As detailed earlier, Centex is making an extremely desperate move to clear underwater inventory. Well, they have been joined by several peers in extreme discounting. Hovnanian, Meritage and Standard Pacific have all offered highly discounted sales with discounted financing. This is, in my opinion, a (probably necessary) act of extreme desperation that clearly demonstrates how much trouble these companies are in. By overpaying for depreciating real estate with excessive debt that is supported with negative and still declining cash flows in the bust phase of an boom/bust bubble market, these companies have put themselves on the radar for potential ruin. I don't know who will make it and who won't (I wouldn't bet on Beazer, though), but the results of these fire sales, thus far, don't appear to be promising. Furthermore, the failure to move these houses at depressed prices lowers the ability of others to move similar property, especially those who don't have the marketing clout (read the individual homeowner). Even if these companies succeed, the comparable values that are used to appraise single family homes will be devastated (Centex is cutting some of the prices by up to 56%). This potential massive decline in comps valuation will not even register in the widely followed real estate indexes. If you are new to the blog, click here to see why.
For those that are not familiar with how real estate comps work, it is very simple. I sell my house for $100k, you sell your house for $110k, and three neighbors sell their houses for $105k. An appraiser takes the average of the the 5 sales, assuming they are all similar sized houses in the same neighborhood, and comes up with an average price per square foot. This price is adjusted for individual qualities, such as the presence or absence of certain amenities, ex. fireplaces, driveways, pools, etc. and the condition and relative location of the property (ex. corner lot) and then multiplied by the gross living area to come up with an appraised value. In the situation above, assuming these properties needed no adjustments, and they were all roughly 2,000 ft homes, the value per sq. ft. would be $52.50, which would lead to an appraised value on a new 2,000 ft. home purchase of $105,000. Now let's assume that you are in a Centex built community, and you and your latest 5 neighbors have this property value, but Centex holds a fire sale with 15%-56% off, averaging about 30%, and sells 3 properties.This drops the average value for sq. ft. to $47.25, which means that your 2,000 sq. ft. house is worth slightly less than (due to the fact that it is not as new as the newest builds and the downward trending bias of the broker's market) $94,500. That is a 10% of our equity destroyed, and if your down payment plus any financed closing costs are less than this 10%, you now owe the bank more than your property is worth. Let's just hope you don't have an ARM!!! The more Centex (or any other builder, let's be fair) discounts their property to alleviate their problems, the more of a problem you will have. If they sell 6 properties in this example instead of three, and your equity is less than 20%, you're underwater, and the parade goes on.
To add to this bearish sentiment, every CountryWide type bank out there that needs to dump the REOs (bank owned real estate obtained via foreclosure/default) will further depress prices, for they are in the same situation as the homebuilders. The circular issue is, the lower they cut the prices, the faster they dump the inventory. The faster they dump the inventory, the lower the prices, hence less collateral for the mortgages of the CountryWides, and lower inventory valuations for the homebuilders, and probably most importantly, the lower your home value is. This spiral will cause a real property crash, and there is relatively little the Fed can do about it. Cutting rates will affect it very little unless there is an extreme cut of 100 basis points or more, and potentially spark additional speculation, which is what got us here in the first place. As a matter of fact, if rates don't RISE to counter inflationary pressures, the cost of construction and commodity housing components may very well skyrocket further, it has nearly doubled in NYC in the last 3 years, potentially causing the price of the houses to increase. For all of those calling for a rate decrease, be aware of the spike in construction labor costs, material costs, and the demand driven price of housing that the low interest rates have caused over the last few years. Just take the time to think it through, Mr. Hovnanian, et. al. A percieved short term solution to your problem at the nations economic expense? I am not a economist, but I do pay attention... Alas, I digress.
To add to the misery of the homebuilders and the banks with REOs, it is my opinion that prices will have to drop significantly below the point of the builders margin for error in order for the inventory to move en masse. Most people who have not bought a first home (HOV is a luxury home builder, so may not be strong in the 1st home market) already, will do so only (hopefully) if they can afford to do so. At current prices, with current mortgage terms and rates, the average family cannot afford to buy a home. The reason is because the components that go into a home: a.) the land, b.) the hard and soft costs of construction, and c.) the comparable value, were all established during a period of very easy credit and very low interest rates which made for ample liquidity in what is normally a very illiquid market (real estate).
The factors listed above tend to change VERRRY slowly, but the mortgage market has turned VERRRY quickly, thus causing a significant disconnect between what is available for sale (the inventory, or supply side of the supply/demand equation) and the capabilities and willingness of the buyers (the demand side of the equation). So, back to econ 101, supply and demand are not in sync, and in some places they are so far out of sync so quickly that nothing but an actual crash will restore equilibrium. Following my train of thought (yeah, I know I'm all over the place here): 300% of appreciation in 7 years in lieu of the historical 14%-21% in the same period adjusting for income growth and inflation, less even an extreme 56% discount as in the case of Centex, still leaves properties a staggering 111% excess gain that needs to be whittled away - way above where they should be (assuming the original 300% growth rate was not the result of a demographic change in the area, such as gentrification). Think about condos in Miami or Vegas...
Methinks that even many of the so called "experts" have no concept of how far these hard assets can and probably will fall before the oft sought "bottom" is met.
I am very interested in how long it will take local governments to acknowledge the new property values in assessments after these sales. I expect a lot of governments to drag their heels, and then either have to dramatically increase tax rates or face significantly lower tax income.
Posted by: MattJ | September 17, 2007 at 08:05 AM
You would be right in expecting governments to drag their heels, for they would be sacrificing a lot of new found revenue by marking to market the downside as fervently as they were willing to catch the upside.
I think an increase in tax rate will be politicial suicide in manyclimates right now, and with a slowing economy, the prospects of lower tax revenue will cause the populace to turn against the pols due to lesser delivery of services, which will have a definitive lag. Thus, this may be the way out for those who will be moving up, laterally, or otherwise out of their current position.
Posted by: Reggie | September 17, 2007 at 02:36 PM