Wednesday, January 11, 2006

Do the Math: Why Real Estate Will Get Cut By At Least 50%, and more likely 75%

Q: How do you know how much a Bainbridge Island house is worth?

A: The owner will tell you.

I keep hearing about how real estate will "only" lose 10% - 15% in the coming "correction." This is in conflict with my predictions of a 50% to 80% drop in prices in the more bubbly areas of the nation. Perhaps the best way to look at this is by studying the underlying mathmatics at work in purchasing residential real estate.

First, our assumptions:

1. The economy is generally considered to be healthy, and could slip into recession. While bulls and bears disagree on the general health of the economy, the assumption is that the economy can shift into recession in the next few years. Bulls believe the economy is underpinned by sound fundamentals, and we are in a new paradigm of expanding credit and service oriented jobs. Bears would believe that what is passing for a good economy is nothing more than a government funded, FEDERAL RESERVE sanctioned, sugar high, and when it wears off, the economy will suffer until the debt bubble is worked off.

2. Interest rates will rise to historical norms or even higher. This will be necessary to keep foreign investment in the US as the dollar continues to lose value.

3. There is a general euphoria about real estate that is bringing in more money than would be necessary just to provide shelter. This is what I call "hot" money - the money that is diverted from other assets to capture the upside of a raging bull market in real estate. Think back to 1998-99 and all the money people were setting aside to chase the .com era stocks.

4. People are stretched to afford mortgages under present conditions. The plethora of interest-only, negative amortization (IONA) loans being written is proof-positive that monthly payments are as high as they can be, given the present job conditons.

5. Inflation will continue to increase in energy, medicine, education, and food.

6. Local governments are, even in these times of plenty, stretched to the limits on their bloated budgets.

7. Houses are purchased in one of two ways. First, there is the "List Price" method of valuation. This is the number you think of when someone asks you what your house is worth. It is what someone would pay if they were paying cash, and not using a mortgage. It is the method you use when you buy a loaf of bread or a new suit. The second is the "monthly payment" method, which is what 99% of buyers use to see if they can get into the house. Creative financing lowers the monthly payment, and allows the total value to increase. Keep in mind, buyers only use the total payment as a benchmark for what they can afford each month, but really look at monthly payment when buying a house. As interest rates decline, the same monthly payment buys more house, and the converse is also true.

OK, now the math part. Let us use a typical home in my city.

This home lists for $628,500, and was purchased in August of 2001 for $439,000. It is assessed by the county at $362,780 for 2006. For the year 2005, it was assessed at $311,760. If you put 20% down, and take out a loan for 5.875%, your monthly payment will be $2930 per month. You can get a 5/1 interest only ARM for 4.95%, which is the route most buyers will go. I didn't look at interest only loans with negative amortization for this example.

At 4.95% (IO), that payment drops to $2074. If you add taxes ($297) and insurance ($75) to this, that brings the entire principal, interest, tax, and insurance (PITI) to $2446/mo. In August '01, the owners took out two loans in the amount of $351,200 and $43,900. They later refinanced in August of 2002.

Assuming you have $125K to sloshing around in your savings account, or if you managed to keep that much equity in your house after a "correction," you can live in this house for $2446/mo. For the overwhelming majority of Americans that won't save $125K in three lifetimes, some creative financing will be necessary.

Let us just stick to the folks that have the money for the down payment. If my predictions come true, banks will, once again, concern themselves with down payments, loan-to-value, and the creditwortiness of borrowers (like they did less than a decade ago).

Our hypothetical buyers, Joe Hippen and Mary Trendy, sell their two bedroom rat trap in Orange County and move north for peace, quiet, and Gore-Tex. They pony up their $125K in equity and life savings, and sign on for $2446/mo in payments for the next 3 years, after which, it will adjust down with the reduction in interest rates (at least that is what they believe will happen). They are now the proud owners of a Bainbridge farm house, that needs a lot of work. Their heating system is oil, and the eight decades of Northwest weather and ambitious renovation projects gone sour have made the place quite a money-pit.

Joe Hippen-Trendy is a mortgage broker for a sub-prime lender. He gets a small salary but is paid on commissions and works in a high pressure environment. Mary Hippen-Trendy gets her Washington Real Estate license and starts schlepping Bainbridge Island real estate. Life is good. They take out an additional $75K home equity line of credit (HELOC) for some basic home improvements, such as new carpets, seismic upgrade, renovating the tiny, closet-sized bedrooms, and the installing the perfunctory granite countertops and stainless appliances. Credit cards were paid off by a home equity loan, which means their new plasma TV is now being collateralized by their Bainbridge home.

Then...the bubble breaks. Sales drop through the floor, as sellers fail to come to terms with the drop in demand, and buyers dig in and wait for more reasonable prices. Suddenly, Mary is spending a fortune on gasoline and advertisements trying to move her burgeoning list of homes for sale, while at the same time, she and the other bazillion Bainbridge Island RE agents can't get any sales.

Joe's career is also stalling. The refi boom is a distant memory, and the folks in the lower income bracket just are not buying homes, as they did back in the bubble.

A cash crunch hits our hip-n-trendy couple. The his/her Escalades in the driveway are putting a major hole in their monthly budget. The oil heater, in combination with the drafty, older home isn't helping either. Ferry tolls, at $600/mo, and the 4 hours of commute time per day are beginning to lose their power to charm Joe.

Quality of life also begins to suffer. Joe is up at 4:30am every weekday in order to make it to his job on the Eastside by 7:30, and he isn't back home until after 7pm. His work day is now work, rather than the easy money of the go-go days during the housing bubble. His wife, Mary, is now more of a roommate, as her evenings and weekends are spent playing tour guide for Bainbridge Island Looky-loos. Her frustration mounts at both seller and buyer. Sellers have dug-in and won't budge on their price, as they believe they are entitled to 15% appreciation every year. Buyers look and look and look. They send up low-ball offers, which are rejected by sellers. Nothing moves, and RE agents get paid on the movement.

Life sucks, and the amount of money coming in every month shrinks, while expenses creep up. Stresses mount, and with the lack of familiarity due to job demands, the marital spats become fights. The Bainbridge life is not what it used to be.

The lock-in period on the Hippen-Trendy's mortgage expires, and now jumps to 7% on its way to 9%. Uh-oh. The county has also hiked their taxes 15% for the last two years, and this year it only goes up 10%. That $297/mo in taxes is now $432/mo, as Washington does not have a Prop 13 protection for homeowners. Their payment to the bank is now $3462/mo. Couple this with their taxes and insurance and the payment is now $3969/mo. That is only a $1523/mo increase or $18,276 annual bite from their already diminished income. Now, they look at next year's tax assessment and possible rate hike from their mortgage holder with dread.

They can't refinance, as they are paying on their second mortgage as well as their first, and the appraisals just are not cooperating. Their savings is zero, and their credit cards swell every month, just to make ends meet. Year-end bonuses and commissions vanish, and a round of layoffs was just announced at Fly-by-Night Mortgage Inc. The stock market is also not playing along. The bears are carrying the day on Wall Street. The Hippen-Trendys just don't have any access to additional funding, and are now wondering how they are going to keep things afloat.

The His and Hers Escalades are sent back to the leasing company. Uber-Chic Leasing Corporation demands money for excess mileage, damage from the combo of the soggy Bainbridge climate and lack of a garage, lease termination fee, etc.

They decide to throw the house on the market, as they don't see how they can make the payments much longer. Given that Mary is in the business, they decide to try $725K (to cover their mortgage and HELOC). They are confident they will get their price, as they have lived in the house for three years, and real estate, ESPECIALLY BAINBRIDGE ISLAND REAL ESTATE never loses value in the "long run."

Their are no takers.

Why? Well, the Hippen-Trendys are asking someone to take out either a $725K loan at 7%, or a $580K loan with $145K cash. No one has $145K to throw around, as they are all on the same real estate "escalator" as the Hippen-Trendys. Both Mary and Joe know this, but have not yet come to terms with the present market. Finding someone with a spare $145K and $3993/mo + tax and insurance, for a total of $4500/mo is just not going to happen. Those people are not buying in this market, or are buying any of the other homes that crowd the MLS.

The no-document income sub-prime buyer trying to finance $725K isn't any easier. $4995/mo + the $500/mo in taxes and insurance bring their monthly nut to $5500, and that is without PMI.

The Hippen-Trendys were asking that someone pay a monthly payment for their home in excess of what they (the highest bidder 3 years ago) could not pay. That $4500/mo, back when they bought the house would have fetched $1.21M, at 4.95%.

In order to attract the same buyer they were three years prior, the buyer would need the same monthly payment of $2446/mo. Back out the current tax and insurance, and you have $1930/mo in interest. That interest is at 7% today, which fetches $413,500 in an interest only environment. Given that I-O mortgages have been shown to be very dangerous, the new buyer would need to originate a 30 year fixed mortgage, to lock in their payments. Now, that $1930/mo buys a $350K house.

But we are not done. This is not realistic.

Remember three years ago, when the Hippen-Trendys bought the house? The mood at the time was that housing was a fail-safe investment. Money. Gold. Cant-lose. Get-on-the-train. The Hippen-Trendys committed an extra 15% to the purchase price in the form of "investment" or "hot" money. Today's buyers, Jason Munn and Jennifer Danes, are not interested in chasing a falling investment. The Munn-Danes pull out the 15% hot money, and reserve another 5% for caution. That $1930 is now $1544, and that $350K house is now $280K.

$280K is now the price of the very same thing that was $625K, just three years ago. Why? Because house prices are driven by peoples' ability to pay.

We have not assumed that the job environment for the Munn-Danes has deteriorated, or that interest rates have climbed. Pull another 10% out for a crappy job environment, and crank the rates up to 9% (where they were at the height of the Internet Bubble), and that house is now worth $211K. That is assuming the Munn-Danes have $42,200 in down payment, and banks are only requiring a 20% equity stake from the buyer.

There is NO WAY the Hippen-Trendys are going to sell to the Munn-Danes for a $489K loss + fees amd closing costs. They will default.

Their neighbors will too.

Now, the Sheriff is selling homes on the courthouse steps. If they don't retail for $211K, with all the advertising, marketing, and personal attention of the phalanx of Bainbridge Island realtors, what would make the Sheriff sell them for anywhere near that amount? These properties will sell at a discount to retail.

There goes the neighborhood. Comps get crushed. Appraisals are also aware of this. Lawyers took out their knives after the bubble broke, and went after inflated and fraudulant appraisals. Appraisers are scared, and conservative. They want to get in front of the trend and appraise even lower than the numbers show.

Property taxes go up to compensate for declining sales taxes, and interest rates continue to climb. Jobs are much harder to find (you can't sell real estate, bundle mortgages or build spec homes), and money becomes scared. Sources of funding continue to evaporate as banks get religion. That $211K house is now even less.

By the way, when the mortgage defaults, the IRS attaches that as income to your tax form. $500K worth of taxable income, without the income continues to drain the pockets of buyers. Equity is almost universally negative.

Remember all those rentals and vacation homes purchased in 2004? (39% of the total) Remember all those IO loans in California in 2005? (80% of the total) Remember all that frenzied building by the home builders in the past two years? Does anyone have any idea how many spec homes and homes under contract the builders are generating? All of this will have to be worked off before we stabilize the owner-occupied, traditional loan segment of the market. This means the bottom will be a long time in the future, and a lot lower than we could have possibly imagined.

That is how we could lose 2/3 to 3/4 of the market value of homes in the aftermath of the Hippen-Trendy's bubble.

Bye-bye Escalade. Bye-bye Volvo. McMansion? Buh-bye. Making $6K/mo at the daily grind, while losing that much in the housing market stinks. Paying off the debt accumulated extracting equity thinking your house would never lose value stinks even more. Having your primary retirement vehicle crater just as you step into retirement is positively horrid.

Sunday, January 01, 2006


The point of this blog is to deflate the stuffy, provincial, self-congratulatory mystique that permeates Bainbridge Island.

Bainbridge Island was, once upon a time, a nice place to live. It was a community with its own identity in the Westsound region. Then, the 1980s came along - and the Californians - LOTS OF CALIFORNIANS.

Prices escalated due to the importation of gobs of home equity money from the seemingly inexhaustable California Real Estate escalator. That happened right up until 1990, when the California RE escalator stopped. California sneezed and BI caught the flu.

Prices were fairly flat until the next California expansion in the mid-late '90s, when BI piggybacked on the inflation of California. Seattle grew on its own, with the dot.bomb industry, but that came to a crashing halt in 2001-02. A buyer's market started to set in, but the Federal Reserve spiked the punch bowl, and the past few years has been nothing short of breathtaking in the appreciation of Island RE.

Bainbridge Island carries the reputation of a place with a lot of money, and as far as home equity goes, the reputation is well deserved. As far as income goes, that is another matter.

BI income ranks 24th of the 522 ranked areas in Washington. Not #1, or #2, or #3. Median income of all households on BI is just a hair over $70,000/year. Not bad by Kitsap County standards, but it is a far cry from the cities that many Islanders like to compare themselves (La Jolla, Hillsborough, Martha's Vinyard, etc.) Keep in mind this data is from the 2000 census, and was a snapshot at the HEIGHT of the dot.bomb/internet bubble. Since this time the internet and dot.bomb money has vanished, but BI has to have one of the hightst Real Estate agent ratios in the entire nation. It seems that just about everyone who has moved to the island is schlepping real estate, or building spec homes. I will attempt to get some hard numbers as to how many builders and sales agents populate the island.

My guess as to how the money gets flashed around Bainbridge Island has everything to do with home equity extraction. If your household income is $70K/year, and you get another $100K in home equity, that's alot of cash to throw around. One little problem is that $100K/yr has to be paid back - either by selling and walking away with nothing, or by servicing the debt on the remaining $70K. Banks are persnickety in that way.

Distorting the housing market was the minor issue with the influx of Californians. Pushing the Puget Sound region, and Bainbridge Island in particular, to the far, moonbat left is the worst legacy of the Californians. The hippies got crowded out of California, so they moved to the forested solitude of Bainbridge Island, and brought their stupid politics with them. Island politics are laughable, even by Leftist standards. This blog will explore this phenomenon as we progress.

Keep it dignified. Don't post things that you would be ashamed to have attached to your name. Tongue-in-cheek is expected. Spirited comments are encouraged. Occasional bruising is OK, but at the end of the day, don't hold a grudge. If you are a hip-n-trendy, uber-chic, see-and-be-seen, California ex-pat Neo-berry, bring it on. I'd love to hear from you. The purpose is to deflate egos, so don't get yours all inflated in the process. Have fun.


Michelle Malkin · July 10, 2004 09:32 AM

My old hometown of Seattle--the Berkeley of the Pacific Northwest--just can't stop showing its contempt for America.Take a look at this disgraceful incident on Bainbridge Island, a few miles west of Seattle proper (and the future home of Hollywood liberals Brad Pitt and Jennifer Anniston).

One of the participants in Bainbridge Island's annual Independence Day parade was Jason Gilson, a 23-year-old military veteran who was injured in the line of duty in Iraq. He wore his war medals and carried a sign indicating his support for President Bush--heresy on liberal Bainbridge Island. Upon seeing Gilson and his sign, the crowd booed and called him names including "murderer" and, yes, "baby killer."

One has to wonder what the mood was on the parade route. Calling a veteran a "murderer" and "baby killer" is a direct throwback to the halcyon days of hippidom in the 60s and 70s. My guess is the bulk of Bainbridge Isl. residents are California ex-pats and aging hippies. They ruined
California, so they are now bringing their filth to the PNW. How original. "Baby Killer?" How much longer until they break into the tried and true "Hey Hey! Ho Ho! (fill in the blank) has got to go!"

Kevin Dwyer, mealy-mouthed executive director of Bainbridge Island's Chamber of Commerce, is quoted in Seattle Post-Intelligencer writer Robert Jamieson's column making excuses for the crowd's outrageous behavior:

"I believe (Jason's) mom when she said her son was called 'a murderer.' But I'm sure it wasn't so much directed at the kid as it was the president. A soldier with a sign represents that."
Crap on a vet to send a message to the President? How educated. How refined. How bold. How Bainbridge.

Meanwhile, at the same parade, Jamieson reports that "people bearing pro-Kerry signs were cheered and applauded for, among other things, tooling around in an environmentally responsible car."

Wear your nation's uniform in armed conflict and get booed, whereas drive a hybrid, or bio-diesel and you get cheered. Such are the priorities of the self-congratulatory Left.