The Real Estate Market: Another Rough Year Looming

Alexander Green
by Alexander Green, Chief Investment Strategist, The Oxford Club

The Real Estate Market: Another Rough Year Looming

by Alexander Green, Investment U's Chief Investment Strategist

Monday, December 20, 2010: Issue #1411

Anyone who reads my investment commentary knows I'm an optimist. But I like to think I'm a rational one.

When the economy tanks, I know it will mend eventually. The same is true with the stock market.

But what's happening with residential real estate right now is the equivalent of a thousand-year flood. Home prices will not rebound in 2011. Indeed, they'll only head lower.

And this is more than just a guess...

Why Residential Real Estate is Struggling to Recover

Residential real estate is weak, in part, because the prices leading up to the peak in 2005 were wildly unrealistic and irrational. You can't explain it with inflation, building costs, or potential rental income. It was just a mania, fueled by ultra-low interest rates, super-EZ credit and the unshakeable belief that "real estate always goes up."

Look at every bubble of the recent past:

  • The Tokyo stock exchange in 1989 - 75% lower today.
  • The Nasdaq in March 2000 - 50% lower today.

Manias generally take decades to work out - and we're not even six years into this one.

The real estate party is over. Now we're left with the clean-up - and the hangover...

Foreclosure: From Calamity to Crafty

Some analysts say housing is weak because of the tepid recovery and high unemployment. But that doesn't begin to tell the tale.

At the end of the third quarter, 10.8 million American mortgages were underwater (i.e. when borrowers owe more on their homes than what they're worth). This accounts for 22.5% of all U.S. homeowners with a mortgage.

Some housing experts say this is a positive development. After all, 11.3 million mortgages were underwater at the beginning of the year. However, this drop doesn't reflect a rebound in home prices. Rather, the number of underwater homes has declined, as banks have taken back the properties and wiped out their debt through foreclosure.

Unfortunately, foreclosure sales force market prices lower, which puts still more mortgage holders underwater. As time passes, more homeowners will realize that they're paying a mortgage that is far more than the value of the house and walk away - even if they can afford to keep paying.

This is a troubling development, but the stigma is already gone. It used to be a mark of dishonor to have the bank foreclose on your home. Today, it's increasingly viewed as a smart business move.

"Why should I keep paying my $400,000 mortgage when the house is worth less than $250,000?" a pharmaceutical rep asked me recently. "I'm not an idiot."

The Millstones Around the Housing Market's Neck

Homeowners are realizing that housing prices aren't going to come roaring back anytime soon. And they're beginning to feel that paying on the mortgage is simply throwing good money after bad. In fact, financial advisors often encourage borrowers to walk away.

"A bad credit record hurts a lot less than a six-figure negative net worth," said one.

There are plenty of other pressures on the housing market, too...

  • Sales Trouble: Most potential buyers can't sell the house they're in. That makes it impossible for them to buy another.
  • Banks Get Tough: Duly chastened by all the no-money and low-money down-payments of the recent past, most banks now require a 10% downstroke or more. Plus a decent credit history. But many potential borrowers don't have both... or either. In turn, that dries up demand. Plus, mortgage rates are rising, making even attractively priced homes less affordable.
  • Sentiment: The psychology of the housing market is fragile. For years, people bought all the house they could afford (and then some) and didn't hesitate to invest in rental properties or vacation homes. Why? Because real estate always goes up, remember?

But now, a second home is more likely to be viewed as an albatross. Speculators rightly see the near-term appreciation potential as nil.

This doesn't mean there aren't bargains available. But buyers need to be extra careful. I know plenty of people who bought homes on the courthouse steps a couple of years ago and are now sitting on terrific losses.

If you can buy a home at a great price and find a renter to cover your costs, by all means, consider taking the plunge. But plan to hold on a few years. The chance of turning a home over for a quick profit - unless you're buying an absolutely distressed property - is remote.

The Real Estate Verdict is in: Another Rough Year Looming

To sum up, a weak economic recovery, high unemployment, rising interest rates, falling house prices, an inventory glut, increasing foreclosures, tight credit, poor psychology and mounting walk-aways will keep residential home prices under pressure in 2011.

And 2012 isn't likely to be any great shakes either. Please don't shoot the messenger.

Good investing,

Alexander Green

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