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Why the real estate market is going to get way worse

Posted on Sep 16, 2007 by Paul White

Last night I had dinner with a couple of clients.  My clients are both in the real estate business.  They look for opportunities to buy homes and condos, then resell them for huge profits. Thus far they have done pretty well for themselves, even though they admit the market is getting pretty bad.

As most of us know, the real estate market is not doing well.  It started back in 1999 and 2000.  Home Demand started to go up.  Then in 2001 we had 9/11 and this put us into a recession.  The Fed dropped interest rates to almost 0.  This had a huge ripple effect in home prices.  Most buyers focus on "How much per Month".  They try all sorts of things to get their monthly payment as low as possible. They use an Interest only mortgage, or maybe extend the term from 30 year to 40 or 50 years.  The result was a buyer who used to only be able to afford a $150,000 house could now afford a 300,000 house.  Those who couldn't afford a house could now afford one, thanks to 100% financing, no money down.  The effect was it became a sellers market.  There were more buyers wanting to buy a home than there were homes to sell.  Of course this kind of demand only can only make home prices go up.  The demand varied on the local economy.  The worst hit of areas was San Francisco, and San Diego.  In SF be prepared to spend 800k to get an average home. 

The Big Problem was many of these people were buying homes are rates that would not stay low.  Lenders were setting home buyers up on 2 year ARMs, allowing them to make the payments now, but not in the future if rates go up.  Lenders get paid based on how big the loan is. So many were setting up buyers on very risk loans, just so they could profit in the short term. 

But of course the recession didn't last too long.  Inflation started to go up, and the FED raised interest rates to keep inflation in check.  But as the fed raised interest rates, it also affected everyone on an ARM mortgage.  The power of the monthly payment dropped and with it so did home prices.  Today in the Houston area if you want to sell your home for market value, it will take more than 9 months sitting on the market to sell.  The Boom in home demand caused many builders to rush to the houston area to take advantage of the market.  Today the market is flooded with new homes, used homes, and condos, that didn't exists just 3 years ago.  When these homes were planned it was assumed they were be a demand for them.  But as interest rates went back up, the buyer that used to be able to afford these homes,   now could only afford something in a lower price bracket.  This naturaly caused the demand to drop, and with it home prices.  Another factor that is hurting the market is the increasing number of foreclosed homes.  This has caused many operations in the financial services industry to go bankrupted.  Even larger companies like CountryWide, or Bank of America are having trouble.  The foreclosure issue is one that even politicians are focused on with the upcoming election year.  But here is what will really hurt things.....

My client who used to be able to use 100% financing to buy homes for investments and then quickly flip them for profits, is having to approach his investments differently.  Just last week he called his lender and told them he needed a loan to buy a home.  He has been involved with these guys for over 20 deals, and has extremely high credit scores.  They told him he had to put 10% down cash.  No second mortgage, he had to have 10% liquid cash.  This is one thing that is going to change the market.  The majority of home buyers in the last 5 years, were able to buy a home because they used 100% financing, or a 80% first mortgage / 20% second ( for the downpayment ).  But now people who want a home have to bring at least 10-15% cash to the table even if they have good credit.  If they have bad credit they need at least 20%, and will be at a high interest rate.  Bascially banks are trying to protect their ASS.  The effect is alot of buyers will be erased from the market.  Even buyers who can qualify for a loan, now will only be able to qualify for a much cheeper house.  This shift is going to cause further depreciation of the housing market.  This shift is what my client is worried about.  How many middle class families do you know with $30k sitting in the bank and no credit card dept.  Because that description is what banks want.  This is going to cause many to stop putting money into the economy.  They will have to cut down their entertainment spending ,and even the things they buy at Walmart.  Then in  3 - 5 years they might have the money saved up to make the down payment on a home.  This is how the housing market will extend to hurt stocks and commodities.  Less money flowing through the market means less profits for your favorite stocks on the DOW.

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vin | Oct 2, 2007 10:32 AM
great article
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