A Time for Yellow Flags
November 28, 2006
Figures from the National Association of Realtors show that the market has done fairly well. Of 148 metro areas, 102 showed year-to-year price gains, 45 were down and one was unchanged.
Twenty-one metro markets actually showed doubled digit price increases. Overall, prices nationwide dipped 1.2 percent to $224,900 from $227,600 a year earlier. As to sales, they're down 12.7 percent when compared to the third quarter of 2005, but 2005 was an amazing year. As things now stand, the country will sell better than 6.25 million homes this year, one of the best years on record.
As good as the quarterly figures look -- and despite some softness they look very good in the context of the past decade -- they do not tell the whole story.
While unit sales are easy to track, data regarding recorded prices is less certain. If you have a strong sellers market you can bet that sale prices are indeed what people paid because sellers have no need to offer discounts and buyers will not pay any more than required. But if you have a market that's losing steam, the same assurance is not plausible.
The problem with slowing markets is that sale prices may not tell the whole story. Sale prices may be discounted, and the extent of those discounts cannot be reliably estimated.
For instance, let's say that in a given local market the common practice today is to offer closing credits to buyers that equal 3 percent of sale prices. That means on the sale of a $500,000 home a purchaser would receive $15,000 in settlement credits -- enough in most cases to buy a property with no closing costs. The discount also means something else: A published price does not reflect the real sale price in terms of the owner's net benefit: $500,000 less $15,000 is $485,000.
Now let's look at the impact of such discounts in the marketplace. Suppose that a home priced at $500,000 today would have sold for 1.2 percent more last year. Last year's sale price would have been roughly $506,000 with no discount.
However, $506,000 last year is worth something else today because of inflation. According to the Bureau of Labor Statistics, when corrected for inflation a home that cost $506,000 last year would actually cost $522,841 in today's dollars.
Suddenly the change in values is more significant than 1.2 percent. Our property has gone from $522,841 to $485,000 in today's dollars -- that's a drop of $37,841 in buying power or 7.2 percent when compared to the absolute top of the recent market.
Not too many people sell at the top of any market -- in effect, the "top of the market" is a mythical place for most buyers and sellers. In addition, offsetting the 7.2 percent decline in our example have been huge price increases seen in the past few years. If you bought several years ago then in most areas your profits are locked-in. Short of a major bust it's hard to imagine any circumstances in most local markets that would lead to a loss for long-term property owners.
For instance, the typical home that NAR today values at $224,900 -- the home that lost some value in the past year -- is worth a bunch more than the same house in 2000. That year the typical existing home sold for just $139,000.
In looking at today's metro figures there's simply no evidence of a bust, a tragic and upsetting price decline. But while red flags in most areas may not be appropriate, yellow ones for "caution" are surely in order.
For example, interest rates at this writing are remarkably low -- just 6.24 percent plus a half point for 30-year, fixed rate financing according to Freddie Mac.
You look at these rates and wonder: What would happen to real estate prices and sale volume if mortgage rates were closer to 7 percent? What would happen if rates were higher still? By historic standards, a 7 percent rate is the stuff of dreams for most homebuyers during the past half century.
Here's another one: There are millions of high-risk loans now being used to finance high-cost real estate purchased with little down. These loans -- interest-only and option ARMs -- allow borrowers to make small monthly payments for a lengthy "start" period, perhaps five years. But what happens when these loans re-set and payments increase? Will local markets be flooded with homes that are too expensive to retain -- and yet with market values that are insufficient to pay off existing mortgage debt?
The bottom line: There's no evidence of a real estate bust to date -- but local markets may not be as strong as they seem on paper.
By Peter G. Miller
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