|Phoenix Phenomenon: Why Real Estate Everywhere Will Eventually Drop Over 50%|
Steven Jon Kaplan seekingalpha.com
During 2005-2006, we experienced a housing bubble in the United States which was accompanied by valuations in many regions trading at more than twice their normal historic levels. Today, we have similar housing bubbles in many countries with prices that are at twice or thrice their typical valuations relative to rents, incomes, and most other standard-of-living benchmarks.
An important question is what will happen with neighborhoods which are experiencing highly elevated housing prices. There are numerous theories, with some analysts suggesting that prices will simply move sideways for a decade or more until inflation and an increasing population eventually causes valuations to return to normal without having to actually decline. Others have projected dramatic collapses for real estate. Obviously this is a significant question, since the last global recession was largely caused by the demise of the U.S. housing bubble and its impact on mortgage-backed securities which led to the bankruptcy of Lehman Brothers and ultimately a global credit crisis.
The U.S. experience is fascinating particularly because the effects of the post-bubble decline have been incredibly uneven. One way of measuring is by comparing the percentage decline from the peak. Prior to the November 2010 Congressional elections, this had been analyzed in map form by Zillow with their results reported here. Another way of establishing valuations is to compare the relative costs of renting versus buying. Rental valuations, which are constructed as the result of negotiations between landlords and tenants, are based almost entirely upon economic considerations including average household incomes for any given neighborhood, the rate of unemployment, and the sizes and qualities of the properties being rented. In sharp contrast, housing prices are based up on numerous psychological factors which have nothing to do with economic fundamentals. This chart from the Wall Street Journal compares the current costs of renting to buying in numerous U.S. cities, oddly omitting New York. Notice that in cities like Atlanta, Detroit, Las Vegas, Minneapolis, Orlando, Phoenix, and Tampa-St. Petersburg, housing prices have fallen sharply and had lost more than half of their value in many neighborhoods. In Tampa-St. Petersburg, the decline was so rapid that there was a moderate rebound since early2010 especially after the U.S. dollar index retreated significantly; this is partly since certain regions in Florida often experience heavy buying by non-U.S. residents looking for second and third homes. Detroit has also recovered somewhat during 2011, partly due to a modest rebound in manufacturing and because prices had plummeted so dramatically. In Phoenix, prices have continued to retreat, but the supply of available homes has plunged which historically will tend to lead to a price rebound.
The question is whether the above cities are the exception to the rule, or simply experienced their pullbacks earlier than most other places. In other words, is Orlando the anomaly, or will most of the remainder of the United States, Canada, Australia, China, Brazil, and the rest of the world eventually behave like Orlando? Or are there "special situations" in each of the cities which have collapsed? Can we blame Mickey Mouse for Orlando's housing demise, or the pathetic performance of the Cardinals' football team in Phoenix for their housing-price plunge?
Most real-estate analysts are completely confused about the bubble, or won't acknowledge the significance of the U.S. divergences in recent years. The consensus is that real-estate prices will continue to weaken the most in precisely those cities which have already lost more than half of their value, which is almost surely a badly misguided conclusion.
In order to reach a logical determination, it is essential to understand why prices dropped by two thirds in the above cities, but have not done so elsewhere. Is there any special set of circumstances which applies to the above cities? Many analysts believe so, but I do not. instead, I think that the entire decline in the above regions was caused by a major psychological shift. While people in all of the above cities were confident in 2005that either prices would continue to rise, or that any decline would be strictly limited, the first pullback of 20% shattered these illusions. Most other regions in the United States have experienced losses of 20%-30%, but have not suffered through losses of 50%-75% which have occurred in a minority of areas. It is rare to find a neighborhood where prices have dropped between 35% and 50%. When such cases exist, almost always prices end up down by 50% or more several months later. This can be seen most graphically in this fascinating Zillow analysis from September 2011, which at the bottom of page 3 shows the percentage decline for the 25 largest U.S. metropolitan areas. The most important observation is that six of the 25 areas have suffered average housing losses of more than 51%, with the other 19 regions experiencing declines of less than 37.5%. Not a single region in September 2011 experienced a total pullback of between 37.5% and 51.0% -- not even one!
This is precisely the opposite of what you would expect from a traditional bell-shaped or Gaussian curve, in which the most frequent behavior occurs roughly in the center of the range -- rather than at both extremes with literally nothing in the middle. Why is it that virtually nowhere in the United States do we have a loss of three eights to one half of the peak valuations for housing prices?
If you live in a neighborhood where prices have dropped by 20%, then there will be a number of people with mortgages which exceed the values of their homes. However, since the difference will be relatively modest, these people will be likely to continue to make their monthly payments especially if they are able to renegotiate their loans at lower rates. Once prices are down by 35%-40%, however, there will be a lot more people who are underwater, while the percentage that prices will have to rebound to get back to break even will be considerably higher. If your mortgage exceeds the value of your house by 5%, you're likely to think: "I made a bad decision, but if I wait a few more years prices could recover and I'll end up ahead. So I'll keep paying off my mortgage and maybe even prepay somewhat to reduce my debt." However, if your mortgage exceeds the value of your house by 20% or 25%, then you're much more likely to conclude: "If I keep making my payments, I'm just throwing good money after bad. I hate to become delinquent, so I'll see if I can arrange a short sale which I've read is better for my credit rating in the long run. Once I eliminate this debt burden, I can get on with my life with a clean slate." In my opinion, that is why prices which are down more than 35% usually quickly end up down 50%-65% or more, as many people simultaneously reach the same conclusion. They default, unload their homes at bargain prices, and otherwise create a surge of foreclosed properties which thereafter weigh on the market and cause the prices of non-foreclosed houses to drop precipitously in order to be able to compete with foreclosed homes.
If you look at areas which have fallen by only 20%-30%, then you will usually notice that they have been accompanied by a rise in the number of months of supply available. This makes sense, since housing prices in these regions remain overvalued relative to rents (see the above chart again). If it is uncompetitive to buy a property, then eventually more people will sell because buying remains irrational when compared with renting. Imagine if used shirts were suddenly worth two hundred dollars apiece: people might initially do nothing, but eventually there would be yard sales everywhere in which people are unloading their used clothing, and the oversupply would force prices to plummet. The longer that housing prices remain too high relative to renting in any neighborhood, the more that people will progressively choose to rent rather than to own, which will cause the supply of unsold homes in that area to progressively increase. This won't necessarily immediately lead to lower prices, but that has to happen eventually. Then, there will be a situation in which a lot more homeowners are underwater on their mortgages, which will lead to a surge in defaults and eventually a sharp rise in foreclosures.
In other words, there is a "tipping point" with housing prices which applies in the general case. As long as prices are not down very much, people will remain hopeful and continue to make their mortgage payments. As soon as they reach a certain level of loss, which is slightly more than one third of the peak price, people simultaneously give up and conclude that getting out at any price is the best option. Whether people decide this from talking with each other, or independently, or a combination of both, is an interesting question, but either way it appears to be a universal phenomenon which I expect will become the standard around the world. When this surrender occurs, the resulting glut of defaults leads eventually to a surplus of foreclosures which causes prices to plummet by more than half from their respective high-water marks.
Therefore, I think that most of the world will end up following the path of Las Vegas, Orlando, and Phoenix. These cities were simply several years ahead of most other places, because for whatever reason people panicked earlier than the average. Most likely, a plunge in housing prices will tend to occur at the same time that the stock market is slumping, unemployment is surging higher, and other economic ills are increasing. Therefore, the next equity bear market is likely to be accompanied by a substantial rise in the number of areas in the U.S. and elsewhere which experience dramatic declines for housing prices. Those regions which are most at risk are not those which have already suffered the greatest weakness, but in which the psychology is still in the early stages of transformation from a reluctance to give up on the hope of a real-estate rebound to conviction that prices will never be able to get back to their previous peaks at least for many more years.
The primary reason this is so important is not for the sake of real-estate valuations themselves, which only matters if you own a house or other property. When people observe that their houses have lost a significant percentage of their value, even if their incomes and other assets remain roughly constant, they will spend far less money. This is known as the negative wealth effect, and has been documented worldwide such as the following report from Holland. A respected academic study of real estate concluded that wherever housing prices rose the fastest, a sharp rise in debt tended to closely follow; once prices inevitably declined, the most dramatic declines in household spending occurred shortly thereafter.
This is why a collapse in housing bubbles usually leads to a significant subsequent economic contraction. The media will usually blame jobs lost in construction, which is a minor part of the equation: the negative wealth impact is enormously more important and pervasive. While I remain positive toward global economic growth over the next few months as central banks cut interest rates, amateurs and hedge funds switch to the long side, and governments cut taxes, eventually the collapse of an all-time record number of housing bubbles will lead to repeated dramatic losses for global equities during the next two years. We experienced the first such wave earlier in 2011 as global housing prices mostly stopped rising and began to modestly retreat in many countries. The next downtrend will likely be more severe, as we experience U.S.-style plunges in various regions around the globe at some point in 2012. This process will likely continue in 2013and perhaps also in 2014, depending upon how long it takes various billions of people to suffer their first-ever housing-price losses and how people respond to this phenomenon.
Historically, the worst losses occur whenever people are most confident that they can't lose money. In early 1973, many people were absolutely convinced that even a bear market wouldn't negatively impact the "rock solid" stocks known as the "Nifty Fifty". In early 2000, almost the whole world believed that we were in a new era in which technology shares had no upside limits. Many of those in U.S. cities six years ago couldn't imagine housing prices dropping by even one third, and the same is true with many today who live in Canada, Brazil, and elsewhere. Of course they know what happened in the United States, just as those in the U.S. mostly were familiar with Japan's 15-year downtrend for housing prices which declined each year from 1990 through 2004. However, people will always rationalize their situation as being magically unique and having no connection with what has happened in the rest of the world. I still hear from subscribers in Vancouver, British Columbia or Sao Paulo, Brazil who simply can't imagine prices dropping even by 15%, because they think there is a special combination of circumstances which ensures that their part of the world will continue to prosper no matter what is happening elsewhere. The stronger the delusion, the more severe will be the negative reaction when myth is inevitably replaced by reality.
There is already evidence, highlighted here, that housing prices in Australia have dropped by an average of about 5% from their respective peaks. While this is a tiny decline, the psychology is already beginning to shift. Inventories have surged as a group of intelligent people realize that they had better try to get out ahead of everyone else -- which of course will eventually prove to be impossible since an overwhelming number of sellers relative to buyers will eventually cause prices to become much more depressed. At least the Australian and Brazilian central banks can cut interest rates repeatedly, which will initially postpone the inevitable just as similar rate cuts by the U.S. Federal Reserve helped to keep equity valuations inflated for several months and even to achieve new all-time highs for some industry sectors. However, even if the game is going well in the beginning, the end has already been fully predetermined and will not be a pretty picture. By the end of the current decade around 2020, I believe there will be a relatively small percentage of worldwide neighborhoods where housing prices did not eventually drop by two thirds. The rest of the world will eventually become like Orlando and Phoenix, probably as the above two cities have already begun to enjoy a real-estate rebound because the earliest losers often become the first to recover. Looking farther into the future, as the global real-estate slump subsides and leads to a housing-price rebound beginning around 2014or 2015 -- at least in nominal terms (i.e., not adjusting for inflation) -- this will create a euphoria which will likely usher in a multi-year bull market for nearly all risk assets. I don't expect real estate in inflation-adjusted terms to increase in most regions of the world until probably around 2020.
There are many who naively believe that U.S. housing prices "have bottomed", which is almost always what realtors have been saying both on and off the record each year since 2006 -- although they have been wrong each time. If you study the housing data which was released by Zillow on December 13, 2011, paying special attention to this multi-year chart, you can see that housing prices remain far above where they stood in 1997. Rents have merely kept pace with inflation since then, indicating that there remains a fundamental overvaluation in those areas which have not yet experienced the Phoenix phenomenon. This must lead to lower valuations for real estate in most parts of the United States sooner or later.
Looking at the rest of the world, this link from The Economist has an interactive chart where you can enter the country of your choice to see how housing prices have fluctuated relative to the rate of inflation. The picture is clear: housing prices are dangerously elevated today in many countries. A psychological shift in the perception of real estate as an investment will inevitably lead to prices slumping below the tipping point and declining soon thereafter by more than half from their original peak valuations. As a significant percentage of the global population suffers from plummeting real-estate valuations just as Phoenix and Orlando have already done, the negative wealth effect will exacerbate the next worldwide bear market for equities and all other risk assets.
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