The Oracle

I wrote this a year ago because no one wanted to believe what I have been saying for the last three years. Now with the incredible increase of oil prices and the extreme transfer of wealth to these few companies and, more importantly, out of this country, expect it to be even worse. For what it is worth:

Here’s what I see pertaining to the real estate market in California (if you care). You can skip down to page 6 to see (my vision of) the future if you wish.

THE PAST

In the mid 1980s wild appreciation in the real estate market occurred. Many people used this opportunity, both in the residential and commercial sector to step up by buying and selling properties. As the market continued to explode many people and companies leveraged their ability to purchase with an expectation of continued appreciation. In effect, they bought today’s property with tomorrow’s equity. And why not? A house bought for $100,000 in a 90 day escrow might be worth $110,000 by the time it closed. The same house a year later might be worth $130,000. And the numbers worked the same way with large commercial properties. An office building bought for $10 million with a six-month escrow might be worth $11 million at the close. And a year later it might be worth $13 million. This attracted many foreign investors including a great deal of money which came from Japan.

In 1989-90 the market peaked and caught most people by surprise. During this time it became increasingly difficult to sell properties. Many experts claimed this to be only a temporary situation. Many denied a problem even existed. Nevertheless, new homes became increasingly difficult to sell and developers and contractors felt the pain. Incentives were offered and prices were reduced. Inventory was high and people began walking away from their recent home purchases because of negative equity situations and an inability to pay their mortgage payments. At this time credit cards were not an accepted way of paying bills or for purchasing consumables such as food and gasoline. Banks foreclosed on these properties and quickly turned them to get them off their books by lowering the prices. It wasn’t long before the market was flooded with foreclosures which began to dictate the market price. In many neighborhoods there were far more sales of foreclosure properties owned by banks and financial institutions than there were properties that were owner-occupied. This further depressed the market.

This trickled into the commercial sector as well since commercial projects took years of planning. Projects that began several years before it was recognized there was a problem, often with hundreds of thousands or even millions of dollars invested prior to commencement of the actual project construction moved forward. Larger projects could take years to achieve full occupancy and even smaller projects were leveraged and needed tenants willing to pay 1989 rates to pay the debt. However, existing businesses had begun cutting back and new business startups were in a decline. This resulted in a glut of commercial properties on the market. Many projects sat vacant or had large vacancies and subsequently asking rents began to fall. Huge concessions were given for leases including free tenant improvements and even free rent. This continued the downward progression of rental income thus reducing the value of income producing properties.

In 1991 and even more so in 1992 there was a general recognition that the market was in serious trouble. Those unfortunate enough to be in the midst of projects or holding inventories of speculation properties and specifically, highly leveraged properties lost vast amounts of money. The losers included financial institutions as well as individuals and companies. Obtaining loans became difficult and for many, impossible. Many banks required two appraisals from two different appraisers before committing to a loan, and then required substantial down payments. The market continued to deteriorate through the mid-1990s until it finally bottomed out around 1995.

For the next five plus years the real estate market in general was tranquil with very modest appreciation in most areas. Some areas outperformed others but the value of property was tied to the income it produced on a real-time basis and residential properties had a direct connection to the income of the buyer. Through the year 2000 things were relatively normal.

The aftermath of this devaluation left many, many people and companies bankrupt. Astute investors and developers threw caution to the wind in favor of a certain greed which resulted in decisions that were not viable for the market.

The reason for this? In my opinion, the real estate cycle is basically this. Residential properties are built and, as the income and economic circumstances of the buying public increases, property owners step up to these newer properties. Their existing properties in a lower price range are bought by the entry-level buying public. As this process continues and more new homes are built, there is a need for new commercial properties to support the new neighborhoods, as well as schools and fire stations, etc. As these new commercial properties are developed the asking rents are higher, enticing businesses to leave the older neighborhoods in favor of the higher traffic developments. Rents are higher in the new developments, justifying the cost of the development but at the same time pulling up the rents in the older developments, subject of course to the supply and demand of the market. As long as new houses are built and bought, new commercial developments are built and leased, first time home buyers have the ability to buy the houses left by the new house buyers, and new business startups lease the older properties left by the businesses relocating to the new developments, the cycle continues. But, when the market is not driven by the income and economic circumstances of the buying public, but is driven instead by the artificial gain (equity) generated by emotional desire without the underlying basis of an ability to pay, pay day has to come at some point. Without the stability of an ability to pay, the house of cards has to fall; there has to be a reckoning.

THE RECENT PAST

The 21st century began modestly enough. But in the early 2000s things began to change. The real estate market had settled to a degree of normalcy from the early 1990s wherein a loan for real estate was based on the buyer’s ability to pay and, as homebuyers achieved a higher degree of economic stability and income they were able to step up in a modest fashion to a newer or new house. Real estate appreciation was modest and generally was not a factor in the buying decision.

But within the first few years of this new decade a new phenomenon began. Californians and indeed, Americans, among many others in the world at this time were accustomed to “owning” things far in advance of when they could be afforded. With the advent of credit there was no need to wait to purchase a desired item. In the preceding 50 years people no longer “owned” much of anything. There were loans for cars, loans for furniture, loans to pay other loans and then, easy credit to obtain credit cards. Credit cards began to be used to pay for everyday living expenses such as food and auto expenses, and many people who previously could not qualify for a credit card were nonetheless given credit cards. Credit became a means for living, and financial institutions were poised for record profits. All at the expense of the consumer who was paying outrageous interest rates on this credit card debt, frequently approaching 25% or more. Trouble was on the horizon.

Also early in the decade, creative home loans with extreme deviation from the norm were introduced to the market. Low money down and no money down, stated income, adjustable rate, teaser rate, 125% value, piggyback; the list of loans goes on and on. It seemed that every conceivable trick that could be used to qualify a buyer or a property to complete the sale was considered and then utilized. Each time a new door was opened to a previously unqualified buyer there was a house that could be sold and every house that was sold created money for the seller to buy yet a more expensive house. Additionally, there was always money to buy more “stuff” and pay down credit cards.

But we must talk here about credit cards. As stated above in the years approaching this present-day situation consumers changed their buying habits relative to credit cards. Debit cards were introduced to even those who couldn’t afford the easy-credit credit cards. Credit cards were used more and more for living expenses. Bankruptcy laws were changed so that credit card debt could not be dismissed in a bankruptcy filing which opened up even more clients for the eager and greedy financial institutions. During the early 2000s it became commonplace in many households to expand their buying practices with the increased availability of home-equity loans which granted credit lines based upon expected appreciation of home values. Another cycle began wherein a homeowner exposed to easy credit bought “stuff” (boats, motorcycles, cars, furniture, etc.), charged up some living expenses, paid minimum payments for a year or two, and then refinanced their house to pull out enough equity (usually the maximum they could get which was usually more than they should have had) to pay off their credit card debt and even have a little money to upgrade their house and buy more “stuff”. And then a year or two later they could sell their home, repeat the cycle and buy a new home with very little down payment and an incredibly low interest rate, which would qualify them for an even higher priced home than they could normally afford. This was terrific news for the economy and for all businesses from furniture stores to real estate agents, from swimming pool contractors to loan companies, and almost everybody in between.

New housing tracts sprang up everywhere. There was a mad rush to build houses and with every new housing tract came a shopping center, then office buildings and big-box department stores and shopping malls. More small businesses were needed to service the households and they sprang up everywhere. Retail, industrial and commercial space was being built at a tremendous pace. In a short period of time there was a tremendous explosion of personal wealth and net worth, based largely on homeownership and the equity therein. However, this increase was not really in cash and cash equivalents but in assets of property, both real and personal. In effect, the average homeowner owned lots of toys and “stuff” and had lots of credit card debt which continued to accumulate. But the worries were few as all that was needed was a simple home loan refinance wherein all these debts could once again be paid to be charged up another day.

Continuing on, the many California families now lived in houses far more expensive than they could afford, drove new cars, had new furniture and other “stuff” and were living the good life, at least by all outward appearances. But in fact they lived hand to mouth and had loans on most of their assets. And many of the loans had “teaser rates” that started out with low interest (the interest used to qualify them for their overpriced home) and was due to increase in one or two years. Others had high interest 2nd TD loans or loans with adjustable rates that would also increase in the future. Further still, most had incredibly high credit card debt at incredibly high interest rates.

It should be noted that during these years of incredible economic growth and real estate appreciation there began to be questions from individuals as to the reality behind the growth. Personal incomes could not support the loans necessary to purchase a median priced home in California. In fact, without the continuation of the expected appreciation and the funny loans the growth was impossible. Debates began over whether these economic circumstances were reality or just a bubble that was getting bigger and bigger. The talking heads, most of which were making incredible profits (realtors, loan companies, investment firms, banks and other financial institutions) insisted that the cycle would continue indefinitely. They denied the existence of a bubble and refused to even acknowledge the possibility. Their adversaries however, told a different story but were largely ignored.

In 2004-2005 this debate became more pronounced as different areas of California began to experience a stagnation and even depreciation in real estate values. Also around this time foreclosure news became more pronounced. But data continued to be released which showed moderate increases in values and unit sales which bolstered the claims of the talking heads, claims that there were no problems. Finally, in 2006 there was a general acceptance that the market was flat. But ridiculous smoke and mirror loans continued to be touted and the talking heads were happy to wait this out the few months they told everyone the flat market would continue. But they assured everyone that things would continue as before soon.

2006 brought continued bad news as housing inventory increased and sales decreased. New home sales all but stopped. Builders offered free swimming pools and other tremendous incentives such as landscaping packages and furnishings to try to move inventory. New home tracts were opened to outside real estate agent salespeople who could earn commissions by selling within the new home tract. In short, the new home market all but crashed around this time. And along with it, many commercial projects that were early in their existence.

Also in 2005-2006 the sale of existing single-family residences experienced a severe slow down. Decreasing home prices and slower home sales began to have an affect on the market. People weren’t buying the newer houses; they weren’t able to sell their older houses. Foreclosure filings were increasing and there was increased talk about the effect of the adjustable rate mortgages increasing from their “teaser rates” in the near future. The public began to understand there really were problems. And yet the talking heads continued the spin to convince everyone that this was simply a sideways market or at the worst, we were at the end of problem times and the good times would begin again soon.

2007 ushered in some harsh realities. People began to walk away from contracts to purchase new homes and condominiums. New home sales vanished. Existing home sales were few and far between and many realtors were not even accepting new listings. Real estate related enterprises were beginning to shut down offices and foreclosure activity was in record territory. The public was convinced there was a problem and the talking heads were getting harder to find, although many continued to defend the industry and its practices. The talk changed from whether there was a bubble to how big the bubble was and if it could pop.

Subprime mortgage news became the topic and lending practices in general began to be scrutinized. While loans for real estate purchase were still available it became increasingly more difficult to find money for all but the most credit worthy buyers. This further debilitated the crippled real state market. Now there was a discussion as to whether there was actually an economic basis to all this equity activity in the real state market or whether this was simply a house of cards that would soon come apart. Again there was extensive arguing from both sides.

THE PRESENT

As this is written, February 7, 2008 California and indeed the country now acknowledge the gravity of the situation. The real estate market has all but dried up. Values have fallen dramatically over the past several years and the bottom is nowhere in sight. Foreclosures are at record highs (and that does not include the fact that many banks and financial institutions are choosing to actively work with delinquent homeowners, allowing them to live in their homes so as not to flood the market with foreclosures, further depreciating values). Some of the largest loan companies in the country have closed and others are on the verge of collapse.

Within the past few days, with the earnings reports of the banks and other financial institutions who underwrote or purchased all of these funny loans, the world has been shocked by what is being disclosed. Some of the most profitable financial institutions and companies (who have made shameful amounts of money in the past several years from these loans and credit card fees) are on the verge of collapse. Indeed, several have only been saved with the assistance of foreign investors, who now own significant portions of American financial institutions. The economy is now acknowledged to be in trouble for the first time since this all began. And the million-dollar question which no one can answer is how deep the hurt will be.

The world economy is also deeply affected by this and stock markets around the world have seen significant selloffs along with all of the American exchanges. The Federal Reserve has granted a 1 1/2 point reduction in the fed rate. And the government of the United States has decided to give away $600 to qualifying taxpayers to stimulate the economy.

THE FUTURE

The United States is in considerable trouble and is facing a very difficult road ahead. But the intention of this discussion is to identify the future in California real state. Although much of what happens in California will be repeated throughout the United States the following pertains to California only. It is also my humble opinion for those who care to read it.

The economy of the state of California has largely been fueled by a distortion in the actual value of real state on a true economic scale versus the inflated values on the books today. It is no longer in dispute that these values are fundamentally too high. There has to be a reckoning to bring these values back to a realistic range. Payday has started and it is going to be tough.

Home values will continue to decline. The money for these purchases came from equity that didn’t exist. How much we do not know but we do know it is continuing to disappear. As it disappears more and more people will find out that the home they purchased has now decreased in value to below the value of the loan on the books.

Credit card defaults will skyrocket. Many people not in trouble with their home loans will not survive their credit card payments, even at the minimum. There will be no equity this time to bail them out.

Many people will walk away from their homes and rent. As more and more homes become available on the market in the form of foreclosures existing homeowners who have to sell their homes will be forced to compete with the falling prices of the foreclosures, which will continue to escalate. The real estate market will continue to disintegrate as values fall.

Many Californians will also find that they cannot afford the toys and other “stuff” they have purchased. Personal property in the form of cars, boats, and motorcycles, etc. will become available at bargain prices. Buying used items will become more practical than buying new, affecting retail businesses. Simply stated, the lack of disposable income and the inability to borrow for purchases of nonessential items will severely impact companies across the board, both large and small.

While the pressure and scrutiny continues on the financial institutions, now in trouble, there will be no easy out loans without government or other outside intervention. And if we do see government or outside intervention, it will only serve to slow down the inevitable, making it worse for all involved.

Commercial properties of all types will be affected. Businesses will continue to scale back and rethink expansion, cutting jobs, store locations, new equipment orders, etc.. Many businesses will fail and occupancy rates will drop.

Office, retail, industrial and warehouse properties will get very aggressive with lease rates to attract new and keep existing tenants. As these new leases containing reduced or free rent, tenant improvements and other incentives are offered by the landlord to new tenants, existing tenants will renegotiate their leases. This will further exacerbate the commercial market resulting in reduced income to the property.

Owners having built or bought their properties in the past several years, or those who have leveraged their properties to buy or build without adequate capitalization will be in trouble. Many will not be able to make their loan payments resulting in foreclosures in the commercial sector. Many are in trouble now, hoping that this is a problem that will go away soon. But it will not.

As in the residential side, commercial foreclosures will begin to determine market value and the new construction boom will largely be a thing of the past. Developers and investors with cash will find many bargains.

Those affected will be spread across all areas of the economy. The effect on the state will be staggering. Unemployment will rise as jobs are lost and cutbacks are implemented. Taxes will decrease as retail sales decrease (cars, boats, motorcycles, etc.)and property values decline along with corporate profits.

While I do not have an educated guess as to the length of the current crisis, based upon the last crisis in the 1989-90 meltdown I believe it will far exceed the five or six years of devaluation we saw then. And I believe it will be far more reaching than the meltdown 17 years ago.