Foreclosures Will Moderate as Home Prices Continue to Fall

There will come a time when most of the homeowners that intend to walk away from their mortgages have done so. True, whether defaulting by choice or by the lack of the ability to pay. As the 2005, 6 and 7 vintages mature, their default rates will be more tied to the local economies than bad underwriting. Unrealized losses related to the fluctuations in housing prices will become less relevant.

Some of the strongest banks have recently announced plans to eliminate prepayment penalties on the first mortgages and freeze or lower rate adjustments on the home equity loans that they maintain on their balance sheets. We are beginning the see a divergence between bank owned loan modifications and securitized loan modifications. This trend will strengthen the commercial and savings banks at the expense of the investment banks. No government programs required.

This paints a fairly optimistic picture for the commercial and savings banks, as long as they can maintain the confidence of their depositors. So how can an upbeat forecast for commercial and savings banks reconcile with continued home price declines? Two reasons: First, MBS and CDO trusts have too many conflicting stakeholders to modify loans in a pragmatic manner. This will lead defaults and subsequent foreclosures to skew in their direction. Second, much of the housing stock built recently to feed the investor boom does not meet the needs of current owner occupiers.

I classify investors broadly to include owner occupiers who bought more home than they needed with an eye toward appreciation and second home buyers with the same intent. With energy, insurance, property taxes and home owner association costs rising rapidly, the number of people that can run a 4000 square foot Toll Brothers (TOL) home is becoming more limited. As mortgage qualifications tighten, fewer buyers can even enter this arena. And those that can qualify are too cautious to over invest (so says Bob Toll). Clearly this near luxury segment is out of sync with current buyers’ interest.

The near luxury trend will lead to cost problems as this housing stock ages. Kitchens and baths were equipped with non-standard appliances and fixtures. The next generation of owners will be facing expensive repair or replacement bills for the Sub Zero refrigerators and Viking commercial style ranges. A General Electric (GE) replacement cannot be popped in. An owner occupier might be scared away.

The South Florida market was particularly tailored to the needs of investors over owner occupiers. As boom gained momentum, condo square foot pricing had the potential to leave out many investors. To address that concern, developers shrunk one bedroom units to under 800 square feet and eliminated second baths. Two bedrooms shrunk to 1000 square feet or less. Beyond investors, New York City dimensions won’t sell in Miami. The limited audience for these will reduce the square foot prices from the $400 to $800 that investors paid back to the $150 level of the mid 1990s.

South Florida also has excess of very large planned gated communities (golf, tennis, boating and others). Most are high cost, high amenity developments focused on ostentation. They lack any sense of emotional warmth that the “new urban” architecture is successfully developing. Boca Raton is a microcosm of the old trend. Golf communities are now spending heavily building grand entrances and on upgrading their amenities trying to stay relevant. They do not realize that they are dinosaurs and their home values cannot be saved.

I like to draw a parallel between the housing market and the car market. As styles change, most owners maintain the payments on their loans. But the resale value of their investments decreases. There is little appetite for extremes when trends shift. Prices for extremely large and extremely small homes will continue to have the most rapid decline, while right sized homes could soon begin to stabilize. Toll Brothers style homes are going the way of the SUV.

No Disclosures.

Comments

[JimmyLathrop]

Speaking in my experience and training as a real estate attorney, Mr. Steinberg's article is the most insightful and accurate piece describing the evolution of the next generation of home building.

The WSJ had an article Friday on the evolution of "cottage" building, with square footage less than 1000 feet selling for $550,000 in small intimate communities close to city centers. This was shown to be the stark contrast to the McMansions of lore.

Speaking from personal experience, a home I am familiar with, a 5 bedroom 4 bathroom 2 living room house in Fairfield County, Connecticut, appraised at 985k in April of 2007, went on the market at 1.2 million in August of 2007. It received two offers for 500,000 from two separate Russian couples and no interest for the rest of the winter. It sold for $685,000 in April of 2008. a decrease of between 50 to 30 percent, depending on how you look at the valuation. We are not talking about Detroit or Bakersfield. We are talking about a town with a median income of $350,000.

In New York City, we have a similar situation with the resale value of condominium units which are given a 15 year tax abatement. I explain to the buyers that purchasing these units is like buying a Hummer which immediately depreciates when you drive it off the lot. Once the 15 year tax abatement ends, the unit is taxed at the same rate as a one family house, without the square footage. This increases the tax bill roughly 90 percent when the abatement ends, sending the resale value sharply downward. So you have a 15 year mortgage for a unit that sold at 950,000 and after making 15 years of payments plus interest and maintenance you have a unit worth 750,000 because of the tax liability. Even if you sell the unit five years after buying it, the new buyer will demand a premium because they face the same dilemma trying to sell it in five years with more difficult returns.


For the past three years, for every prospective home buyer that has come into my office, I have talked at least fifty percent of them from buying their home. How do I do it? The selling pitch of real estate agents and mortgage brokers tend to focus on mortgage payments and what the buyer or buyers can afford on their monthly budget.

I ask the buyer how much the home will cost in home heating oil bills in a month. They usually look at me with a blank expression. I then ask how local tax rate increases will factor into his purchase. In New York City, water rates have gone up 15 percent and will increase another 15 percent in the next two years. Finally, electricity deregulation has led to skyrocketing. At that point, the buyer understands that they are paying more than a mortgage, taxes and insurance.

If the buyer still insists on going through with the deal, they invariably are upset that the lending environment has tightened significantly from the signing of the contract to the completion of the unit to the setting of a closing date. At that point I usually ask how much the mortgage broker is getting from working on the loan and I see that it is three times as much as my fee. In the mind of the buyer, if a broker is receiving a fee three times as much as their attorney, then the broker is three times as trustworthy.

My diligence pays off in the fact that months down the line I am asked to represent the buyers when they are selling their condo when they discover the shoddy construction. I get the calls asking to help negotiate with Loss Mitigation specialists in the banks when the homeowner falls behind because of a loss of work or illness. I also get the calls from people who are recent immigrants to this country who have been burdened with manifestly unfair loans through predatory lending and require mortgage foreclosure defense. Most of these cases involve the larger homes.

Mr. Steinberg is correct - "Size Does Matter."

[CharlieStromeyer Jr]

On Thursday, the government will release the national home vacancy rate for Q2 which was 2.9% in Q1. Does anyone have a graph correlating this rate with the foreclosure rate?

[TonyC-SA]

Well I do have to disagree about the small end. People have to live somewhere, and almost any way you cut it this is a buyer's market, and in a buyer's market, buying is better than renting.

Now when it comes to buying any investment I agree that a prime concern should be how you will unload it in five years, so standard replacements and construction and amenities are a necessity, and the future of taxes and utilities are a concern. Smaller homes are less subject to such concerns, and for an owner/occupier, can be a good investment. (I am not selling any, btw!)

Homes are big purchases, but like any purchase the best time to buy is usually when sellers have already accepted the fact of loss and are desperate to just stop the bleeding. My advice to buyers would be to calculate the valuation using mid-2001 numbers + 25% to 36%, i.e. pre-bubble numbers adjusted for normal inflation. This factors out the effects of speculation.

If the deal looks good at that valuation, and the tax and utility and maintenance expenses look good going forward, and the construction and appliances are standard issue, it is a pretty good deal for an owner/occupier. Eventually the recession is over and we return to the long term trendline, about 4.5% annual appreciation (which includes about 3% annual inflation), and that turns out to be a real investment because it is significantly less than the alternative of renting. I repeat, people have to live somewhere.

[doug poretz]

Interesting to compare large houses to SUVs. From about 1986-1991, I worked at senior (corporate job) management for a very large public builder -- what I saw happening was that extraordinarily good marketing brains applied to product design and positioning strategies resulted in changing the basic law of residential real estate to: product product product. But that could not stay a "law" for long. We should see the emergence of a trend that shows efficient, conveniently located homes will be strong, and the over-priced homes in the distant suburbs will be dinosaurs for a long time -- who will want to buy them?

[rm]

While I agree with the content of the article, your headline is a contradiction.

As we've seen, negative equity is strongly correlated with foreclosure.

If prices continue to decline, we'll see more homeowners underwater.

Despite the popularity of the "walk-away" myth, there's no data that proves that this was ever a significant portion of the default population.

Many (most?) of the borrowers in this vintage were hanging by a thread, even at the teaser mark. Any additional job weakness, combined with higher heating costs- which impact a fair amount of the country- will put a significant number of people over the edge.

Unless we begin to see principal write-downs at some point, there's plenty more room to the downside. And the "moral hazard" argument against this practice grows more hypocritical with each governmental response to this crisis.

[bigd]

This man is a foolish optimist of the highest degree. His opinion is on par with the propagana machine of the Nazi Party during WWII and I wonder if he has ever done any personal research about anything. How much more do the false prophets of this economy want the people to follow after their idol, their false god of the dollar bill? To borrow a quote from the bible...1 Thess 5:1 For when they say, "Peace and safety!" then sudden destruction comes upon them, as labor pains upon a pregnant woman. And they shall not escape.
NKJV