The Coming Real Estate Price Crash

December 2008

The real estate crash is here. Regardless of the world's governments' stated attempts to support the bubble, property markets around the world are going to lose substantial value. The government bailouts of the financial sector will - perhaps - prevent the banking system from collapsing completely, but will have very little effect on the value of real estate. Many people with their wealth based in real estate are going to see that wealth disappear, almost overnight. This was not "real wealth," - purely the effect of a rising property bubble, and it will evaporate as quickly as it materialized.

Creating Genuine Wealth

Creating genuine wealth requires timing, funds and the foresight to enter a position at the correct time. "Buy low, sell high." Many bought high in the recent real estate bubble, and will be paying the price over the next two to three years. Banks may be able to ask for a bailout when they make a disastrous decision based the sure knowledge that it does not matter whether they are making a sound decision or not, very few individual investors are in the same position. When the market crashes, the small real estate investors will be fed to the wolves along with all the smaller funds and investment houses. Thus, as a smaller investor, one must be careful to make the correct decision.

The 2009/? Crash

First , it is necessary to understand the reasons for the bubble, the mechanisms involved, and then seek to predict the next steps in the ballet. Easy access to cheap money is the crux of the problem. The world's banks, in collusion with the governments, created a situation whereby it made far more economic sense to borrow heavily and gamble on ever increasing property prices than it did to create genuine wealth. Creating more cheap money is not going to fix the problem.

The "fault" for the current crash lies squarely with the governments and the banks. As a member of the public, one should be able to trust the actions of the governments and financial institutions on the basis that it is their duty to act in the interests of the public and in the case of the banks, shareholders and depositors.

Sadly, this is not the case. The World's governments were happy to ride the bubble as it grew, siphoning money off for whatever needs they felt were paramount at the time, and the banks have acted in a fashion that will ultimately cost the smaller shareholders vast amounts of money. The financial institutions are not to be trusted and have proven beyond a shadow of a doubt they have no interest in the financial well-being of their smaller investors.

The outcome of the crash so far has been that most of the world's wealth has moved towards being government owned and controlled - through the banks, mortgage lenders and Sovereign Wealth Funds. But this is unsustainable also. Being government-owned these SWFs are extremely expensive to manage, and are as exposed as any other investor to the current market, therefore, many of these will be liquidated in the coming crisis as governments seek more funds to support their individual economies.

Confidence in the banking system and stock market is at an unprecedented low, and the efforts of the Federal Reserve and the Bank of England have so far failed to restore confidence. Largely because of looming debts that will go unpaid in 2009. Banks are keeping tight control of their reserves and will continue to do so until such time as the previous decade's excesses are purged from their books.

Real Estate Values Always Go Up

This is, in fact, a true statement, but the upward trend does not straight line, and there are many peaks and troughs along the way. So, while the general trend is upwards, in line with or slightly more than inflation, the dips tend to follow unrealistic peaks. We are currently experiencing one of those dips. Probably the biggest dip in monetary values in history. This follows one of the biggest peaks in history, and prices will overshoot on the way down.

When will we reach bottom?

The United States and the UK

Discussing the UK and US housing markets is a logical place to start. These two countries led the real estate asset bubble, and their banks and governments were instrumental in creating the current bubble/burst scenarios. We will discuss European, Asian and emerging markets in a separate article.  The US sub-prime mortgage implosion began the process, but there are still vast amounts of mortgages in the pipeline that are destined to default. Nothing is going to stop this. No amount of government intervention, no amount of money supply growth or "quantitative easing." Nothing. The next in the chain to implode will be the Option ARMs in the prime sector.

Option ARMs

An "option ARM" is typically a 30-year "Adjustable Rate Mortgage," that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment.

These types of loans are also called "pick-a-payment" or "pay-option" ARMs.

The obvious problem with these "prime" ARM mortgages is that the outstanding sum increases if the borrower makes the minimum payment, which somewhere in the region of 80% of these borrowers have chosen to do. Foreclosures in the United States will continue to increase throughout 2009. Many of these loans were due to reset 2010-2012, so it is realistic to think we will not reach bottom until these have been purged from the system.

A combination of falling property values and increasing mortgages puts the bulk of this group of borrowers in a position where they can now owe mortgages far in excess of the value of the property. Estimates vary, but conservatively, 70% of these mortgages will default at reset, judging from the default rates already being seen. Amherst Securities estimated the value of these option ARMs combined with Alt-As is in excess of $1.5 trillion in the United States. Credit Suisse estimates a minimum of 16% of all mortgages in the US will default in this period with peak resets now coming in December 2009, rather than 2011 which was the original reset date. "Renters waiting to foreclose," is a most apt description of this group.

Citigroup, already the recipient of substantial amounts of US taxpayer's funds, is heavily exposed to this group, their asset base is dwindling on a daily basis, and the true extend of their debt is not yet known. As and when this becomes public knowledge, as must happen 2009, there is a good chance Citi will fold, regardless of the government bailouts. Citi  are shedding staff because they are going to lose money in 2009. We feel this will be one of the turning points in 2009, and speed up the crash, or at least remove some of the artificial obstacles being placed by the Federal reserve, The Bank of England, and the British and US governments.

In the United Kingdom, lenders are already tightening lending restrictions, and as borrowers of "Flexible Mortgages" as they are called in the UK come off the low introductory rates, they are going to be faced with a massive increase in payments. Abbey National, the country's second biggest lender, has already stated they will increase the SRV (standard variable rate) to 7%, and has taken the unusual step of writing to customers with outstanding mortgages informing them that when the mortgage resets, if property prices continue to fall, which they are doing, customers will be expected to make a lump sum payment to keep the loan to value ratio (LTV) below 90%.

Residential property prices in the UK fell around 18% in 2008, and this trend will continue through 2009, with a likely fall in excess of 20%, perhaps as much as 35%, and will mirror the fall in the USA.

The British Prime Minister, Gordon Brown, has  instituted a new law, the Homeowner Mortgage Support Scheme, stating that any one made redundant (out of work through no fault of their own) during the recession, will be offered a two year moratorium on mortgage payments, guaranteed by the British government. These missed payments and accrued interest will be added to the mortgage, one again placing a large group of UK mortgagees in the position of being "a renter waiting to foreclose," and leaving the British taxpayer with an impossible-to-determine commitment. This law is at best ill-advised, and at worst a political tool to delay the inevitable. Many homeowners who take this option will find themselves burdened well beyond their financial capabilities.

The next to fall will be commercial real estate. Rents have spiraled higher and higher throughout the last ten years, mostly fueled by unrealistic, artificial gains in the financial services industry. London will no longer be the financial hub of Europe, nor Wall Street in the US. They will still be there, but no longer able to dictate unrealistic returns on commercial or residential property.

As of mid-December 2008, a minimum of $107 billion worth of commercial property is in distress in the US. The distress is occurring all across the country, but New York tops the list because of the number of costly high-profile transactions that occurred during the boom years. Real Capital Analytics predict a total of 268 properties in the New York area, with a value of $12 billion are already or potentially in trouble. This is not including as much as $84 billion in abandoned or stalled projects that are unlikely to be completed.

Commercial real estate in the UK is facing similar issues. London in particular is heavily hit, and the amount of companies holding loans that were in breach of financial covenant almost doubled by mid-year 2008 – to 78%, compared with 45% at the end of 2007 – while 43% of organizations put loans into administration, up from 33% during the whole of 2007. Financial covenants are the terms governing lending such as the loan to value ratio. It is currently estimated that British banks are exposed to a £70 billion loss in 2009, which will result in another government bailout some when in 2009, further devaluing the pound, and most likely leading to several banks becoming fully nationalized, if not the entire British retail banking sector.

Retailers will fold, leaving high streets in the UK decimated, and strip malls and commercial centers in the USA devoid of tenants. It will take far longer for the commercial sector to recover than the residential sector.

The UK and US property markets are crashing hard and will continue to do so through 2009/10. The measures taken by both the governments and the banks are almost certain to add more pressure to over-extended homeowners. We see the bottom around end-2010, although distressed property at bottom prices will start to become available late 2009 and continue to be in ready supply throughout 2010.

How best to take advantage of the coming property crash?