The subprime crisis of 2007 has faded somewhat as the market has focused its attention on other issues, such as the slowdown in China and debt problems in the Eurozone. Yet, real estate will continue to be a challenge as surplus inventories will take many years to work off. Despite the collapse of housing starts, excess inventories have only been partially absorbed. In fact, new inventory is being added as both renters and homeowners foreclosed out of their homes resort to living with friends or family. As with anything, excess inventories are the mortal enemy of prices.
New buyer tax credits have expired and programs to postpone and modify mortgages have largely failed. Through June, 40% of the 1.3 million mortgages modified through the federal Home Affordable Modification Program (HAMP) have been canceled because of failure to return paperwork or missed payments on modified mortgages. Of the mortgages modified in the fourth quarter of 2008, 60% defaulted within a year. In March of this year, the Administration liberalized the program to include second mortgages, which will likely meet with the same fate. Fitch Ratings has estimated that 65% to 75% of mortgages modified under HAMP will default within 12 months.
Unfortunately, recent price declines have encouraged homeowners to walk away from their houses even though they can afford the monthly mortgage payments. Current estimates indicate that 25% of mortgages are underwater. That number is likely to grow to 40%. For those still willing to make their payments, underwater mortgages are impossible to refinance. Approximately 35% to 40% of all borrowers with conforming 30 year fixed rate mortgages are paying more than 6% and are unable to take advantage of today’s historic low rates.
When home prices were rising, first time buyers were encouraged to buy as much house as they could. And why not? With a 5% down payment and appreciation of 10% a year, the purchaser made a 200% levered return on investment and had a place to live. Declining prices are changing the whole psychology of home buying. Smaller houses and fewer bedrooms are in vogue. Baby boomers will be downsizing – if their children are not coming home to live with them. Demand for large houses will decline for economic and demographic reasons.
The reduction in housing starts is affecting construction costs. But construction costs are not as elastic as real estate prices. As the price of housing falls, building permits fall, too. A builder will stop building because his costs cannot decline proportionately to the price. The value of residential land is the difference between what a buyer will pay for the combination of the land and the house. But the construction cost of replacing that house will not decline as much as the price depreciation we are seeing now. Consequently, land prices are declining significantly more than construction costs. Land owned or optioned by home builders may prove to be an additional concern.
Not only is real estate not expected to play its traditional role of supporting an economic recovery, further downward pressure will extend well into the future before we see a stabilization of prices and construction activity. When prices do stabilize and construction eventually normalizes, it is unlikely real estate will bounce back to former levels. In the meantime, we should expect further weakness in property values.