Subscribe to Money Morning get daily headlines subscribe now! Money Morning Private Briefing today's private briefing Access Your Profit Alerts

It's Time to Get Real About Real Estate

By Peter Schiff
Guest Columnist

Once again, real estate market watchers have pounced on a shred of seemingly positive news to proclaim that the long sought "bottom" is in sight. The routine is becoming extremely stale, but somehow the media never seems to tire of it. This time the "good" news was that the percentage declines in national home prices (according to Case Shiller) in July were not as large as they were in June.

Although the report contained many other negative data points, including increased inventories and a spike in foreclosure sales, it was the slowing declines that got the spotlight. Talk about grasping at straws.  The truth is that real estate has been grossly overvalued for years, and the adjustment process back to realistic pricing has only just begun. 

But the problem is this: Few "experts" seem to appreciate the magnitude of this adjustment and its implication for an economy dependant on inflated assets values.

By most accounts, the decade-long housing boom began in 1996 and finally went "poof" in mid-2006. In January 1996, the Case Shiller 10-city composite home price index stood at 76. By June 2006 it had tripled to 226 – by far, the largest increase in U.S. history. Since then, the index has pulled back by 20% to 180. For those who believed that home prices could never retreat nationally, this 20% correction is more than enough. In reality, it's just the down payment.   

When real estate prices were expected to rise in perpetuity, the price of a house had two components – one part representing shelter and the other investment.   The shelter component was the actual utility and desirability of the house and the investment component was the expected future appreciation.   My guess is that at the peak of the real estate mania, a $500,000 house might have consisted of $250,000 for the shelter component and $250,000 for the investment component. 

In effect, the appreciation potential, and the ability of the homeowner to tap into it though refinancing and home equity loans, offset the real costs of home ownership, such as mortgage payments, taxes, insurance, and maintenance.  So the main reason a buyer would commit to a mortgage that would soak up 50% of his disposable income was that he expected to recover most of that outlay through future appreciation.  Absent the expectation of that windfall, buyers would not have been willing to pay such staggering prices for houses or commit to burdensome mortgage payments.

Lenders were caught up by the same delusion.  Since they, too, believed prices could only rise, lending standards were thrown out the window.  If the collateral (the house) were to always rise in value, what difference would it make if the buyer made the payments?  In effect, instead of relying on the borrower's ability to pay to mitigate its risk, lenders merely relied on the house's ability to appreciate.

However, now that real estate prices are falling, this has all changed: Lenders are beginning to rely solely on the borrower's ability to pay.  As this trend continues, lending standards will tighten and mortgages will be brought back into line with the incomes of borrowers. 

In addition, down payments will be larger to reflect the greater likelihood of losses should loans end up in foreclosure.  When prices were rising the foreclosure risk was negligible.  However, now that foreclosures are soaring and recovery rates are less than 50 cents on the dollar, those risks are enormous.

So, with falling real estate prices, mortgages are much less appealing to both borrowers and lenders.  The only solution is for home prices to fall far enough to where they are cheap enough for buyers to afford the mortgage payments (both interest and principal), without relying on appreciation, teaser rates, or negative amortization, and save enough for a down payment that would protect a lender in the event of default. 

In addition, the collapse of the mortgage securitization market means houses must be cheap enough for our limited pool of domestic savings to supply the funding, as we will likely lose access to much of the foreign funding that fueled the bubble.  

Of course, we need to be honest about the winners and losers of this credit crunch.  Just because mortgage money becomes scarce, and lending standards tighten, does not mean people will not be able to buy houses – it simply means they will pay a lot less for them and that fewer new houses will be built.

Therefore it is sellers, builders and those holding or insuring existing mortgages who lose, while buyers win big.  There's a reason for that: Despite higher interest rates and larger down payments, they end up borrowing a lot less money.  In the end they will become true homeowners, rather than indentured servants.  If home ownership is truly the American dream that so many realtors profess, then the ongoing collapse in home prices will actually be a dream come true.

Editor's Note: Peter D. Schiff, Euro Pacific Capital Inc.'s president and chief global strategist, is a regular contributor to Money Morning, and most recently wrote about the gloomy "financial reality" that's facing U.S. consumers and the looming spike in gold prices.]

News and Related Story Links:

Join the conversation. Click here to jump to comments…

  1. Jay Salvati | September 2, 2008

    It's nice to see someone speak the truth on the subject!

    It should come as no surprise to savvy investors that the housing market will continue to fall.

    This is one of the perils of putting all our economies eggs into a derivative basket backed by bundled mortgage debt.

    Want to find a great investor to follow? Research the people losing the least right now…or better yet…making money right now!

    It just goes to show that we as individual investors cannot rely on Wall Street to give us investing advice.

    We are much better off following Warren and others who shun the Street's daily speculations.

    The investor should always ask…what is the "True Value" of my investment across all markets and economies.

    If that had been done in real estate it would have been easy to forecast this as you say in your article.

    Many Kudos….great write!


  1. It's Time to Get Real About Real Estate | •••Special Bulletin from The Money Map Report: The “Super Crash” That May Soon Devastate Millions Of Americans… says:

    […] By Peter Schiff Author of Crash Proof Guest Contributor for Money Morning […]

Leave a Reply

Your email address will not be published. Required fields are marked *

Some HTML is OK