The uneven housing market of Southern California – Middle tier of Los Angeles and Orange County down over 8 percent in last 24 months. Lower tier holding steady over 24 months.
Purchasing a home is a major decision and will likely be the biggest purchase a person will ever make. For this reason the vetting process to purchase a home in the past required due diligence and also a demonstration that the buyer had the capability of saving to purchase a large commitment. Owning real estate carries many unforeseen expenses. When looking at the rising default rates with FHA insured loans one has to wonder if buyers really factored in the true cost of owning a property. In Southern California many who bought in the last few years thinking the bottom was in were still speculating in the sense that the property ladder game would be back in vogue. That has not happened. What appears to be happening and this is clear in the figures is that the market is stabilizing but at the lower tier of the market. It always helps to look at the facts since there is a tremendous amount of noise in the media.
The story of L.A. and O.C. home prices
One of the most followed metrics on home pricing is the Case-Shiller Index. The index does one of the best jobs tracking real estate prices because it looks at repeat home sales. Karl Case developed the method to examine pricing behavior for the same home over time. Case-Shiller now offers tiered levels of prices and this is extremely valuable for diverse markets like Southern California. The figures tell us a fascinating story since the peak was reached in 2006. More to the point, the middle tier of the LA and OC housing market is in the middle of a double dip. The lower tier seems to be stabilizing. I went ahead and ran some numbers over the past two years:
First, let us clear something up. This bubble burst has hit every segment of the LA and OC markets. The lower tier, home prices under $285,895 has seen prices fall by 53.8 percent since the peak. The middle tier, homes with a price of $288,895 to $467,090 has seen prices fall by 42.2 percent since the peak. The high tier, homes with prices above $467,090 has seen prices decline by 31.5 percent. Every segment of the market has been hit hard.
Looking at more recent data, figures from the last 12 to 24 months highlight what we have been discussing for well over a year now. The middle tier of the market is now facing the strongest impact of the current correction. For example, the lower tier of the market has done the best in the last 24 months. Home prices in the low tier have increased for two consecutive months and 12 months and 24 months figures are only slightly off (3.1 and 4.1).
The middle tier is where most of the recent correction has hit. In the last 12 months this segment of the market for the LA/OC region has fallen by 6.2 percent. Over the last 24 months it is down 8.1 percent. This is significant given the large number of people jumping in with FHA insured loans that only require 3.5 percent down. The high tier has also corrected in the last 24 months by 7.5 percent and 4.9 percent in the last 12 months showing a similar pattern.
The above chart shows the mini spike that really did occur in 2009 and went into 2010. If you remember the absurd tax gimmicks and the belief that the “true bottom” was now reached created a temporary frenzy. Much of that momentum has disappeared, even with the government virtually buying up every mortgage that is made and providing risky leverage with FHA insured loans. Many of those who try to deceive the public especially in the finance sector are quick to lend money that is secured by the government (aka the public) but would they risk lending out $500,000 at 4 percent with only 3.5 percent down if it came from their own account?
Let us try to put some actual figures to the decline over the last one and two years:
This helps to put a dollar figure loss over the last couple of years. I realize that $500,000 is slightly higher than the Case-Shiller middle tier cut off but the high tier goes from $467,000 up to multi-million dollar properties. $500,000 seems to be a price point many are looking at today so running the numbers might help out. Let us look at the low tier first. Someone buying a $175,000 home in say Lancaster or Palmdale might have seen only a few thousand dollars decline on the home value over this time frame. Given the low tier trend, the last 24 months have seen stabilization and a $5,582 equity cut in two years is very marginal.
The middle tier is where the shadow inventory coming online is having a larger impact. Take for example someone that bought a townhome or condo in Orange County or Culver City in January of 2010. Let us assume it was a quality place that was newer. The price tag of $500,000 seemed like a bargain given that some of these places might have sold for $650,000 to $750,000 during the mania. How have they done? Over the last two years the value of the property has dropped by $40,650. Let us assume they purchased with the minimum down payment of 3.5 percent ($17,500 plus closing costs). Not only is the value of the place much lower, but they are now underwater by a sizeable amount:
$500,000 purchase price
Loan balance after 2 years ($467,898)
$459,350 current value
6% sales cost $27,561
In other words the home is underwater in the equity department plus with the sales commission, this seller would need to come to the table with money to actually sell the property (over $36,000). I’m not sure where some people learned about finance but losing money like this is not exactly a wise financial decision.
Of course this is merely looking at the facts. We have the grim reality that household incomes have gone sideways for many years and the market is incredibly artificial with government and banking intervention. Rates of 4 percent imply little risk but that is absolutely not the case. Just look at the incredible rising defaults in FHA insured loans. Buying trillions of dollars in mortgages might keep rates low but what is the long-term repercussions? We’ll soon find out.
Let us run some more numbers. I know a few readers were sending over condos in Orange County that once sold for $700,000 now going for $500,000. These places would likely rent for $2,000 a month. Let us be generous and run the assumption that home values, starting today will increase by 2% annually and rents will increase by 2% annually as well. Let us look at a 5 year horizon here:
The above assumes a 3.5% down payment, a 4.25% mortgage rate, taxes (high for OC condos), an opportunity cost of 4% on alternative investments, and other miscellaneous costs that are likely to come from owning the place. After 5 years including a home sale the total amount spent was $181,978 (roughly $3,032 per month including tax benefits). Let us look at the renting side of the equation:
Over the same 5 year period including rent hikes the total spent was $135,206 (roughly $2,253 per month). Since those that bought in early 2010 were speculating (knowingly or unknowingly) just like those in 2006 (although not to the extreme) it is important to understand that buying and renting is not merely an easy equation. The above scenario assumes annual increases in home values by 2% when prices in the middle tier are still going down! The above figures that the $500,000 condo purchased today will sell for $552,000 in 5 years. Since no one has a crystal ball we have to look at macro economic data and try to look forward. What evidence do we have that household incomes will rise sharply in this time frame? Are we certain mortgage rates will continue to remain this low for years to come? FHA insured loans will be getting more expensive in the next few months, this is something we know. How will this impact the market? What about the now coming online shadow inventory where over 50% of all MLS listed inventory is now short sales?
All this suggests a couple of things. If you are buying in the low tier segment of the market it does look like some bottom may be taking place. Run the numbers to see if it makes sense for you. The middle tier has made a post-bubble low and only now are we seeing more quality inventory hitting the MLS showing banks are starting to move on shadow inventory. Anyone telling you should buy today because rates are low is missing the point. It is wiser for someone to take a higher rate with a lower home price. You have more options with a higher rate (i.e., pay down the loan faster with extra payments, refi in the future, etc). The fact that we have sub-4% mortgage rates by massive artificial intervention and FHA insured loans dominating the market tells us buyers are simply stretching to get into homes. The silver lining to this all is that people are realizing that housing is a big purchase and few are starting to run the numbers for themselves.