Sunday, July 20, 2008

Beneath the Housing Crisis: Variation in Housing Inventory

We've all heard of the overconfident swimmer who was convinced he couldn't drown in a lake that averaged four feet in depth. Averages don't tell us anything about variability and, when it comes to keeping one's head above water in swimming or in real estate, variability matters quite a bit.

This lesson hit home during a weekend car ride. Son Macrae, shown above in rocker incarnation, has his learner's permit, so he took Dad for a drive around hometown Naperville. We headed southwest and soon reached formerly rural areas that are now the sites of multiple housing tracts. As we drove, the signs for open houses in housing developments first became more numerous, then they became larger. Still further to the southwest, every major intersection was overrun with the signs.

As we forged ahead, the signs began offering massive discounts on the new properties--many of which were obviously not selling. Indeed, many of the developments were half-completed, seemingly frozen in place. By the time we ended our trek, we came across a large sign for a development that offered a free Toyota Prius, $75,000 in options/upgrades, and five years of free utilities to anyone who would buy one of the homes.

It was clear from our drive that there is no single housing crisis. Much of Naperville real estate is in slow-down mode: prices are holding reasonably well, but taking longer, on average, to sell. In the formerly hot areas of development, however, the overexpansion is mind-boggling. Not even free cars and large rebates can move the inventory--particularly with the tightening of mortgage loan criteria for would-be buyers.

This is not an intensification of the slowdown in the general market; it is many standard deviations from the mean. I have significant doubts that many of these subdivisions are viable at any price. From the pricing of the regional bank stocks that have loaned to these developers, I don't seem to be alone in this opinion. C'mon: are you going to jump in and buy a home in a half-filled, half-built development, when it's not clear that the builder will ever be able to finish the work? Are you going to buy a condo in a partially filled building and hope that the remainder of the units will sell, so that you won't have to cover the shortfall in maintenance assessments?

A number of discussions treat the housing problem as if it's a general slowdown that just requires a boost of confidence among homeowners, a cut in mortgage rates, and perhaps some government aid to those at risk of foreclosure. My drive with Macrae suggests the opposite: this is like tech stocks in early 2000. While many sectors back then were overpriced and experienced a significant but normal bear market, a host of internet-related companies were brought to market with no underlying demand or value whatsoever. The bust wasn't over until many of these roundtripped to zero.

The difference, of course, with housing is that, when developments fail, contractors don't get paid; their suppliers aren't paid; bank loans go into default; mortgage-backed securities are threatened; homeowners lose value in their homes; municipalities lose property tax income; and on and on. Just as surviving the 2000-2003 period meant staying out of the formerly hot areas, I suspect that those who get through the current crisis will insulate their funds from the many areas touched by the collapse of developments that are forced to resort to increasingly desperate discounts and come-ons.

To be sure, not all the outliers in the housing market are marked with large signs. When I last looked at the number of Naperville properties for sale as a function of price--and then compared those numbers with the average number of properties that sell each year at each price level--I found similar large variation. Many houses were for sale in the $500,000 and under categories, but not hugely more than the number that sell in an average year. When I looked at the homes that were selling for $1 million and over, however, there was six years or more of inventory on the market. Is anyone likely to pony up that kind of money for what looks to be a depreciating asset? With tightening loan conditions, where are these buyers going to come from?

The irony is that, in the national scheme of things, Naperville is a relatively healthy real estate market. But its housing problems, like the hapless swimmer's lake, average four feet in depth. How many more markets are like this--or worse? My next post will take a look.


Regional Bank Woes