Existing and new home sales seem anemic and the media continue to play up the doom and gloom scenarios based on general market indices. For example, “The Housing Horror Show is Worse Than You Think” July 11, 2011, Bloomberg BusinessWeek, p. 43. Have we forgotten that the three most important things about real estate is location, location, location?
A potential home looking to buy a home worth $500,000 but keeps hearing that the Case-Shiller index is going down and that prices are still falling so, like a deer caught in the headlights, they procrastinate unable to make a decision on the right timing to buy a home. In some neighborhoods prices will continue to fall and they should wait. In other neighborhoods prices are stable and this is occurring in the same metropolitan areas. So, where buyers are looking matters, but it is not clear if they understand this. It is also not clear if they understand that catching the bottom of a cycle is not that easy and that mortgage rates matter as much as prices in terms of affordability. We will expand on this point below.
The Case-Shiller Indices are not really representative of the local market
Some in the media seem to think that everyone lives in the average home represented by the Case-Shiller index. If we did live in this mythical average home as represented by Case-Shiller it would be about one fourth distressed and the balance of the home purchase would be normal. Yet, we know that sales are either distressed, such as Bank REO sales that show discounts of 20% to 50% depending on the market, or they are not distressed and yet the industry guides it’s actions based on an index that contains both to suggest what is happening to home prices in all markets. Such an index may be appropriate for national and regional trends, but is not representative of what is happening at the local level. In the past three to five years we have seen distressed sales affecting market averages so the question one might ask is how typical are these of local market trends?
In the first Exhibit above we show how the Case-Shiller index compares to San Diego since June of 2005. According to the Case Shiller index the average home in San Diego has declined by 37% over this time period, but we find that 59% of the zip codes have declined less than the Case Shiller index and some have actually started moving up in price during 2011. If a buyer bought into a zip code that was on the left side of the chart they did worse than the Case-Shiller index. In such markets we find a concentration of distressed sales with huge discounts. In such markets even normal sales are tainted by the contagion effect and there is no escaping the downward effect on all prices in the neighborhood. These neighborhoods where distressed sales are still significant and dominating the local market could continue to decline and remain very risky, even today. If a home buyer was looking at some of the zip codes on the right side where regular sales dominate, they would find prices are already stable or increasing as most of the contamination from distressed sales is over and the percentage of distress sales was never very high. In such markets where price decline risk is low, it would make sense to take advantage of the attractive mortgage rates. Again, almost no one buys the average basket of homes and localized markets show different price trends.
In Exhibit 2 in San Diego, we see that prices in some zip codes are moving sideways today, others are heading down and a few are heading modestly up.
If we look at the 20 major markets in the Case Shiller index we find that Minneapolis has been the worst performing for the period of April 2010 through April of 2011. Aside from the fact that these indices are reported rather slowly in arrears, let’s compare the local zip codes to the overall index. See Exhibit 3. Again we find that only one third of the local markets did worse than the Case Shiller index and 18% of the zip codes actually saw prices start to increase, suggesting that those who are waiting for a bottom may not realize just how “local” markets are and how some sub-markets are already stable or heading up. Those looking in neighborhoods on the right side of the chart would have missed the bottom if they continued to wait, while those on the left side might be better off waiting as significant price decline risk continues. Markets are very granular, do not move in perfect synchronization, and neighborhoods deviate greatly from metro based indexes.
Now may be the bottom for mortgage rates?
Normally the mortgage rate spread over treasuries is about 120 basis points over 30 year treasury bonds suggesting that in normal markets the current mortgage rates would be about 5.5%. Additionally, the current US treasuries are well below historical averages for 10 year and 30 year bonds, thanks to QE2 and countries like Greece that make US treasuries seem like better safe havens. In the year 2000 the 30 year bonds exceeded 6% which has been typical of the last several decades. One might assume that we have a better handle on inflation than in the year 2000 but gold price data and recent consumer price index trends suggest that we could easily see inflation rates go up over the next several years. So, if the 30 year treasury rate went to only 5%, well under historical figures and the mortgage spread went to 100 basis points we would see 30 year mortgage rates of at least 6%. In a few years, this could easily be the case, so those who say they don’t want to buy a house now because prices have not bottomed out yet may be focused on the wrong parameter. Correspondingly, all mortgage product rates will likely increase over the next few years. Payments on an 80% loan to value mortgage with a rate increase from 4.75% to 6% on a home that declines in value by 5% are still 9% higher. One would think that home buyers on the fence would understand just how low mortgage rates are as of mid-2011. In fact some 10 year FRM mortgages are available at 3.5% or less for conforming loans. We all understand that those who plan to stay less than 2 or 3 years should not buy a home as transactions costs dominate the economics. Aside from the possibility that mortgage rates are a steal in the current market, we still have the perception that all homes in a metro move with the Case-Shiller index. Nothing could be further from the truth.
Home buyers, lenders, servicers and investors may be ill served basing decisions on the Case-Shiller indexes we often see in the press. Their financial decisions are property specific and a particular submarket or neighborhood often does not behave the same as the market averages or indices suggest. We must keep in mind that the current Case-Shiller indices include distressed sales which sell at huge discounts compared to regular sales. We used to use 22% as an estimate for the discount for an REO sale but recent statistics suggests discounts of more than 25%. These sales bias metro indices, but even without the distressed sales, local markets do not move in tandem with metro averages. We picked just two markets to demonstrate that most current homes have not declined nearly as much as the Case-Shiller indices would suggest and a few local markets are actually stable or heading slightly positive. Market analysis must be much more granular than at a metro level, and this is all possible today. Last, we have suggested that when estimating the factors affecting affordability, mortgage rates matter as much as home prices and buyers should realize what an unusually great time it is to borrow money. This will not last forever, maybe not even past mid-summer if no debt ceiling agreement is reached.
 According to the ForeclosureNewsReport.com 27.5 % of all sales were REO sales in June of 2011 and the average discount compared to normal sales was 35%, fairly consistent with data from Collateral Analytics.
 Foreclosure discounts were historically lower, but then we have not lived through a period when displaced borrowers decided to rob their own homes and vacate the unit prior to the sale like they are doing today.
 If mortgage rates included the kind of premiums necessary to cover those engaging in strategic default there would be a greater spread and even higher rates, but let’s assume that the default rates going forward are nil and the mortgages fairly safe for lenders, at least for now.
James R. Follain, Ph.D.
James R. Follain LLC and Advisor to FI Consulting
Norm Miller, PhD
Professor, Burnham-Moores Center for Real Estate
University of San Diego
Michael Sklarz, Ph.D.
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