This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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At the heart of some of the most contentious debates in the otherwise drab world of macroeconomic theory is that of inflation (yes, there are in fact contentious debates about macroeconomic theory). To wit, economics can’t even agree on a definition for the term.

The laymen understanding of inflation is the rising of prices. Some economists agree, while another camp argues that higher prices are merely one of many signs of inflation, which they define as an increase in the supply of money within an economy.

Commonly, inflation is measured by the Consumer Price Index, or CPI, which purports to be a representative basket of goods and services that reflects what the average consumer buys with his or her hard-earned dollars. And while there are myriad criticism of the CPI and how government bean counters arrive at the final tally, that is a debate for another forum.

Suffice to say, as can be clearly seen below, prices in the US have been steadily rising for about as long as anyone can remember. And as some generations remember better than others, during the 1970s and 1980s, prices rose rapidly indeed.

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Most credit then-Federal Reserve Chairman Paul Volcker (currently the chairman of President Obama’s Economic Recovery Advisory Board) for breaking the back of inflation in the early 1980s with a hard-line policy of high interest rates. High borrowing rates discourage investment, curtailing economic growth, which can slow the pace of rising prices. This politically unpopular monetary policy led to persistently high unemployment and a deep recession, but ultimately inflation was brought under control.

Since Volcker’s tenure as Chairman, successive Fed Chairmen have kept interest rates low, while presiding over a period of slowly rising prices. While this sounds like a perfectly healthy economic balance, many argue this “balance” fostered the eventual imbalances that threw the global financial system into such wild disarray.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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A cursory look at the long term trends for inflation and home prices reveal strikingly similar patterns. Until, that is, right around 2003 (see dotted line below).

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In the wake of the short recession caused by the dot-com bust and September 11th terrorist attacks, then-Federal Reserve Chairman Alan Greenspan aggressively lowered interest rates to spur economic growth. Leaving rates at historic lows for several years encouraged active borrowing, helping to bring the US economy out of its tailspin.

Greenspan critics now wonder, at what cost?

As homeowners, real estate speculators, investment bankers, mortgage brokers, real estate agents, appraisers and credit rating companies (among others) rushed to grab their piece of property values, the historic relationship between moderate inflation and steadily rising home prices broke down. Home prices leapt, while inflation continued its casual march upward.

Then, around the beginning of 2007 (the “peak” of our 6-month moving average dataset), the relationship flipped inverse (see arrow above). Rising prices as measured by the CPI faced off with tumbling home prices, feeding the feverish macroeconomic debate of inflationists vs. deflationists.

Now, as what feels like the entirety of the financial world awaits the inevitable inflation that “must” come after trillions upon trillions of dollars in economic stimulus, we hope the following few pages shed some light on what we can expect if it turns out the majority (in this case, the inflationists) prove to be correct. Since policy-makers’ key tool to fight inflation is higher interest rates, and higher interest rates translate into more expensive mortgages, future inflation has serious implications for real estate markets around the country.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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It stands to reason that falling interest rates leads to higher home prices. After all, for every one percent drop in mortgage rates, buyers can afford around 10% more house. Against that backdrop, the chart below makes sense: After sky-high interest rates of the late 1970s and early 1980s, a consistent decline in interest rates helped usher in an historic increase in home prices.

But, as is often the case when complex macroeconomics are at play, there’s more to the story.

In order to fully understand what on the surface seems like a relatively straightforward relationship, we need to more fully understand what moves mortgage rates, which have such a direct effect on home prices.

Since it’s creation in 1913, the Federal Reserve has been charged with overseeing our nation’s monetary policy and maintaining price stability. Chief among it’s responsibilities is to set the “Federal Funds Rate,” which in simple terms is the rate at which banks lend to one another. Virtually all other borrowing rates are pegged at some “spread” above this baseline rate, based on the perceived riskiness of the loan.

With this tool, the Fed tries to maintain the modicum of inflation it believes strikes the proper balance between economic growth and stable prices. Lower rates encourage growth but push up prices, while higher rates curtail rising prices but at the cost of retarding economic activity.

However, with the Full Employment and Balanced Growth Act of 1978, Congress tacked on another mandate to the Fed’s list of tasks: “long-run economic growth.” The seeming contradiction of “stable prices” and “economic growth” is at the root of the debate over the role of the Fed in our economy.

So, using the logic laid out above, Paul Volcker and his inflation-crushing high interest rates of the 1980s should have sent home prices tumbling. Why then did home prices keep on rising during this period of high mortgage rates? Read on to find out.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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Given the widespread expectation for future inflation, and as an extension higher interest rates to combat rising prices, the question above is the most common one we hear from home buyers and real estate investors alike. To try and resolve the issue to completion on this short page would be ambitious, to say the least.

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During the inflationary period of the late seventies and early eighties (flip back to pg 5 for a picture of
inflation during this period), mortgage rates climbed to almost 20%. In a world where locking in a rate north of 5% feels like a rip-off, 20% mortgages are a thing of fantasy.

Yet, despite this seemingly gale force headwind, home prices still climbed. While there are number of reasons for this increase (demographic, regulatory, etc), let’s focus on one in particular: Inflation Expectations.

Thumb through speeches written by pointy-headed Fed economists and you’ll find this phrase, “Inflation Expectations” peppered throughout discussions of monetary policy and the fear of rising prices. This is one of the least appreciated, yet most important aspects of effective use of monetary policy to manage inflation.

At the core, all economic decisions reflect participants’ view of the future. Specifically, buyers consider what utility (ie, use) they can receive and whether the price for that utility is fair. Embedded within this decision is some expectation of what can be done with that money in the future: Saved, spent, invested, etc.

When consumers fear rising prices, that a gallon of gas will cost more tomorrow than it does today, they buy the gas today. This pushes future demand forward, increasing aggregate demand and in turn, prices. The cycle continues, and in extreme cases (think Zimbabwe or the Weimar Republic), hyperinflation ensues.

As inflation rises, so too do Inflation Expectations. Consumers deploy capital towards assets they perceive to be a better store of value than the worthless paper in their pockets. They buy gold, they buy oil, they buy real estate. So, even with higher rates, money still flows into housing.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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The belief that the Federal Reserve kept interest rates too low, for too long, is one which is now nearly universally held. Well, outside the Fed, that is. Here’s a smattering of quotes which show how the view of Greenspan’s loose monetary policy (and now Bernanke’s) varies from group to group, and from year to year.

“The best response to the housing bubble would have been regulatory, rather than monetary.”
- Fed Chairman Ben Bernanke, January 3, 2010

“Given the decloupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have prevented the housing bubble.”
- Former Fed Chairman Alan Greenspan, March 11, 2009

“The reason I wrote this book was so that the average person could understand the scope of the housing bubble, and what its bursting was going to mean and…where blame should be placed…at Greenspan’s Fed.”
- William Fleckenstein, on his book Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve

“Bernanke has done a great job, post-Lehman. But going into this crisis, he really was the architect, if not the co-collaborator, in creating some of the conditions in the economy that led to the recession.”
- Stephen Roach, chairman of Morgan Stanley Asia, Ltd, August 25, 2009

“We artificially lower interest rates. It’s been going on for 10 years and longer and now we’re bearing the fruits of that policy.”
- Ron Paul (R-TX) at Chairman Bernanke’s testimony to the Joint Economic Committee, Nov. 8, 2007

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”
- Then-Fed Chairman Alan Greenspan, during a speech on February 23, 2004

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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Since we just spent the last ten pages laboriously scratching the surface of complex macroeconomic trends with a few over-simplified charts, we will now analyze every single US housing market by looking at sales data in two cities.

As we wrote in April 2009, “The bifurcation of the real estate market continues, as troubles in the high end are picking up the slack while low-end markets grope for a bottom.” This trend has persisted for months, and as foreclosures creep into higher end markets, we believe the trend will persist for the foreseeable future.

Below are sales transactions for the past ten years in East Palo Alto. East Palo Alto, which in 1992 had the dubious distinction of being “murder capital, USA” by tallying the highest murder-per-capita rate in the entire country, has undergone a renaissance of sorts. Sort of.

As Silicon Valley wealth swelled during the dot-com boom, so too did housing prices. One of the last bastions of affordability on the Peninsula, real estate speculators flocked to this rough town for high risk, high reward development. The town experienced a decade of gentrification on steroids, as home prices became completely unhinged with the economic prospects of the area’s residents.

This story was repeated in cities across the country, each with it’s own unique flare. Vegas condos went through the roof. Track homes in Phoenix were flipped monthly by amateur and professional real estate speculators alike. Waterfront homes in the quiet town of Cape Coral, FL approached $1 million apiece.

But now, as prices in these markets have returned to earth, buyers are wading back in, armed with government loans, tax credits and a newfound fear of the stock market. Inventory is being constricted by ongoing foreclosure moratoria and in certain markets, prices have begun to stabilize.

The arrow below points out the steep price declines from 2007-2008 on few sales transactions. The shaded circle shows buyers stepping back in and prices groping for a bottom.

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On the other side of Highway 101, the city of Palo Alto exists in precise contradiction to its neighbor to the east. Quiet streets, large lots and excellent schools make Palo Alto one of the most desirable places to raise a family in the entire country. Home prices, as one would expect, are very, very high.

Palo Alto residents have had decades of prosperity to accumulate wealth, and a few bad months in the stock market or the loss of a job doesn’t necessarily spell financial ruin. Fewer mortgage defaults, less dependence on credit cards and a general affluence meant that the bubble popped here later, and with less vigor. In other words, the “Price Discovery” (ie, a precipitous drop in prices resulting from a void of buyers, only to be stabilized as buyers step back into the market looking for bargains) that has occurred in East Palo Alto is yet to come to well-to-do areas like Palo Alto.

As can be seen from the green shaded oval below, Palo Alto experienced a mini-bubble on the tail end of the dot-com boom. Prices have now fallen to around where they were back in 2004, but only just below the maniacal glory days of Pets.com and WebVan. And, as foreclosures infiltrate these luxury markets, forced sales are becoming more common. This is beginning to drive down prices, as can be seen in the recent dip that picked up steam earlier in the year.

Luxury markets around the country have seen a similar trend in home prices: A later peak and less dramatic fall, but prices that are yet to be supported by opportunistic investors. But all is not bleak in other Palo Altos around the country.

These high-end markets have benefitted from the strong stock market of the past 9 months. If the economy can avoid another tumble and markets can remain resilient as the government gradually withdraws its stimulus, high end markets may find support sooner than many skeptics think.

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US Median Home Price 1965-2009
Gray area is “Inflation” period of 1972-1983, 201% total increase in home prices during that 12 year period, or 10.5% annually.
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Consumer Price Index 1965-2009
Gray area is “Inflation” period of 1972-1983, 147% total increase in CPI during that 12 year period, or 8.5% annually.
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CPI vs. Median Home Price 1972-1983
Close up of the gray area, home prices seemed to outpace inflation a bit during the peak inflation late ’70s early ’80s.
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CPI vs. Median Home Price (y/y change) 1972-1987
Extended the view a bit, on the way up Home Price change peaked before CPI (’72) and bottomed first as well (’80, ’82). Home prices off to the races again in the mid-late ’80s.
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30-yr Fixed Mortgage rates vs. Median Home Price 1972-1987
Home price gains slowed as rates ramped, but even with 18% rates annual home price change only briefly declined.
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30-yr Fixed Mortgage Rates vs. Median Home Price 1972-1987
As shown above, high rates slowed down increases but declines did not last long and prices started going up again when they lowered rates.
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This post first appeared on Minyanville.

There’s a good amount of buzz surrounding the Wall Street Journal’s piece on the staggering number of homeowners underwater on their mortgages. This, on the same day the Case-Shiller Home Price Index posted its fourth consecutive month-over-month increase.

Mixed signals? Possibly. But in reality, these two seemingly disparate data points suggest that even as foreclosure moratoria continue to keep bank-owned properties off the market — which is artificially limiting supply and creating the illusion of a tight housing market (the supply of existing homes is back to historical norms) — behind the scenes, more and more borrowers are falling behind, and staying that way.

The number of mortgages in the “90+ delinquency but not yet foreclosed” bucket is still growing and the rate of change is yet to slow. The looming backlog of foreclosures not yet completed is growing much faster than banks can (or are allowed to) push them through the system. Lender Processing Services (LPS), a spinoff of Fidelity National Information Services Inc. (FIS) estimates that 710,000 mortgages are more than six months delinquent but not yet in foreclosure. A year ago, that number was “just” 203,000.

So what does all this mean?

While another leg down in housing is certainly in the cards, another cliff-dive isn’t the likely scenario. Rather, a continued slow bleed, with increasing localization as certain markets recover while others languish. Second home and jumbo markets are still under pressure, even as investors feast on low-priced homes in some of the country’s seedier neighborhoods. But as long as the US government dominates the secondary market for mortgages (FHA/Fannie Mae (FNM)/Freddie Mac (FRE)/VA, etc), mortgages will be available to qualified (and unqualified, in the case of the FHA) buyers.

Betting on another all-out collapse in residential housing prices is akin to betting on the bankruptcy of the US government. Could it happen? Sure, but that certainly isn’t the base case.

A much more interesting (and profitable) bet is to find areas that have fundamental (ie, demographic) drivers for demand, and looking for affordable submarkets where demand is strong and not driven by the FHA. Are there a ton of these neighborhoods around? Nope, but they’re out there if you know how and where to look.

One of themes we harp on here at Cirios is how home price trends are becoming increasingly localized as individual real estate markets grope for a bottom.

Some areas, particularly the hardest hit by foreclosures, have seen fantastic price declines. Others, mainly the high end, are only recently feeling the ill-effects of job losses and our slumping economy. And while this dynamic makes for a tricky housing market, it also breeds opportunity for those savvy enough to identify which markets will be the first to stabilize and eventually rebound.

Take a look at the 2 graphs below showing price per square foot in Redwood City, CA.

The first shows all residential sales in Redwood City. The steep declines in 94601 and 94602 not only show price declines, but help illustrate how areas with high foreclosure rates — like these 2 zip codes — are seeing steeper price declines than areas that are holding up better. (For more on this subject, read about foreclosure sales effect price data.)

The second graph shows 1 segment of the market,
homes with living areas of 1,200 – 2,500 square feet.
While a somewhat arbitrary cutoff, the idea is to pick
like homes within each area to try and compare apples
to apples.

What we see is that in the second graph, is that the “spread” between each zip code, that is, the premium you pay to live in 94063 vs. 94601 or 94602 remained essentially the same throughout the boom and into the bust. Meanwhile, the first graph shows that price per square foot in 94063 (the least desirable part of town) almost touched 94061 (the most desirable part) right around the peak of the bubble.

So what does all this mean? 2 takeaways: First, be skeptical when you look at housing market data, since very small changes in data collection can lead to quite different results. Second, real estate always has been, is, and always will be local. No national, statewide or even citywide trends can capture what’s going on at the street level.

Want to see this analysis for your town? Contact Cirios Real Estate today!

Looking for great schools, rolling hills, big lots and a quick BART ride to the city?

Orinda and Lafayette, two of the most desirable towns in the East Bay, have all this and much more. Home prices remain in a downward trend, to be sure, but inherent desirability and established neighborhoods should keep these two from falling off a cliff, even as their high-end brethren around the Bay Area feel the pain of an tight jumbo loan market.

The graph below shows price per square foot for homes with 1200-2500 square feet, pretty middle of the road for these areas. Once you get above 2500 sqft, you start losing your marginal price per square foot and comparisons with smaller homes start to lose meaning.

What did that mean? Read more about Price per Square foot here.

Want to find out more about these two towns? Contact Cirios Real Estate today!

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