and recorded. All the sales pairs in a region are then aggregated into one index. Sales pairs are carefully screened for any data points that would distort the index"

The local data is generally maintained using the U.S. Office of Management and Budget's Metropolitan Statistical Areas or MSAs. Data for ten MSAs and a total of the ten locations is available since January 1987. A broader data collection for twenty cities became available in January 2000. The MSAs used in the composite of 10 are Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York (includes counties in New York State, Connecticut, New Jersey and Pennsylvania that are within commuting distance of New York City), San Diego, San Francisco, and Washington DC. The ten additional regions used in the composite of 20 are Atlanta, Charlotte, Cleveland, Dallas, Detroit, Minneapolis, Phoenix, Portland (Oregon), Seattle, and Tampa.

The decline of real estate values prevents owners from selling to avoid a foreclosure, and further encourages solvent owners to let an "under water" go back to the lender. According the Mortgage Banker's Association (MBA's) National Delinquency Survey issued at the end of May 2009, the delinquency rate for mortgage loans on residential properties was a gloomy 9.1 percent at the end of first quarter 2009. This is the highest in the MBA's records since 1972.

The commentary from MBA's chief economist that accompanied the report was equally sobering, and included:

"… we suspected that the [prior foreclosure] numbers were artificially low due to various state and local moratoria, the Fannie Mae and Freddie Mac halt on foreclosures, and various company-level moratoria. Now that the guidelines of the administration's loan modification programs are known, combined with the large number of vacant homes with past due mortgages, the pace of foreclosures has stepped up considerably."

"… What has changed is the shifting of the problem somewhat away from the subprime and option ARM/Alt-A loans to the prime fixed-rate loans. The foreclosure rate on prime fixed-rate loans has doubled in the last year, and, for the first time since the rapid growth of subprime lending, prime fixed-rate loans now represent the largest share of new foreclosures. In addition, almost half of the overall increase in foreclosure starts we saw in the first quarter was due to the increase in prime fixed-rate loans."

"… What has not changed, however, is the oversized impact of California, Florida, Arizona and Nevada in driving up the national numbers. … It is difficult to overstate the severe impact home price declines have had on mortgage performance in those four states. 10.6 percent of the mortgages in Florida are now somewhere in the process of foreclosure. In Nevada it is 7.8 percent, Arizona 5.6 percent and California 5.2 percent."

"… Looking forward, it does not appear the level of mortgage defaults will begin to fall until after the employment situation begins to improve. MBA's forecast, a view now shared by the Federal Reserve and others, is that the unemployment rate will not hit its peak until mid-2010. Since changes in mortgage performance lag changes in the level of employment, it is unlikely we will see much of an improvement until after that."

Real estate lenders will continue to be quite cautions in this environment. It is likely that real estate will be one of the last industries to escape the current recession.

Fulcrum Inquiry performs economic analysis and appraisals. We have substantial real estate experience.