Housing: Part 1 – Price Declines

By Brad Thomason, CPA

 

In a recent interview, Warren Buffett said that he thought houses represented a good bargain.  As with most general comments though, a bit of finer slicing is probably worthwhile.  Buying a house to live in is different than buying a house as a pure investment.

Buffett mentioned that for folks planning to be in the same area for the next 5 to 10 years, home prices were hard to ignore.  You can buy a lot more house for the money as compared to the recent past.  In fact, in some areas you can find houses selling for less than what the construction materials would cost.  The intrinsic value of having a place to keep your stuff out of the rain doesn’t change when the market does; and it’s nice to be in a situation where the cost is less than history says it ought to be.

For investors, the basic message needs some further consideration.  Depressed prices may set the stage for future gains.  But they don’t create a guarantee.  To be cautious, it helps to look at why the prices are depressed to begin with.

Location x 3
This is still real estate folks, and location still matters.  Prices in one area may be lower for a different reason than similar declines in another area.  Why does that matter?  Because the reason for the decline may impact how the recovery ends up going.  Here are three broad themes that have lead to price declines:

General Economic Decline:  This is the garden variety driver.  It comes about as part of a larger downturn in an area.  Could be because a large employer or two leaves town.  Or it could just be reflective of the broader US and global slowdowns.  As people get concerned about finances, and maybe even lose the ability to cover their budgets, transactions levels of all types become depressed, including home sales.  Falling demand and steady supplies of housing lead to downward price pressure, just like you learned in economics class.

Overbuilding:  Basically this is the other side of the equation.  The number of new houses being built was more than the area could absorb, but the developers and builders had access to enough borrowed money that they were able to create a substantial local overhang before they went bust.  Same demand, too much supply, lower prices are the result again.

Foreclosure sales:  There are foreclosures everywhere these days.  But they are more concentrated in some places than others.  When this happens, even houses that are not involved with delinquent loans get impacted when they enter the market.  If the same basic house down the street is selling for 20% less due to a bank problem, a seller may volunteer for a lower price just to get their house sold instead of the foreclosure house.  The foreclosure house doesn’t even have to sell.  Its mere presence is enough to drive prices lower if other sellers are reacting to it being in the marketplace.

The Backside
No one knows exactly what’s going to happen over the next 1-3 years.  But as a thought exercise, I think it’s reasonable to speculate that when the broad causes are different, the lingering effects, including price recoveries, could differ as well.  In areas where general economic conditions caused the decline, a recovering economy has a better shot at being an all-lifting tide, bringing housing prices up along with other measures of prosperity.  In essence, the slowdown is exerting a systemic, yet temporary pressure, and normal market dynamics will start to fix things over time once the pressure abates.

Similarly, in areas with lots of foreclosures, we would expect that prices could rise on their own once foreclosure volumes drop.  There have always been mortgages in default, and there probably always will be.  But as delinquencies return to more normal levels, there should be a corresponding decrease in the supply of troubled properties.  Just as their presence makes everything worse, their departure will hopefully allow things to get better.

As for overbuilding, depending on the degree to which it took place, this could be a more lasting problem.  Houses that sit vacant do not do so in a vacuum.  If someone is taking care of them, the meter is running on carrying costs.  If not, vandalism and increasing degradation become more likely every month that passes.  So holding an empty house for  a long time is a loser either way.  Do not be surprised if 5 to 10 years from now there are still houses (not to mention unbuilt lots) in the most overdeveloped areas that have never been moved into, and will require as much money and hassle to clear up (both physically and legally) as starting all over again with a new house somewhere else.  We had a chance to buy over 100 building lots the other day for less than $100K.  We said ‘no thanks’ because we did not like the area’s prospects for being able to absorb new construction, even looking 5 years out.  In my view, this is the localized problem with the greatest potential for long-term staying power.

Bottom line, just remember that a general notion that houses are a good value impacts homeowners and real estate investors differently.  And it doesn’t change the fact that each real estate deal is still its own unique transaction.  The more time you spend trying to understand the individual story, the more likely that you’ll spot problems that can turn your great opportunity into a middling proposition (or worse).

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