2009 State of the Market

Are local home prices going up or down?

State of the Real Estate market February 10, 2009

 
Jim Hughes, CRS ABR, GRI, ChFC, e-PRO, CDPE

The real estate market in the Twin Cities today is, in one word, confused.  There is little consensus as to what the future holds.  As a result, almost no one is taking action.  Home buyers, sellers, investors, and builders are as frozen as Minnesota lakes.  It is a truly unusual time in the real estate marketplace.

Many people have made predictions concerning what home prices will do, and these predictions have varied wildly.  My personal opinion was shaken around Thanksgiving as I started seeing more inconsistent market data.  In early December, I began a thorough study to predict the future of the market for my clients and myself.

My approach has been as logical and objective as possible, yet no one claims to know for certain what will happen, regardless of the level of their convictions. My goal is purely to determine what is most probable to happen.  I have examined the opinions of others, considered their justifications, questioned their motivations and their data, and focused it all on our local north metro Twin Cities area.  I believe I’ve arrived at an unbiased, independent position.  

Home Prices in Anoka County

 
In my opinion, the average middle class home price in Anoka County and the surrounding north metro cities is 5-10% overvalued.  Now, understand that this 5-10% is meaningless by itself.    There is so much variation that it is like saying the average US temperature today is 48? F.  Although true, it is far from the temperature in your yard today.   

In my quest to bear down and predict the future of the market, in one sense I’ve failed. Although I have arrived at 5-10% with confidence, the timing and the route that will be taken is uncertain.  Saying 5-10% overvalued implies that home values will continue to trend downward and I think they will.  But there are so many variables and my degree of certainty about future values is hardly better than a coin flip.

If you just can’t wait see the meaningful findings section below.

Home Prices today by the numbers

 
At the end of this report, is a list of statements I have considered for this project.  Many of these statements are facts researched from many sources.  Some are mini-conclusions at which I have arrived.  Forgive me for not documenting sources carefully.  I have been more interested in determining a position directly than in defending a position in a pure academic environment.   I only listed information for sources I deemed reliable, or verified with another independent source when possible.
 
There is a lot of evidence. The trick is to discern which factors impact the market the most and should carry the most weight in forecasting.   In my view, a few factors stand out as especially vivid.

Important Home Price Statistics:

• The normal nation home price to rents ratio was 20:1.  Now it is 25:1.  
• The normal national income to home price multiplier was 2.7-3.0 times.   Now we are at 3.5. 
• The inventory of homes for sale in 2004 was 3.5 months supply (3.5 times the number of homes that sold in one month), in December, 2007 there was 14 month supply, in December 2008 it was 11.  A balanced market is historically considered to be a 5-7 months supply.
• New residential construction virtual stopped in late 2006.
• St. Paul, Minnesota - At a January 14th press conference on the Minnesota state budget, state economist Tom Stinson said Minnesota will lose a lot of jobs; 58,000 between now and when the recession ends. He said the recovery, projected in 2010, won't come easily.
• In December of 2008, 53% of metro homes sales were foreclosure liquidations.   Nationally 3% of existing mortgages are in the foreclosure process in November 2008 (baseline is under 1%).  Nationally 7% of loans are in default but not foreclosure (yet). Up from 5.5% one year ago.   The February 6, 2009 issue of the Anoka County legal newspaper had 60 pages of foreclosure notices (approx. 540 properties).   For comparison in any given issue in 2002 there were approximately 30 foreclosures notices.
• Interest rates are currently low.
• Mortgage qualification requirement have tightened dramatically since 2006.

 

Home Price Statistics:

• The normal national home ownership rate from 1970 until the recent bubble was about 62%.   We are now at about 68% - still too high.  This may indicate a stronger pool of renters to come?

• Real estate is out of public favor. There is little competition among buyers.
• The initial wave of subprime foreclosures in the metro area is about half done.  A second wave of Alt-A foreclosures is likely coming.
• Anoka County home prices peaked in late 2005 to early 2006.  In the 3 years since then, the median home sales price has dropped 22%.  Most of that drop (about 15%) occurred during 2008.
• Lots of home owners that bought in 2004-2007 with low down payments can not refinance.
• The government wants to help home owners and buyers

• Population shift - Minnesota is losing population slowly to other states.  But within the state there is net migration from the rural area to the metro area.
• Locally, inventory has dropped slightly over last 12 months.
• Twin Cities sales volume has increased over the last 12 months.

Debunking the Subprime Mortgage Crisis

A lot has been written regarding the real estate bubble and how it popped. Much of it is accurate, so I will not dwell on the topic. However for context, I will scream through the history here.

There is plenty of blame to share. Checks and balances got thrown out the window, and incentives aligned all in the same directions. Buyer’s wanted homes, and if the bank said “yes”, that was good enough.

Realtors sell properties for sellers at the highest price possible. Realtors, representing buyers, try to get the price down, but found it impossible in an environment where supply is short and there are plenty of buyers competing. Realtors live on commissions, and are only paid if there is a deal. The Realtor population in the Twin Cities doubled from 2001 to 2005. Three quarters of all local agents had never seen a slow market in their professional careers. The last one was in 1991-1992, relatively mild, and mostly forgotten. Many Realtors did not believe values could drop. They had the National Association of Realtors chief economic advisors giving regular glowing forecasts. Even if they had a crystal ball, they’d go broke telling buyers not to buy. I personally believed values had peaked in 2002, and we’d see prices go sideways. But as the bubble continued, my conviction weakened, and I continued acquiring investment property selectively. If you are interested in my 2002 prospective, before the bubble burst, see Residential Real Estate at its Peak?

Loan officers believed their job was to sell loans, and that it was up to the underwriter to decide if the borrower was qualified. Many years ago, appraisers were paid by banks that lent money. In more recent years, they have been independent contractors selected by loan officers, who are paid on commission. Appraisers felt pressure to appraise properties high enough so loans would be approved out of fear of losing the mortgage companies future business. Meanwhile, underwriters felt that it was not their job to decide on a loan application’s quality, but to make sure the loan met the guidelines set by the investor, or a semi-public agency like Fannie Mae, Freddie Mac, etc. These agencies were very aware there was a correlation between homeownership and people’s financial success and thus, they eased loan guidelines. They felt that getting more people into homes was good for the individuals, the economy, and the country. It is now clear the correlation was not “causal”. In the end that assumption made some good, stable renters into financially distressed homeowners. 

All these newly qualified buyers meant more demand for homes, which pushed prices up, driving a building boom. Buyers, sellers, Realtors, lenders, builders, developers, cities, everyone loved it, and soon believed that home prices would go up forever. More and more loans were issued, packaged together in groups and sold to investors through Wall Street firms. 

Some firms also sold credit default swaps – an unregulated insurance policy – to investors that guaranteed the mortgage loans would not default. Investors bought credit default swaps and did not care about how risky the loans were. In addition, fast rising home prices hid the impact of the bad loan, because a home owner in trouble just sold the house and paid off the mortgage in full. When we started running out of buyers in 2005, prices stalled and defaults rose. The firms offering credit default swaps were highly leveraged, so they could not cover their promises to investors. Suddenly, trading stopped and the value of the loans was unknown. Lenders tightened underwriting standards and fewer buyers could qualify. Fewer buyers meant less demand, which resulted in prices declining. Needless to say the new mortgages approved today meet much more realistic qualification standards.

This time isn’t not different

Many propose that we can now throw out traditional standards for measuring home values against traditional benchmarks like median household income, and market rents, etc. They argue that we now have advanced banking models, new risk assessment tools, new information systems, and technology that make old standards unreliable in predicting and determining home value norms.

I submit that the bursting of the bubble and revaluation of properties toward the older baseline measures suggests that those old rules still apply. In fact, our recent market turbulence is a result of the prices correcting back to the baseline defined by those old rules. It is this data that makes me believe that median home prices are about 5-10% above the value they should be. Some believed that the rules had changed during bubble. 

That was a psychological misjudgment to reconcile the inconsistency between where home price should have been by baseline measurements and the much higher actual prices they traded at. It was the fog of denial, supported by social proof. I confess I was in and out of that fog for a couple of years too.

Meaningful findings

Part of the confusion in the real estate market today is that as much as we’d like a tidy statement like “homes are 5-10% overvalued”, it is not useful. The reality is not tidy at all. The market is messy, volatile, and has diverged from the bubble period’s irrational valuations. Transitioning back to older baseline valuation standards is messy. During this period the messiness is creating great hardship for some and great opportunities for others. In some cases, it is even creating both hardship and opportunity for the same people at the same time. 

This is the take-away message. This messiness has resulted in a less efficient market. Prudent investors don’t buy property at its market value. They select from those properties at prices and terms that are below the property’s intrinsic value. Since that value is harder to determine now, there are many opportunities for prudent investors and home buyers that do their home work and get good guidance. With the current low interest rates available to lock in for the next 30 years, acquisition is definitely worth considering.

The buying opportunities today are very good. The opportunities may get even better, or may not. It is difficult to get a firm mental foothold on where the shorter term market is heading. It is for this exact reason that there is opportunity now. Like a herd of sheep, as soon as there is clarity that prices have bottomed out buyers will begin to take action. Soon a tipping point will follow. This is why the short term is so hard to predict. Will the stimulus package now being considered by Congress spur buyers to begin to buy this spring? Will the current recession linger and delay buyers for the a few years? I don’t know. But I am quite certain that “this too shall pass”. In the longer term the economy will recover and grow. Today’s excess housing inventory will be reabsorbed and demand will rise again. The government is printing money like crazy right now. Someday I believe we will have to pay the piper and it will result in high inflation, high interest rates, or both. When that day comes I will be thankful that I bought tangible property cheap, with low interest rate 30 year mortgages. I will have payments that are locked in while collecting rents that are increasing, as equity grows.

Short Term Effects on the Housing Market

The especially vivid factors above suggest that home prices are generally too high. Unemployment has a big impact on home demand and consumer confidence. Home price-to-rent and price-to-income ratios are a reliable indicator of value. It is safe to say that median incomes are not going to go up sharply very soon. But when mortgage interest rates are as low as they are now (5-6%), and have been low for most of this decade, the same income can support more houses, so a slightly elevated home price-to-income ratio is to be expected. Rents have remained relatively steady for a while, with vacancy rates slowly declining.

Although inventories have reduced somewhat in 2008, the staggering number of unsold homes is undeniable. Even though builders have added almost no new inventory, and the volume of homes sold has increased, there are lots of foreclosures – and lots more on the way. Buyers are few, even fewer can qualify for mortgages, and many of those that can qualify are tentative. Note that when I say fewer buyers can qualify, I mean fewer than could in the go-go bubble days of loose lending (approximately 2001 to 2006). Today’s mortgage qualification standards are back to the baseline - about as stringent as they were from 1960 to 1995. 

Historically, when a financial market swings significantly in one direction exceeding a sensible limit, it reverses and often exceeds the sensible limit in the opposite direction, much like a freshly permitted teenager behind the steering wheel. I think this may be the case here. If median home prices in this environment are 5-10% over intrinsic value and have fallen fast, what will keep it from overcorrecting on the downside? I expect that it will, unless a dramatic incentive is introduced, (i.e. 4% mortgage rates, a $15,000 tax credit, zero down loans, etc.). If interest rates climb significantly in the short term, there is an even higher probability that prices will drop below their intrinsic value before they stabilize. So should buyers wait for prices to overshoot the intrinsic value indicators? Maybe, maybe not? No one knows how home prices will get back to true value. They may swing below and then turn up quickly “alerting the herd”? They may linger here until wages catch-up, bring them into balance without further price decline? Price is only part of the equations. Market inefficiency creates opportunities. When the direction of the market is better known, it is more efficient, offering fewer relative bargains. Interest rates also determine cash flow. We know what rates are today, we don’t know what they will be.

What will median home prices be in 6 months? In that short of a period, I really don’t know. But in 3, 5, and 10 years I am confident they will have had a healthy appreciation at about the rate of inflation. Some say we are now at a real estate market bottom, and others say we are not. But everyone agrees that they want to know when the bottom is. 

Multiple Real Estate markets: An investor’s dream

In this volatile market it is more difficult to get a foothold on an individual sub-market. By this I mean that the standard deviation of median home prices for similar properties is quite high. The market is less efficient now than during a traditional, stable period. It is highly segmented because the effects of certain factors are more amplified than they are usually. Here is a partial list of these factors: high rate of foreclosures, high rates of sellers that are upside down, low interest rates, absence of low down payment financing, geographic concentrations of homes built during the bubble, fewer seller financing opportunities for buyers, falling prices. . .

How do these factors create market segments? A few examples may help.

Cities like St. Francis, Zimmerman, Big Lake, Elk River, Isanti, North Branch, and Albertville, and others really boomed during the bubble. Cheaper land attracted developers, builders, and buyers. “More affordable” homes with low down payments sprung up like popcorn. Now those values are lower, so virtually entire communities of home owners are underwater. Foreclosures are concentrated and competing for very few buyers in those areas. This results in homes that are worth less (today) than in those same homes in a similar established community that developed more slowly over time.

Statistically, foreclosures sell for 15-20K less than they do in traditional sales. This seems to make sense intuitively, since they are typically in poorer condition and offer fewer warranties. However, this is often not the case. Banks seem to be inconsistent in what offers they will accept. Many times it seems a dart board is their evaluation tool.

Apartment rental seems to be stable. Large apartments are still selling at solid prices. But 2-4 unit rental buildings are selling dramatically lower than they were a few years ago. This is generally the same product. There are several reasons for this that I will not cover here, but as a result, some duplexes, triplexes, and fourplexes are real opportunities right now.

Some areas of town are very, very cheap right now. At first glance it seems you can’t go wrong. A home in North Minneapolis may be ½ the price of one in the Northeast, a couple miles away, and of 1/3 the cost of a similar house in Fridley, a few miles away. A north Minneapolis home at 37K may be a good buy and very profitable, but the risk is higher and must also be considered. A full 30% of all homes sold in that area during the peak of the bubble were by investors, 3 times the rate for the Twin Cities in general. This implies a glut of rental housing, and a glut of foreclosures at the same time. This is a recipe for longer term blight. With blight also comes additional government regulation. This is high risk but with the potential for high return or high loss.

Speaking of government regulation, local municipalities are introducing new rental regulation an alarming rate. Why? It is a perfect storm of city councils getting more complaints from citizens about vacant and rental houses, the councils feeling that they need to “do something”, overstaffed inspection departments left over from the building boom with nothing to do, no appetite for laying off public employees, and fee grabbing to help with tight city budgets. The tragedy is that many of these well meeting ordinances are just making the problems worse. It has driven some buyers away from cities like St. Paul, Minneapolis, Brooklyn Park, Isanti, and probably soon Coon Rapids. This creates more opportunity and, at the same time, more risk for buyers in those communities. Rules are changing fast, so check with any city before you buy in it.

Homes along the Hwy 94 corridor in Wright county have many of the same characteristics as those along Hwy 10 in Anoka county and Sherburne county. They both depend on an often congested freeway and both skirt St. Cloud. But there is one difference in their futures: commuter rail. Homes in the two areas are priced similarly to each other, but I don’t believe they will be in the years to come. Commuter rail is not the sole answer to traffic relief, but it is an asset that will benefit the owners of home north of the river more than those south.

Some townhouses and condo developments are in trouble right now. When sales begin to slow, some developers leased out many remaining units. Some limit rentals to a certain percent of the units in the association. Some home owner associations are in financial hardship. All these and other factors can make 2 similar townhouses have very dissimilar values.

What to track in the future

In my mind there are nine key indicators to track that influence the future of home values. Of course, there are many other factors, but these 9 together have the largest influence in a regional market. 

• Interest Rates
• Unemployment levels
• Inventory for sale
• Foreclosure rates
• Housing affordability index
• Median household income to Median home price ratio
• Local population shifts
• Law / Ordinance changes
• Loan program availability

Who will win?

Prudent investors with the courage to buy in these uncertain times. The trick here is to select the right properties now, with clearly prioritized exit strategies up front. 

First-time buyers blessed with low interest rates and tax incentives. 

Move-up families. Even though they will sell their current home for less then they had hoped, they can buy a home in a higher price range at an even more dramatic price reduction.

Sellers that can take advantage of advanced creative techniques to liquidate maximum equity from properties (I am talking strictly about legal techniques).

Sellers that are upside down on their home will experience minimal discomfort IF they act early, objectively, get qualified professional advice, and commit to constructively managing their situation. Unfortunately most won’t. 

Who will lose?

Everyone -taxpayers, footing the various government bail-out bills.

Banks and mortgage loan investors.

Homeowners that can’t make there mortgage payments today. These are families that bought too many houses at the peak of the market, paid too much, lied on their mortgage applications, or have since had a financial misfortune. By whatever means that they got into this pickle, their choices to get out are few. Short sales, foreclosure, bankruptcy, all have consequences, but immediate, proactive planning is the difference between a cold and double pneumonia. Sadly, few families are seeking help. They are struggling to keep up day to day like Lucy in this clip, but the bills just coming faster and bigger. http://www.youtube.com/watch?v=4wp3m1vg06Q. Please contact Greenwell Realty ASAP if you know someone in this situation.

Conclusion

So are local home prices going up or down? In the short term ( 6 months ) I don’t know. There are to many factors: interest rates, bail out plans, a new president and cabinet, stimulus plans…

Those of you that know me know that it is my nature to: be skeptical of the claims of most others unless soundly justified, cautious in my predictions, and purposely understate my predictions. I don’t get rattled by media talking heads, or the day-to-day yakking on CNBC, Bloomberg, CNN, real estate guru’s, etc.

In preparing this report I considered much more information than what has been written here. If you have questions, want to explore the topic deeper, or question my conclusions, feel free to contact me. I am most interested in continually understanding the most probable future, and less interested in maintaining my personal pride. All comments are welcomed.

This is my 20th year in real estate biz. I’ve seen fast and slow markets. Today’s market is the by far the most volatile, and least efficient I’ve ever seen. Many nasty pitfalls remain, but it is also the most interesting time, and offers great opportunities for diligent investors and buyers. 

Jim Hughes founded Greenwell Realty in 1991. He personally began real estate investing in the 1988. His firm represents residential buyers, sellers and investors in the northern Minneapolis / St Paul metro area. He has earned several professional designations including Certified Residential Specialist (CRS), a Charter Financial Consultant (ChFC), Certified Distressed Property Expert (CDPE), GRI and e-PRO. Hughes serves on the Northern Metro Realtors Association Board of Directors, and Minnesota CRS chapter Board of Directors. Finally, since he writes his own bio – he is an all around smart guy and a swell fella’ too.

Information nuggets

• The normal nation home price to rents ratio is 20:1. Now it is 25. It peaked at 32:1.
• The normal national income to home price multiplier is 2.7-3.0 times. Now we are at 3.5. At the peak, we were at 4.1-4.5.
• St. Paul, Minn. — At a January 14th press conference on the Minnesota state budget, state economist Tom Stinson said Minnesota will lose a lot of jobs; 58,000 between now and when the recession ends. He said the recovery, projected in 2010, won't come easily.
• 3% of mortgages were in the foreclosure process on 11/1/2008.
• 62% is about the normal national home ownership rate form 1970 until the recent bubble. We are now at about 68%- still too high. This may indicate the stronger pool of renters to come.
• 7% of loans are in default but not foreclosure. Up from 5.5% one year ago. 85% are ARMS.
• According to Fitch Ratings Inc ., U.S. home prices will fall another 8% to 10% before they show signs of stabilizing. According to a Fitch forecast, the peak-to-trough price decline will be 30%.
• Alt-A foreclosures may not be as big of a threat as subprimes. As of A 1/1/08 only 7% of Alt-A loans were 60+ days delinquent as opposed to 21% for subprimes. 
• Average Anoka county 3 bedroom, 2 bath peaked in value at $219,000 early 2006. In all of 2008 average price was 170K. 22% decline. But the 4th quarter of 2008 average was $153,000. 47% were foreclosures. Average 2008 non-foreclosure sale price was 185,000.
• In the largest declining local MLS district, a portion of North Minneapolis, the 2006 median home sold for $153,000. In 2008 the median price has $37,000, 76% decline! Interestingly the volume of transactions in 2008 was nearly triple 2006.
• In the most affluent suburbs of the Twin Cities median home prices remains approximately flat from 2006 to 2008.
• Case Schiller expects 30% peak to trough price decline, part of that is an overshoot. There baseline is long term price/income and price/rent. Then price should grow at the rate of median income.
• Case Schiller uses a price / effective rent ratio. It says we are almost back to 20 year average. 
• Case-Shiller expects bottom to last one flat year. Mid 2009 to mid 2010.Conclusion regarding foreclosures: We will see a lot more of them (continuing the current pace or increasing) through 2011-2012. Loans issued in 2008 and beyond will be solid, low default loans, if job rates don’t collapse. This will keep the pressure on low housing prices and prevent them from rising quickly.
• Real estate investment is mostly out of public favor there is little competition. It lacks social proof.
• Most economists agree that most banks have weak balance sheets and more than a normal number of them are insolvent.
• Consumer confidence is very low.
• Dean Baker says nationally half of foreclosure filings end in a REO. The other half must sell, refinance, or short sell?
• Dean Baker says nationally that 20% of mortgages are underwater.
• Home inventories on the market are up.
• Homes in Minneapolis / St. Paul market area are now about 4 times the annual household income. This is the 1990’s average. They were as high as 5.5 in 2005-2006.
• Housing prices are not well tied to Housing Affordability Index. But they are well tied to the general economy.
• In 2008 34% of all home sales were banks liquidating foreclosed homes. 30-35% of those properties are purchased by investors. In the worse hit areas 70% of all homes sales are foreclosed homes. In those areas prices of 15-30K common place.
• Statistically, in Anoka County 3 bedroom, 2 bath foreclosures sell for 15-20K less than the same house in a traditional sale. However, the standard deviation is high.
• Interest rates are very low
• Median home price dropped 13-17% in 2008.
• Minnesota median household income grew slowly but steadily the past few years, but grew only a tiny bit in 2008.
• Nationally the recession will likely last through most of 2009. Unemployment could get to 7% then.
• New construction has virtually stopped.
• Over 56% of conventional Option ARM’s were issued in 5 states FL, CA, NA, AZ and HA.