Replies to post #476734 on Zeev's Turnips Patch-No Politics (ZEEV)

[marketmaven]

Entire US Real Estate Market Falling
Fri May 26 2006
Why?
http://patrick.net/housing/crash.html

1. Prices disconnected from fundamentals. House prices are far beyond any historically known relationship to rents or salaries. Rents are less than half of mortgage payments. Salaries cannot cover mortgages except in the very short term, by using adjustable interest-only loans.

2. Interest rates going back up. When rates go from 5% to 7%, that's a 40% increase in the amount of interest a buyer has to pay. House prices must drop proportionately to compensate.

82% of recent Bay Area loans are adjustable, not fixed. This means a big hit to the finances of many owners every time interest rates go up, and this will only get worse as more adjustable rate mortgages (ARMs) get adjusted upward. Nationally, about $2 trillion of ARMS will adjust their rates to much higher levels this year and next.

3. A flood of risky "home equity loans". An adjustable-interest home equity loan is often a serious mistake. These loans do not have defined limits on interest demands. When the interest rate adjusts upward, it can double monthly payments, forcing owners to sell.

4. Massive job loss. More than 300,000 jobs are gone from Bay Area since the dot-com bubble popped. This is the worst percentage job loss in the last 60 years. It's worse than Detroit car problems or Houston's oil bust. People without jobs do not buy houses and owners without jobs may lose the house they are in. Even the threat of losing a job inhibits house purchases. Santa Clara County posted its fourth straight year of job losses in 2005, so it's not over yet.

5. Salary declines. From http://www.mccallstaffing.com/need/needsal.html we hear that "salaries have in fact returned to 1997 and 1998 levels." Local household incomes are not even half of what they need to be to sustain current house prices, even with both husband and wife working.

6. Population loss. San Francisco continues to lose population at the fastest rate of any city in the US and most of those are professional jobs. The problem is not only the dot-com crash, but also the outsourcing technical jobs to India, which continues at a frantic pace as corporations realize they can pay an Indian only 20% of what they must pay a similarly qualified employee in the Bay Area. Fewer people in the Bay Area means less demand for housing. It recently cost $3623 to rent a UHaul from San Jose to the midwest, but only $1800 to move the other way. This is because far more people are moving out of the Bay Area than are moving in.

7. Stock market crash. The NASDAQ at about 2000 is still only 40% of the 5000 it was at the peak of the recent stock market bubble. The crash in the NASDAQ probably hit the Bay Area harder than anywhere else because of all the stock held by employees of tech companies. That money would have been spent on housing, but is now gone.

8. Extreme use of leverage. Leverage means using debt to amplify gain. Most people forget that losses get amplified as well. If a buyer puts 10% down and the house goes down 10%, he has lost 100% of his money on paper. If he has to sell due to job loss, he's bankrupt in the real world. Even a small price decline will bankrupt buyers with small equity. Buyers foolish enough to buy with no money down are already bankrupt, but still unaware of the fact.

House prices do not even have to fall to cause big losses. The cost of selling a house is six percent. On a $600,000 house, that's $36,000 lost even if prices just stay flat.

9. Shortage of first-time buyers. According to the California Association of Realtors, the percentage of Bay Area buyers who could afford a median-price house in the region plunged from 20 percent in July 2003 to 14 percent in July 2004. Strangely, the CAR then reported that affordability fell another 4 percent in 2005, yet claims affordability is still at 14%.

10. Surplus of speculators. Nationally, 25% of houses bought in 2005 were pure speculation, not houses to live in. It is now possible to buy a house with 103% financing. The extra 3% is to cover closing costs, so the buyer needs no money down. All this is on the unwise assumption that housing will rise ever higher, covering interest payments through appreciation. Even the National Association of House Builders admits that "Investor-driven price appreciation looms over some housing markets."

11. Lightbulbs going on in many brains in the Bay Area: "Hey, I can just go to New Mexico or Oregon, buy a gorgeous house outright, and comfortably retire on the price difference. My neighbors just did it, so I'll have friends there too."

12. Trouble at Fannie Mae and Freddie Mac. They are now being forced to tighten up sloppy lending. This means they are not going to keep buying very low-quality loans from banks, and the total money available for buying houses is falling.

13. The best summary explanation, from Business Week: "Today's housing prices are predicated on an impossible combination: the strong growth in income and asset values of a strong economy, plus the ultra-low rates of a weak economy. Either the economy's long-term prospects will get worse or rates will rise. In either scenario, housing will weaken. Caveat emptor."

Who disagrees
that house prices will continue to fall? Real estate related businesses disagree, because they don't make money if buyers do not buy. These businesses have a large financial interest in misleading the public about the foolishness of buying a house now.

1. Buyers' agents get nothing if there is no sale, so they want their clients to wildly overbid, the exact opposite of the buyer's best interest. Agents take $100 billion each year in commissions.
2. Mortgage brokers take a percentage of the loan, so they want buyers to take out the biggest loan possible.
3. Appraisers need mortgage brokers for their business, so they are going to give the appraisals that brokers and agents want to see, not the truth.
4. Banks get origination fees but have been selling most mortgages, so they take no risk on those loans. They do not care about the potential bankruptcy of borrowers, so they will lend far beyond what buyers can afford. Banks sell most loans to Fannie Mae or Freddie Mac. The conversion of low-quality housing debt into "high" quality Fannie Mae debt with the implicit backing of the federal government is the main support for the housing bubble. That is ending as Fannie Mae shrinks.

Even for loans that banks keep, they have a motive to lend beyond what buyers can afford. Banks designate interest as "income" whether they receive it or not. As long as borrowers do not actually default, additional interest owed is counted as bank income, and banks can claim higher "earnings". That is going to end when those borrowers cannot even make the principal payments.
5. Newspapers earn money from advertising placed by Realtors®, so papers have a strong motive to publish the Realtors'® unrealistic forecasts.

Even worse, Realtors® have a near-monopoly on sale price information, and newspaper reporters never ask Realtors® hard questions like "how do we know you're not lying?" The result is an endless stream of fluffy stories which minimize or just ignore the crash. Asking a Realtor® if you should buy now is like asking a barber if you need a haircut.
6. Owners themselves do not want to believe they are going to lose huge amounts of money.

What are their arguments?

1. "There are great tax advantages to owning."
FALSE. It is now far cheaper to rent a house in the San Francisco Bay Area than it is to own that same house, even with the deductibility of mortgage interest figured in. It is possible to rent a good house for $1800/month. That same house would cost about $700,000. Assume 6% interest we can see that a buyer loses at least $4,936 per month by buying. Renting is a loss of course, but buying is a much bigger loss.

Renting:
Rent: $1,800
----------------------
Monthly Loss: $1,800

Buying:
Property Tax: $486 ($729 per month at 1.25% before deduction, $486 lost after deduction.)
Interest: $2,333 ($3500 per month at 6% before deduction, $2333 lost after deduction.)
Other Costs: $450 (Insurance, maintenance, long commute, etc.)
Principle loss: $1,667 (Modest 3% yearly loss on $700,000. Reality will be much worse.)
----------------------
Monthly Loss: $4,936

This is a very conservative estimate of the loss from owning per month. If you include a realistic decline in house prices, as in this rent-vs-own calculator, you'll see that owning right now is a very poor choice.

Remember that buyers do not deduct interest from income tax; they deduct interest from taxable income. Interest is paid in real pre-tax dollars that buyers suffered to earn. That money is really entirely gone, even if the buyer didn't pay income tax on those dollars before spending them.

Buyers do not get interest back at tax time. If a buyer gets an income tax refund, that's just because he overpaid his taxes, giving the government an interest-free loan. The rest of us are grateful.

Under current conditions, a renter would be able to live in a Bay Area house for 30 years, then buy that $700,000 house outright with the saved principal payments and have avoided $810,846 in interest payments. Rent would be only $648,000 over those 30 years, so the renter comes out at least $162,846 ahead. See an "amortization table" if you don't believe that interest will cost more than the house. This doesn't even count the huge losses the owner will suffer as the value of his house falls year after year for the next decade or more, just as in Japan, nor property taxes, insurance, and maintenance.

Rents will rise eventually, even though they have been falling every year for about five years now. Rising rents should be more than offset by appreciation on the renter's saved principle payments, assuming the renter invests in index funds or any other investment that brings in more than a CD.

There is no need to wait 30 years to buy a house. As this crash accelerates, prices will fall to the point where it is cheaper to buy than to rent, though that could take five years or more.

If you don't own a house but want to live in one, your choice now is to rent a house or rent money to buy a house. To rent money is to take out a loan. A mortgage is a money-rental agreement. House renters take no risk at all, but money-renting owners take on the huge risk of falling house prices, as well as all the costs of repairs, insurance, property taxes, etc. It is much cheaper to rent the house than to rent the money.

There are large tax disadvanges to buying in California. Because of Proposition 13, more properly called "screw the newcomer", it is common for new buyers to pay ten times the property tax that their neighbors pay. Tax rates are set at the time of purchase, which means those who bought long ago pay essentially nothing, and the new buyers pay all property tax for everyone else. Upgrading houses makes you a newcomer all over again.

Then there's earthquake insurance. It's really expensive, so most people just skip it and risk everything on the chance that no earthquake will happen.

2. "A rental house provides good income."
FALSE. Rental houses provide very poor income in the Bay Area and certainly cannot cover mortgage payments. A $1,000,000 house can be rented out for 25K maximum per year after expenses. The return is therefore 2.5% with zero liquidity and a huge risk of loss.

If you actually have a million dollars, you can get 5% with no risk, no work, and no state income tax by buying a US Treasury Bond. And your money will be liquid and secure.

3. "OK, owning is a loss in monthly cash flow, but appreciation will make up for it."
FALSE. Appreciation is negative. Prices are going down, which just adds insult to the monthly injury of crushing mortgage payments.

4. "House prices don't fall to zero like stock prices, so it's safer to invest in real estate."
FALSE. It's true that house prices do not fall to zero, but also true that the value of your equity in a house can easily fall to zero, and then way past zero into the red. Even a fall of only 10% completely wipes out everyone who has only 10% equity in their house. This means that house price crashes are actually worse than stock crashes. Most people have most of their money in their house, and that money is highly leveraged.

5. "We know it will be a soft landing, since it says so in the papers."
FALSE. Prices could fall off a cliff. No one knows exactly what will happen, but the risk of an massive crash in prices is severe. As Yale professor Robert Shiller has pointed out, this housing bubble is the biggest bubble in history, ever. Predictions of a "soft landing" are just more manipulation of buyer emotions, to get them to buy even while prices are falling.

Most newspaper articles on housing are not news at all. They are advertisements that are disguised to look like news. They quote heavily from people like Realtors®, whose income depends on separating you from your money. Their purpose is not to inform, but rather to get you to buy.

6. "If you buy, at least you have a house, but if you rent, you end up with nothing."
FALSE. Renters in the Bay Area end up with much more money, while living in the same quality house as an owner. At the end of 30 years, a renter would have enough principal saved to buy the $700K house mentioned above and would have spent $162,846 less on rent than he would have spent in interest payments. And he would have lived in an equivalent house all that time. Owners frequently end up with nothing because they lose the house to foreclosure.

7. "Prices have been driven by supply and demand."
FALSE. Supply is increasing rapidly as building continues, and demand is falling as the population of the Bay Area decreases and the salaries of those who remain decreases. Prices have been driven by low interest rates and increasingly risky loans. The dramatic drop in rents and widespread rental vacancies prove that demand for housing is actually much lower now than a few years ago.

The www.census.gov site has data for Santa Clara County for the years 2000-2003 which shows that the number of housing units went up at the same time that the population decreased:

year units people
2000 580868 / 1686474 = 0.344 housing units per person
2001 587013 / 1692299 = 0.346
2002 592494 / 1677426 = 0.353
2003 596526 / 1678421 = 0.355

So housing supply in Santa Clara County increased 3% per person during those years. There is an oversupply compared to a few years ago. In a sane market, prices should fall 3% to compensate for the extra supply of housing.

At a national level, there is a similar story in the years 2000 to 2005:

2000 115.9M / 281M = 0.412 housing units per person
2005 124.6M / 295M = 0.422

At a national level, there is 2.4% more housing per person now than in 2000. So national prices should have fallen as well.

Banks caculated that risky loans were offset by rising prices, allowing them to recover their money from bad borrowers through foreclosure. Now that prices are falling, those risky loans cannot be justified. If the borrower does not pay, the sale price of the house will not cover the loan. Banks now have a real incentive to improve lending standards, and that will lower house prices more because fewer people will qualify for loans.

8. "Nobody is making land."
TRUE, but builders are making houses at a record rate, which is increasing supply dramatically at a time when new houses are not needed. We have the highest rental vacancy rates since the 1950's.

9. "There's an under-supply of housing. That's why prices will rise."
FALSE. There is a large oversupply of housing. To repeat: builders are making houses at a record rate, which is increasing supply dramatically at a time when new houses are not needed. The Bay Area has the highest rental vacancy rates since the 1950's.

10. "Population increase will fuel housing price increases."
FALSE. The Bay Area is losing population the fastest of any area in the US right now - worse than Buffalo, worse than Detroit. Immigration won't change this because jobs are emigrating even faster. Rents are falling in part because so many recent immigrants are leaving, with some going back to China because opportunities are so much better there.

Nationally, there is going to be a huge glut of housing as old baby-boomers sell their houses to use the cash for retirement, putting 20% of houses onto the market for that reason alone. An additional 25% of houses are owned by speculators, who will soon sell because they are losing money. Birth rates are declining in all industrialized countries, with the US birth rate barely replacing the citizens who die.

11. "As a renter, you have no opportunity to build equity."
FALSE. Renters are actually in a better position to build equity because:
* Owers are losing every month on a cash flow basis. The tax deduction does not come close to making owning competitive with renting.
* Owers are losing principal in a leveraged way as prices decline. A 20% decline completely wipes out all the equity of "owners" who actually own only 20% of their house.
* Owers must pay taxes simply to own a house. That is not true of stocks, bonds, or any other asset that can build equity. Only houses are such a guaranteed drain on cash.
* Owers must insure a house, but not most other investments.
* Owers must pay to repair a house, but not a stock or a bond.

12. "If you rent you are a buyer. You are just buying it for someone else."
FALSE. It may be true that rent covers mortgage payments in other places, but not in the Bay Area. No one buys with the intention to rent out in the Bay Area because that's not viable. The owner is generously subsidizing the renter, a wonderful thing for renters during this crash.

13. "If you don't own, you'll live in a dump in a bad neighborhood."
FALSE. For the any given monthly payment, you can rent a far better house than you can buy. Renters live better, not worse. All the best neighborhoods have rental vacancies. There are downsides to renting, but since there are thousands of vacant rentals, you can take your pick and be quite happy renting during the crash.

You may worry about being forced to move, but the law says the landlord has to offer you a one year lease at a minimum, and they'll probably be delighted to offer you a two year lease and give you a discount for that. Other people want the mobility that renting affords. Renters can usually get out of a lease and move anywhere they want within one month, with no real estate commission.

It is far easier and cheaper to rent a house in a good school district in the Bay Area than to buy a house in the same place.

The biggest upside is hardly ever mentioned: renters can choose a short commute by living very close to work or to the train line. An extra two hours every day of free time not wasted commuting is the best bonus you can ever get.

14. "Owners can change their houses to suit their tastes."
FALSE. Even single family detached housing is often restricted by CC&Rs and House Owner's Associations (HOAs). Imagine having to get the approval of some picky neighbor on the "Architectural Review Board" every time you want to change the color of your trim. Yet that's how most houses are sold these days.

In California, the HOA can and will foreclose on your house without a judicial hearing. They can fine you $100/day for leaving your garage door open, and then take your house away if you refuse to pay. There's a good HOA blog here.

15. "People buy a house for the long term, so things can't crash quickly."
FALSE. People are now buying houses for the very short term. This is how they justify interest-only adjustable mortgages to themselves. The thinking is, "I will own this just long enough to make a profit, maybe a year or two, so there's no need to get a long term loan at a higher interest rate." The distinction between the long-term owner and the short-term flipper has gone away.

16. "If and when the market goes south, you can walk away."
FALSE. If you have a single loan with just the house as collateral, it may be a "non-recourse" loan, meaning you could indeed walk and not lose anything other than your house and any equity in it (along with your credit record). But if you refinance or take a "home equity loan", the new loan is probably a recourse loan, and the bank can get very aggressive, not to mention what the IRS can do. A reader who lived through the 1989 housing crash in LA pointed out the following nasty situation that can happen:
* Let's say you buy a house for $600,000, with a $500,000 mortgage.
* Then the house drops in value to $400,000, you lose your job, or otherwise must move.
* If you can't make your payments, the bank forecloses on you and nets $350,000 on the sale of your house.
* The bank's $150,000 loss on the mortgage is "forgiveness of debt" in the eyes of the IRS, and effectively becomes $150,000 of reportable income you must pay tax on.

It is true that buyers who put zero down and have nothing invested in the house are much more likely to walk away. The large number of new uninvested buyers increases the risk of a horrifying crash in prices rather than a "soft landing".

17. "The house down the street sold for 25% over asking, and that proves the market is still hot."
FALSE. Realtors® try to create the false impression of a hot market by deliberately "underpricing" a house. Say a seller's agent knows that house will probably go for $500,000. He places ads asking $400,000 instead. (Bait-and-switch is illegal when selling appliances, but apparently not when selling houses.) The goal is to first of all prevent buyers from knowing what a realistic price is, and secondly to get buyers to blindly bid against each other. There are four players in this game and three of them are against the buyer: the seller, the seller's agent, and the buyer's agent. Yes, the buyer's own agent works against the buyer, because there is no commission if there is no sale. There's a saying in Las Vegas: "There's a patsy in every game, and if you don't know who the patsy is, you're it."

If you want to prove your agent is not on your side, ask to see houses "for sale by owner" or houses listed by discount brokers.

18. "I was lucky that my Realtor® told me to increase my bid by $100,000. Otherwise I would have lost, because my Realtor® knew about a secret bid $90,000 above mine."
FALSE. Your agent gets paid nothing if you don't buy the house, and he gets more if you waste more money by bidding too high. Those are two big motives to invent false bids.

19. "The MLS proves things are great."
FALSE. All sorts of funny things happen in the MLS (Multiple Listing Service, a private database controlled by real estate agents). For example, if a house just doesn't sell, Realtors® can remove its record in the MLS so that you cannot see that it failed to sell. Then the house comes back on the market at a lower price, and unsuspecting buyers think it's on the market for the first time. Their Realtor® can "prove" it's a new listing by showing the MLS record to the buyer: "See, here's the listing date, just came on the market. Better hurry and buy it, this one is hot."

There is nobody checking that the MLS shows true selling prices. The MLS prices are often just wrong.

Furthermore, the MLS will not list any house for sale by owner or for sale through a discount broker, except perhaps those listed by Help u Sell. Those cheaper prices are just not in the system, because if you save money, they lose money.

20. "The Bay Area is a special place that will always be expensive."
TRUE, but it was just as special ten years ago, so that does not account for the current housing bubble. Even at half of current prices, it will still be expensive.

Many people are confused about the difference between high prices and increasing prices. Prices are high, but they are not increasing. They are falling. This makes housing a bad investment.

21. "Rich Chinese (or Koreans, or Arabs, or Ethiopians) are driving up housing prices."
FALSE. The percentage of US houses bought by rich foreigners for investment is tiny. Furthermore, American housing is clearly a bad investment at this point. Rich investors are not dumb enough to buy into a badly overpriced market, but your broker is hoping that you are.

22. "There's always someone predicting a Bay Area real estate crash."
TRUE, yet irrelevant. There are very real crashes every decade or so. Even a broken clock is right twice a day.

23. "But housing was high when interest rates were 21%."
FALSE. Inflation was much higher then, so fixed debt was easier to pay off with increasing salaries. Now we have stagnant salaries and adjustible mortgages.

House price increases exactly mirror the increase in mortgage debt. According to the Washington Times: "Consumers have doubled their mortgage debt from $3.5 trillion to $7 trillion since 1996, borrowing and spending profusely on the assumption that house prices will keep rising." So the increase in house prices is not backed by assets. It's backed by debt. The debt in turn is backed by the houses. It's just smoke and mirrors.

24. "My dad made money on his house, and it will work for me too."
FALSE. Your dad bought his house when houses were cheap compared to salaries, maybe 3 or 4 times annual salaries. Go ask him. Things are different now. Here is a chart of median house price vs median income in Palo Alto:

Year Median House Price Median Income Multiple
1980 148900 24743 6.0
1990 457800 55333 8.3
2000 910000 90377 10.0

Most bankers use a multiple of 3 as a "safe" price to income ratio. We are well beyond the danger zone, into the twilight zone. Another rule of thumb is that a fair house price is between 100 and 200 times the monthly rent. If a house rents for $2000 per month, then a fair price is from $200,000 to $400,000.

25. "The government will make sure housing prices don't fall, because all the powerful people in the government have houses and want to keep values up."
FALSE. There have been many local crashes, and the government can't stop them. Nor would they necessarily want to; the current Republican administration would probably be happy to see blue states like California, New York, and Massachusetts crash and burn, and those states are where the worst bubbles are.

26. "Look, housing continued to rise after the dot-com crash, so it will always rise."
FALSE, consider the turkey in the farmer's barnyard. He thinks the farmer will always come feed him and not ask for anything. Then Thanksgiving comes. Whack. Past performance is no indication of future results.

27. "Rent can go up, but a 30-year fixed mortgage payment cannot."
TRUE, but irrelevant. House owners lose even with a fixed mortgage, because the price of a house falls as interest rates go up. Most people want to sell within 7 years of moving in, and many have to sell because of job loss, illness, or divorce. No one can afford what the owner paid for it, so the owner has to take a large loss. Renting it out will not come close to covering the mortgage. Bay Area rents have fallen 23% in the last 4 years.

28. "You have to live somewhere."
TRUE, but that doesn't mean you should waste your life savings on a bad investment. You can live in the same kind of house by renting during the crash. A renter could save hundreds of thousands of dollars, not only by paying less every month, but by avoiding the devastating loss of his downpayment. In fact, it's currently cheaper to live in a nice hotel in most parts of the US than it is to make mortgage payments in the Bay Area.

29. "Newspaper articles prove prices are going up."
FALSE. The numbers in the papers are not complete and have murky origins. Those prices are "estimated" from the county transfer tax and making that tax public record is optional. A buyer who does not want you to see how little he paid has only to ask to put the transfer tax on the back of the deed and it will not show up on computer searches of the deed, which show only the front. Others voluntarily pay more tax than they have to, in order to inflate the apparent price to fool the next buyer. At a tax rate of about $1 per thousand of sale price, as in San Mateo county, you have to pay only $100 extra tax to make your purchase price look $100,000 higher. Another common occurrence is for the buyer to get a large cash payment back from the seller. So the house price looks high in the paper, but in reality the buyer got a huge rebate.

Even though you can in theory go to your county building and get sale price information, in reality the county will give it to you in a painfully slow and inconvenient way. For example, in Redwood City's county building there are PC's where you can look at data for any particular house, but you cannot print, you cannot save to a floppy disk, you cannot email data out. All you can do is write things down manually, one at a time. And that's how real estate interests like it. Your elected representatives are serving them, not you. Please vote against County Clerk Warren Slocum in San Mateo County unless he fixes the Redwood City computers to allow you to save data.

30. "My appraisal proves what my house is worth."
FALSE. "An appraisal in its typical residential real estate form is little more than a comparative analysis conducted by someone with no skin in the game offering confirmation that other lemmings are paying too much for their houses as well." -from an article on morningstar.com

Anyway, as transaction volumes decline, the first few low sales will have a large and sudden impact on appraisals.

31. "If one house sells for a million dollars, a million houses are worth a trillion dollars!"
FALSE. If all of those million houses were all on the market they would sell for far less. Less than 5% of all existing houses were sold last year. The other 95% are merely assuming they can get the same prices.

32. "It's not a house, it's a home."
FALSE. It's a house. Wherever one lives is home, be it apartment, condo, or house. Calling a house a "home" is a manipulation of your emotions for profit.

Also, Realtor® is a commercial term, not a real word. Note the "®" symbol.

33. "If you don't buy now, you'll never get another chance."
FALSE. This argument was also popular in 1989 in Los Angeles, just before a huge crash. There are always sellers and there are always buyers. Prices are always corrected when they get beyond what buyers can pay. In fact, they're being corrected right now.

Here is a great quote from June Fletcher, a Wall Street Journal reporter, that says it all: "The real issue isn't whether you will be stuck being a renter all your life, she says. Its whether you'll get so scared about being shut out that you'll buy at the market's peak and be stuck in a property you can't afford or sell."

34. "Property in the Bay Area is a luxury good, and so will be less affected by economic downturns."
FALSE. 82% of last year's Bay Area mortgages were ARMs, and ARM loans are not taken out by the rich. People on the border of bankruptcy take out ARMs because they can't afford fixed rate loans. The rich don't have loans at all.

Many of these ARM loans have exceptionally deadly repayment terms, and so are known as "neutron mortgages". Like the neutron bomb, they destroy people, but leave buildings standing.

35. "Housing will be permanently higher since downpayments are now obsolete."
FALSE. The first big wave of default will cause downpayments to suddenly seem like a good idea again. Lending standards are already improving.

36. "House ownership is at a record high, proving things are affordable."
FALSE. The percentage of their house that most Americans actually own is at a record low, not a high. We do have a record number of people who have title to a house because they have dangerous levels of mortgage debt, but that is no cause to celebrate.

37. "Long term rates are still at historic lows!"
TRUE, but irrelevant. Most new mortgages and refinancings are now short term, and those will definitely be affected by rising short term rates.

38. "The limited land in the Bay Area means prices will always go up."
FALSE. Japan has a very severe land shortage, but that hasn't stopped prices from falling for 14 years straight. Prices there are now at the same level they were 23 years ago. If we really had a housing shortage, rents would be going up, but they're going down instead.

39. "It would take another 911 terrorist attack or a major earthquake that wipes out this area in order for the price to fall by 50%."
FALSE. Even with a 50% decline in prices to $350,000 or so, the median price in the Bay Area will still be roughly double the median price in most of America, and the median Bay Area household income of about $70,000 will still not be sufficient to buy a house. So a 50% decline is well justified by the fundamentals.

40. "Housing is an excellent hedge against inflation, so you should buy now anyway."
FALSE. Interest rates go up with inflation, and higher interest will be the last straw for ARM mortgages in the Bay Area. Their defaults and foreclosures will drive down the cost of housing for everyone else around here. Remember that 82% of recent Bay Area mortgages were adjustable. There is little chance that salaries of ARM owners can keep up with inflation because of two billion people in India and China who would be happy to do their jobs for much less money.

41. "Houses always increase in value in the long run."
FALSE. House values are actually constant. Adjusted for inflation, prices in Holland, for example, rose less than one quarter of one percent annually in the 350 years since their tulip bubble. Warren Buffett and Charles Schwab have both pointed out that houses don't produce anything. They do not increase in intrinsic value. Unless there's a bubble, house prices simply reflect current salaries and interest rates. Consider a 100 year old house. Its value in sheltering you is exactly the same as it was 100 years ago. It did not increase in value at all. It did not spontaneously get bigger, or renovate itself. Quite the opposite - it drained cash from its owners for 100 years of maintenance and taxes. Its price went up about as much as salaries went up.

My grandmother always used to complain about the cost of milk. "Why, when I was a girl, a gallon of milk cost a dime! Just look at how much people are overcharging for milk now." I asked her how much people got paid back then. "Oh, about $15 a week", came the reply. Hmmm, sounds very much like the reasoning people use now when they talk about how much their father's house appreciated "in the long run" without considering that salaries rose a similar amount.

42. "Maybe we should just accept that we missed out on a great opportunity to get into the real estate in the past N years."
FALSE. Did we all miss out on a great opportunity to get into the stock of pets.com or other Internet companies with no business model? The real question is what is likely to happen in the next few years according to fundamental economics. The answer is a massive crash. The last guy to buy into the bubble will get hurt the most.

43. "I just want to own my own house."
TRUE, most people do and that's fine. Buyers will get their chance when housing costs half as much and they have saved a fortune by renting. House ownership is great - unless you ruin your life paying for it.

As reader Sean Olender put it: "Many people have forgotten that their number one restriction on future freedom -- to do what they want when they want and to go where they want -- the number one power over them in the future isn't the Iraqis, or Iranians, or North Koreans, it isn't the axis of evil, it's their mortgage lender."

[EYE_ON_WALLST]

Damn glad I sold my condo...em

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The Big Glut
Trouble in Paradise
By ROBIN GOLDWYN BLUMENTHAL

A Walk on the Wild Side

IT WOULD SEEM TO HAVE IT ALL: four bedrooms, a guest house, a pool and a rock waterfall. But the vacation home in Naples, Fla., hasn't been drawing much interest from buyers, so the seller recently threw in that most modern of amenities: the $1 million price cut. That's brought the asking price down a full 25%. "If you want to sell, you've got to go back to '04 prices," says Chip Harris of Coldwell Banker Previews International, which is handling the property.

The market for second homes could use a second wind. After a long string of double-digit annual price increases, a number of second-home meccas across the country are suddenly suffering from plunging sales volume and burgeoning inventories of unsold homes. Result: Naples-style discounting is starting to spread. It hit the town of Pocasset, on Massachusetts' Cape Cod, just as retired executive Jack Reen was trying to sell his four-acre, six-bedroom beachfront home. He cut the price several times, for a total of 42% off the listing price, before striking a deal at $3.95 million. Reen takes a philosophical view of the experience, noting that the original price was set at the top of the market. "Calling the tops and bottoms is impossible," he says.
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Barnstable, Massachusetts: One of the first meccas with a drop in prices.

Though the official figures on sales prices have yet to reflect the current round of cuts, interviews with real- estate pros and others strongly suggest that the averages are deteriorating in a number of key markets. Just look at green and hilly Litchfield, Conn., about a two-hour drive from New York City. It was a magnet for Wall Streeters during the past five years, and prices climbed accordingly. But in the past 10 months, prices in the lower end of Litchfield's market -- homes of $300,000 to $600,000 -- are down 12%-14%, and volume is falling at the next level up, says Stephen Drezen of the local Portfolio Properties Group.

IT'S ALL A BIG CHANGE from the seemingly endless rises in prices. For more than a decade, baby boomers have been flocking to the second-homes market and lifting prices, just as they'd earlier lifted the market for primary residences (See Barron's "Eden for Sale," July 3, 1995). The market barreled ahead during the past few years ("Paradise Found," May 31, 2004), and the demographics -- 75 million boomers -- still bode well for long-term growth. But first, the market has some correcting to tend to.

While pundits debate when the bubble might burst in the primary-housing market, the air already is whooshing out of parts of the second-homes market. Naples, on the sun-drenched edge of the Gulf of Mexico in Southwest Florida, is perhaps the most striking example.

Vacationers long have been attracted to Naples' proximity to water, the Everglades and shopping at the likes of Saks Fifth Avenue. Last year alone, buyers bid up the area's median price by 30%, to $482,400. Charles Ashby, president of Naples' VIP Realtors, recalls that one of his sales associates was able to go down to a local bar and sell 26 units in a nearby Fort Myers high-rise the first night contracts were being accepted.

Today, about the most visible activity in that area is the 400 or so daily additions on the multiple listing service -- and price reductions by the dozens. In the 35 years that Ashby has been in the business, this is the first downturn he's seen, even counting recessions. "The mule died," he says.

With mortgage rates rising and home-price appreciation slowing or vanishing, buyers in Naples have pulled back in a big way. The area's sales of homes costing less than $1 million declined 45% in unit volume in the first four months of this year. More expensive homes fared somewhat better, falling 34%. But pressures at the higher end clearly are mounting. All along the pricey Gulf shore, builders still are tearing down old ranch houses and replacing them with two-story mansions, pushing the market toward a classic glut.

The Naples experience is being repeated, to one degree or another, in a variety of other vacation hot spots -- from Palm Desert, Calif., to Phoenix, Ariz., to Ocean City, N.J. Phoenix in recent years has been overrun by property flippers from California, says Mike Messenger, president of Russ Lyon Realty in Scottsdale. But unit sales now are down by 40%-42%, and the city's inventory of unsold homes has shot up more than five-fold, to 39,000.

Likewise, the number of homes for sale on the Multiple Listings Service for the Falmouth area of Cape Cod is up about 65% from a year ago, says Lynette Helms of the local Real Estate Associates. With numbers like that, more price cuts can't be far behind. In fact, the Cape Cod town of Barnstable is among the first of the second-home meccas to show a decline in median prices in the figures tallied by the National Association of Realtors. The price was down 1% in the first quarter, to $385,000.

It's true that the total second-homes market nationwide has managed to keep posting gains over the past two years. Some 3.34 million second homes were sold in 2005, up 16% from 2004, according to the realty trade group. The median price of a vacation home was up 7.4%, to $204,100, and prices have continued to rise in many markets.

But the Realtors' chief economist, David Lereah, expects the volume of second-home sales to decline at least somewhat this year. And there's every reason to think that some markets could be hit hard.

For starters, many second homes have been sold not to serious vacationers but to speculative investors hoping to cash on the national real-estate craze. How else to explain why six out of 10 second-home owners surveyed by the Realtors group own two or more homes in addition to their main residences?

The danger is that if enough of those investors decide the market has peaked, they could trigger a selling frenzy throughout the second-homes market. That, in turn, could add to the pressures in the main housing market. After all, second homes now account for a full 40% of all homes sold in America.

Statistics compiled for Barron's by The Local Market Monitor, a Wellesley, Mass.-based consulting firm, show just how big a role can be played by investors. In Myrtle Beach, S.C., long a favorite vacation and retirement destination, investors owned a full 58% of properties in 2004, the last year with available data. Though Florida communities accounted for eight of the top 10 investor-owned hot spots, Wilmington, N.C., clocked in at 38%, Las Vegas at 26%, and Honolulu at 23%. The normal level is closer to 14%. (See table nearby.)

Says Ingo Winzer, president of The Local Market Monitor: "This makes me very worried because it implies that the price increases have been driven more by speculators than by people who are going to hold onto these properties, and indicates to me that there's a speculative boom."

The price runups of the past several years are reason enough for concern. A report from Cleveland-based National City, a top banking and mortgage concern, points to serious overvaluation in a number of second-home hot spots in Florida, California and elsewhere.

Tucson, Prescott and Phoenix in Arizona are estimated to be as much as 52% overvalued based on income levels, population densities and historical prices. Also high on the list: Bend, Ore., and New Jersey's Ocean City and Atlantic City, where homes are deemed overvalued by 50% and 60%, respectively. (See table.)

Behind all this is a fervor eerily reminiscent of the late 1990s on Wall Street. Some 65% of second-home owners surveyed by the National Association of Realtors said they considered their second homes better investments than stocks, and 29% said they planned to buy additional properties within two years. An eye-popping 64% of investors with four or more properties planned to buy another property within two years.
BUT THOSE HIGH ROLLERS COULD LOSE THEIR nerve quickly if prices continue to weaken.

"People don't believe in the laws of supply and demand anymore," says Alan Skrainka, chief market strategist at Edward Jones. "We're not saying it's a bubble, but we're saying prices are overstated and will likely correct 20% to 25% over four or five years."

He rejects a notion advanced by housing bulls that shore communities in Florida and California will be protected because of the limited supply of coastline. "Japanese real estate and land prices went down for 15 years and Japan is an island," Skrainka says.

SOUTHERN FLORIDA HAS shaped up as the epicenter of the looming glut. In Palm Beach County, inventories of unsold homes have more than tripled in the past three years, to more than 25,000. Some brokers in South Florida are reporting a quadrupling of inventories over the past year. In what some see as a sign of the times, Coldwell Banker Residential Real Estate recently closed four of its 31 offices in the Palm Beach region; the company calls it an anticipated consolidation.
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Ocean City, New Jersey: A slave to the whims of financial markets.

There's little doubt, however, that the market is starting to run out of buyers.

"The homeowner that absolutely has to sell will take a hit," says Paul Boomsma, executive vice president of Chicago-based Luxury Portfolio Fine Property, a unit of Leading Real Estate Cos. of the World. The problems are worsened, he points out, by the continued acceleration of development in overheated areas.

Investors hoping to sell luxury condos that they bought over the past couple of years could be in for some special trouble. A recent report by San Francisco-based JMP Securities analyzing the Florida condo market estimated that 25%-40% of the of condo units now for sale in Florida belong to such investors. "Flippers are already listing units for sale in buildings that are near completion this year but are not closed yet," hurting an already weak market, the report says.

Florida condo sales are down 20%-50% year over year in most markets, JMP says. And the report cites estimates of 50,000 new condo units announced for Miami-Dade County alone, adding to the 50,000 either under construction or ready to begin. That compares with the 10,000 total that have been built in the area in the past 10 years.

Some northern parts of Florida are also taking a beating. On a recent drive around Amelia Island, off the coast of Jacksonville, David Hehman of EscapeHomes.com, a resort and second-home marketplace, counted 50 properties for sale on the water or side streets along a three mile stretch.

BEYOND FLORIDA, some second markets are holding up well and others clearly aren't.

"It's a very spotty market in all of the U.S.," says Robert Toll, CEO of luxury homebuilder Toll Brothers. In some of the markets where Toll builds golf-course and lake communities, like Palm Springs, Calif., Delaware and southwest Florida, demand has softened. The company, however, has had to offer incentives in only two resort communities out of the 15 it owns. "If you've got the right stuff, people still clamor for it," says the CEO.
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Tucson, Arizona: Could face a 33% decline in home prices.

Mike Messenger, the Scottsdale, Ariz., broker, sounds considerably more glum. He says this is the first time in 16 years that the lower end of the market -- always the driver for the area -- has weakened. The culprits? Mainly the flippers; Messenger figures investors account for 35% to 40% of the market.

Las Vegas is causing concern, too. It's "a classic example of an overheated market where there's too much proposed and the reality of the absorption isn't such that it could work in the near term," says David Wasserman, head of Wasserman Real Estate Capital, a developer. But Wasserman, who has luxury condominium projects under development in West Palm Beach, Pasadena, Calif., and Boston, figures that soaring construction prices should help to weed out some of the overzealous builders.

Already, several condo projects in Las Vegas have had to be canceled because they failed to presell enough units to get attractive financing, says Hehman of EscapeHomes.com.

On the East Coast, signs of a glut have been turning up all along the coastline of New Jersey. In an effort to move inventory, brokers in the upscale summer resort of Stone Harbor have been sending out postcards to vacation renters, proclaiming a three-bedroom condo to be "the perfect investment opportunity" at just $739,000. That's about what many of the would-be buyers might have paid for their first homes.

"The market is definitely in a correcting phase," says Timothy Richards of Ocean City, N.J., who recently retired as a realty broker and began a second career as a developer. He says buyers are waiting to see what happens with mortgage rates. "Whenever financial markets are in transition, we go into a holding pattern," he adds.

Real-estate pros in the Hamptons area of Long Island are keeping their fingers crossed. John Halsted of Allan Schneider Associates says he has seen some "price adjustments" -- usually around 3% to 5% downward, and usually in the mid-range of the market, of homes priced at $1.5 million to $4 million. He contends that there's still high demand at the super-high end. That belief will be put to the test by one of his firm's current listings, a $75 million spread in Bridgehampton with its own golf course.

Some would-be buyers appear to be sitting out this edgy period in the market and renting homes instead. That's one reason why the rental market in the Hamptons is considered very strong right now. The Halsted firm recently set its own record for a summer rental: $350,000 for a house in Sag Harbor.
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Las Vegas, Nevada: Over-developed and getting more so.

Other home buyers, meanwhile, are seeking a measure of stability by venturing away from the traditional hot markets (see story nearby). But plenty of once-tranquil towns already have been discovered. "You're finding that smaller towns that 10 years ago were thought of as off the beaten track now have the rich and famous buying," says John McIlwain, a senior fellow for housing at the Urban Land Institute. He points to Rockland, Maine. "Twenty years ago you wouldn't go there at night because you would have gotten beaten up," he says. "Now, it's in international travel guides."

The tough conditions in the second-home market are no small matter for the people who own the homes. And the so-called mass affluent -- folks with investable assets of $100,000 to $1 million -- will probably take the brunt of any price declines. Spectrem Group, a Chicago-based consulting firm, says this group has more than one-third of its assets tied up in real estate. In general, these home owners are more vulnerable than the ultra-wealthy, both because they can ill afford to wait out a prolonged downturn and their losses can hurt if they're forced to sell into a glut.

All the same, many experts are cheering the current shifts in the markets. They call it an essential correction, a step that must be taken before the second-home market resumes its ascent. "In general this is a very good thing, because it got too far on the speculative side," says broker Ashby in Naples. "It needs to correct. If it didn't, it would burst."

Adds Mike McMurray, a broker with VIP on the Florida islands of Sanibel and Captiva. "It's not that the property is bad, but it's like Google. The value is there, but it may have gotten ahead of itself."

There's certainly hope for the long term. The baby- boom generation continues to amass both inherited and earned wealth. And many a boomer will buy a second home with an eye to eventually retiring to it. With any luck, they will see some nice financial returns. "Vacation homes have turned out to be one of the best housing investments, particularly on the coasts," says McIlwain.

The trouble is, home owners may have to wait quite some time before that happens again.
A Walk on the Wild Side

THE SECOND-HOMES MARKET CAN BE A JUNGLE, but some savvy buyers think they've found the answer -- in the real wilderness. The views and the values, they say, are both outstanding.

Take the Methow Valley, in North Central Washington State. It boasts "a million-acre park in your backyard" and breathtaking views of the snowcapped Cascade Mountains, just a few hours' drive from Seattle. "Once you're there, you're in another world," says one investment manager who recently bought in the valley's town of Winthrop.

Hundreds of acres of protected marshland, a view of the Atlantic ocean or the Cape Fear River are some of the attractions of Bald Head Island, N.C., where cars are prohibited. It's a less frenzied version of the always popular Outer Banks.

Philip Thomas, a Charlotte, N.C., builder who also is a partner in a coastal venture called Brinson Thomas Fine Home Building, was so taken with the island that he scooped up for himself a house he had built on spec overlooking the ocean.

The Nevada side of Lake Tahoe, called Incline Village, has breathtaking views of the snow-covered Sierra Nevada mountains and piney forests. Though it has seen double-digit appreciation over the past few years, it is expected to hold its value.

"There's a very limited supply of privately owned land, and a wonderful consciousness between the environment and the economy," says Deb Howard, president of an eponymous real estate agency.

The Green Mountains near Stowe, Vt., are attracting second-homeowners from Montreal, Boston and New York. Single family homes in the valley should fetch 11%-13% more this year than last, when they rose more than 20%.

In Alabama, a 320-mile lake whose waters are still drinkable is being developed by a conservationist. The pristine Lake Martin has become a destination for second-home owners not only from Alabama, Georgia and Tennessee but around the country.

"We're trying to make sure we're building something you can't get anywhere else," says Steven Arnberg, company broker for Russell Lands, of the developer of Lake Martin. The company is using building materials forged from native trees and stone. "It looks like the houses dropped from the sky," says Arnberg. Lake Martin is still being discovered, so there's probably upside left, despite 40% jumps in land values.

The salt marshes, sandy beaches, sunset views of the Gulf of Mexico -- and still moderately priced homes -- in Galveston have become a mecca for both Texans and others who are looking for good value.

A beachfront home in a nice area can still be had for $600,000 or $700,000, though some have doubled in the past few years, says Carolyn Clyburn, proprietor of The House Co., a realty brokerage. With a varied style of homes, proximity to Houston and relative affordability, it should continue to see some gains. Says Clyburn: "Those of us who've been here awhile think it's one of the best kept secrets."