Thursday, April 18, 2019

Anatomy of a Real Estate Meltdown

It's happening.... again.

A recent article in Bloomberg, and reprinted elsewhere, says that college kids are "living like kings" in unoccupied mansions in Vancouver, BC.   In case you are not Canadian or were late for class, there has been a huge housing bubble in parts of Canada, mostly in Vancouver and to a lesser extent, in Toronto and elsewhere.

The Vancouver bubble is driven by Chinese sales.  During our trip there last year, we were chagrined to see billboards - all in Chinese - advertising chirpy young Real Estate Agents, who were young Chinese women.  What the billboards said, I do not know, as they were not bilingual but entirely in Chinese.  They weren't interested in my money, apparently. Chinese millionaires are buying up properties in Canada and having "anchor babies" in Canada and the USA to provide themselves with a "Plan B" in case China decides that its experiment with capitalism was just a fad - a scenario that is looking more and more likely every day.   You can't blame them for looking out for their own interests.

Problem is, or was, it was driving up housing prices in that city by double-digits every year.  Ordinary Canadians found themselves priced out of the market - if they were lucky.  Unlucky Canadians bought at these high prices and may end up bankrupted if the bubble bursts.   Since most of these mini-mansions and luxury condos were owned by out-of-towners, they were unoccupied most of the time.  To stem the wild speculation in housing prices and to trigger a "soft landing" the Canadian government instituted a 3% property tax on unoccupied properties.   They also made it a little harder to get mortgages for these properties.

One solution, of course, was to occupy the properties.  So wily Chinese are renting out at least part of these mini-mansions to students and others, to avoid the 3% unoccupancy tax.

This is a chilling echo to me.   You see, back in the 1980's, Mark was a college student in Boca Raton, and there was a real estate bubble that burst there.   It is the same old pattern - a market takes off, and each builder tries to build the most houses or condos before it all goes bust, convinced the "other guy" will be the one holding the bag when the music stops.   So they overbuilt the market, and luxury condominium developments sat empty.  So they rented them out to college students.  Sounds familiar, eh?

Fast-forward two decades and yet another housing bubble is taking place in South Florida, and this time Mark and I are back there, owning two condominiums.   We would drive down A1A in the cool of the evening in our secondhand BMW convertible and marvel at all the high-rise luxury condos all "topping out" at once.  What would happen to the Florida real estate market when these hundreds of units in one building hit the market?  What would happen when the thousands from all the buildings hit the market?  Well, rather than type this all out, I can just cut-and-paste from the Bloomberg article, because what is happening in Vancouver is the exact same damn thing that happened in Florida in 2006:
One flyer offers a 368-square-foot unit at C$515,000. “Transfer at original price,” it reads in Chinese. Last year, it would’ve fetched as much as C$800,000, says Jerry Huang, a realtor with Nu Stream Realty Inc., which specializes in presale developments.
“That’s an insane deal,” he said.  Presales were once seen as a slam dunk—put down a 20 percent deposit, flip the contract at a premium before completion, and pocket the gains.

Westbank said in an email that in the five years since some investors purchased, values have appreciated from 25 percent to 100 percent depending on the unit. The number of so-called assignment sales is less than 10 percent of total units in the building and “in-line with expectation.” But the broader downturn is beginning to catch some out across various developments. Those who bought at the peak need to find a buyer fast or come up with the full amount to pay the developer. 
With banks in some cases assessing units lower than the contract price, buyers hoping for a loan may face a shortfall. 
 "There are no assurances right now," says Adil Dinani, a realtor with Royal LePage—some sellers may be lucky just to break even. 
There have always been buyers who overextended and needed to sell quickly.
We saw the same damn thing in Fort Lauderdale back in the early 2000's.   You could sign a contract on a new luxury condo and put down a token amount as a down payment.   A year or so later, the building is finished.  You sell the condo and make a huge profit.  Say you "paid" $250,000 for the condo.   You put down $25,000 as a deposit.  Once completed, you sell it for $500,000 and make a $250,000 profit on your $25,000 investment.   Not a bad deal, eh?

Of course, it is an example of leveraging yourself, by speculating on the price of a commodity, in this case, the price of a condo.  If it goes well, you make ten times your "investment".    But if it doesn't go well, you owe tens times as much as your investment, and bankruptcy is almost a foregone conclusion.   If the condos are worth only $125,000 upon completion, you can't get a loan, and your contract with the builder obligates you to buy at the contract price.   If they sued you for "specific performance" you'd be screwed.   Luckily, most "investors" ended up just losing their down payments, as builders themselves went bust, and realized that suing their buyers was not likely to accomplish much.

As the bubble in South Florida expanded, it got so that you could sell the contract before the building was even built.   Some folks would flip a contract within days - to some other chump who felt that the condo might go up to $750,000 or more!  Sometimes a contract would be bought and sold a half-dozen times or more, with none of the buyers having any intent on actually living in these units or even owning them.   The contact itself became a talisman of investment - it was a tulip bulb.

The problem is, of course, eventually someone who actually wants to live there has to buy the unit, and in order to do that, the price has to be reasonable.   Empty condos, like the swapped contracts to buy them, are just a talisman of value - they are like the tulip bulbs of yesteryear.   You can't just keep swapping and selling them forever.   Like Bitcoin or gold, there has to be a "there" there.   And unlike Bitcoin or gold, condos are taxed - and taxed heavily in South Florida - and with condo fees and hurricane insurance, the carrying cost of owning such a place can be quite steep - to the point where rents barely cover carrying costs, if that.

The problem is, of course, the bubble wasn't nicely limited to these new condo developments or mini-mansions in the Everglades.  Once people get the idea that real estate is taking off, the broader market accelerates as well, which happened in Florida, and has happened in Vancouver.   Fast riches attracts all sorts of shady characters.  In Florida and Georgia, it was mortgage fraud - buying and selling the same house over and over again, to straw buyers, inflating the price with each transaction, and mortgaging the place to the hilt - leaving the banks (and by extension you and me) on the hook when the last straw buyer defaults.

But that is hard to explain to people.  Most of the television-watching idiots in the USA think "mortgage fraud" was something the banks perpetrated on the home buyers, not vice-versa.   As if lending too much money on a home was somehow profitable and that banks made money in foreclosures instead of hemorrhaging cash.  The banks weren't bailed out because they made money foreclosing on properties or writing liar's loans.    The fraudsters, on the other hand, made out.

But that is just an example of the sort of dregs that follow bubbles.   The industry itself will wallow in the gutter, putting out articles that "you'd better buy now, before you're priced out of the market!"    Banks start offering funnier and funnier loans to make overpriced houses "affordable."  Ordinary people see prices skyrocketing and think, "I need to get in on this and make money!" or they think, "I need to buy before I am priced out of the market - the real estate agent said so!"   And people who already own homes start to believe they are sitting on a gold mine, and either refuse to sell at these attractive prices, or worse yet, take out second mortgages to "cash-in" on their newfound phantom equity.  These are all pretty predictable things that happened in the bubble of 1989 and again in 2009.

But the worst is yet to come.  Housing prices in Vancouver seem to be making a soft landing so far.  Price are off by 8-10% this year, and many houses for sale are slashing asking prices and are waiting on the market for weeks for buyers.  The old days of multiple offers over-asking (which again, we saw in Florida and Virginia back in 2005) are fading fast.

To begin with, understanding how prices are affected by demand is important. Even a small drop in demand or a small increase can cause prices to fluctuate wildly. 
For example, suppose in a small town there are 100 homes for sale and 99 buyers. Well, clearly, someone's home is not going to sell. So that homeowner will drop his price. As a result, perhaps one of the buyers will buy his house instead. This in turn will cause another homeowner to drop his price. Perhaps if prices drop enough, another buyer will appear to snatch up a bargain. 
Conversely, if there are 99 homes for sale and 100 buyers, one buyer is not going to get a house. He might bid up the prices in an attempt to buy a home, which in turn can cause a bidding war. 
If the median home price in our mythical town is $100,000, it is not hard to see how a small bidding war, between even a few buyers, can increase home prices by as much as 5-10%, as the incremental monthly cost of ownership is not that great. Similarly, it is not hard to see how even a small discrepancy between the number of sellers and buyers can drop prices dramatically - again by as much as 5-10% without effort. And all this because of a ONE PERCENT difference between buyers and sellers! 
So you see, our "housing bubble" was not due to huge demand and the collapse was not due to a huge drop in demand.  People still want houses, just not as much as before. If demand drops 5-10%, housing prices can drop 20-30% easily.
Once prices start to rise, they can rise dramatically, even if the ratio of buyers to sellers is only 1.1 to 1.   Similarly, once a "bear" market starts, prices can collapse, even if the ratio drops only to 0.9 to 1.

The guy who is making "lowball" offers - as illustrated in the article - and finding them accepted, starts to get nervous.  He is elated to "score" a mini-mansion or luxury condo at an attractive price.  But he has this nagging worry, has he in fact overpaid for the property?  After all, there were no other bidders!  If he tried to sell the property today, he might not get what he paid for it.  So the psychology of buyer's remorse kicks in, and prices drop even further. 

The folks in Vancouver can hope for a "soft landing" and I hope for one as well, for their sake.   The Chinese aren't yet abandoning the city, I think, given the political situation in China.   But perhaps many who were merely speculators are realizing the party is over.  And the Chinese do love to speculate - and gamble - which does not bode well for the Chinese economy in the long-term.

And it is not all bad news, either, if the market does crash.  Housing in Vancouver was obscenely priced, and lower prices are good news for working class people looking to buy a home.  Bad news, perhaps, for folks who just got a second mortgage to pay off credit card debt, or the unlucky (unwise) person who bought in at the height of the market, convinced it was going to go higher.

I've been on both ends of the equation - buying houses at the height of the market (1989, 2008) and also snatching up bargains at the bust (1994-2002).   The properties I bought at the valley sold for nearly double their purchase price - often to buyers who approached me unsolicited - while the properties that I bought at the peak merely failed to inflate in value much over time.  Although if you wait long enough, as I did, eventually the house you buy at the peak (1989) can be sold at the next peak (2005) for a hefty profit.

Over time, bulls outweigh bears, even in real estate.

Again, the simple way to tell if you are in a bubble is to compare the carrying cost of a home, including taxes, insurance, reasonable mortgage payments, and upkeep, with the cost of renting the same property.  If it costs more to own than rent, the prices are head of the market.  If it costs two or three times as much to own than rent (which happened in South Florida) you are in for a big, huge, bubble burst.

Right now in Florida, the bubble is in luxury apartments.   Builders rushed to build these in the last few years, convinced that Seniors didn't want to own homes anymore and that they would all pay sky-high rents (with their Social Security checks, apparently) on luxury apartments.   So they all overbuilt, convinced that the other builder would be the one to go bust.   It is a perverse logic and a flaw in capitalism.   If the builder doesn't build, he makes no money, and the other guy does.  So in these hot markets, it quickly becomes a race to the bottom, as everyone tries to meet perceived need, and oversupplies the market as a result.   Raising beets or building houses, it is the same deal.

And markets in Silicon Valley, Austin, DC, and elsewhere, are showing signs of bubbly-like froth, although perhaps these are not as dramatic as the rise in prices in Vancouver.  Nevertheless, when no one can afford to actually buy and live in houses or condos, the prices will eventually "correct" over time.   You can't have a real estate market dominated by unoccupied properties that serve only as talismans of investment and no real homes.

It is a pattern we have seen time and time again, and no, this time it isn't different, and no, there are no special unicorn markets where the laws of supply and demand (and profit and loss) are suspended.