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.

(click to enlarge image)

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.

(click to enlarge image)

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This post first appeared on Minyanville.

It only took 18 months, but the fact that the US luxury real estate market is falling apart at the seams is finally starting to sink in.

Yesterday’s Wall Street Journal chronicled the plight of high-end housing markets, as formerly wealthy homeowners are falling behind on their mortgages at an astounding rate. Defaults and foreclosures are increasing in the Jumbo Prime mortgage space — big loans made to borrowers who were supposed to be good credits — at a faster clip than in any other segment of the market. This is causing distressed or otherwise forced sales, resulting in the type of Price Discovery that can send vulnerable markets reeling.

Meanwhile, cheaper markets have, by and large, experienced the worst of this vicious whoosh down and are now groping for a bottom. Some of these distressed areas — the fortunate few that were allowed to experience a legitimate correction before government-sponsored foreclosure moratorium set a true stabilization back months, if not years — have laid the groundwork for a long, arduous recovery. Others, prevented from finding a bottom on their own, will be suffering from a years-long slow bleed of inventory, crushing the hopes of local real estate investors and first-time buyers and sending capital elsewhere.

As Wells Fargo (WFC), Bank of America (BAC), Citigroup (C), and JPMorgan (JPM) — the biggest holders of property in the country — continue to bow to White House demands to keep housing inventory off the market, a legitimate sustainable recovery in housing will remain elusive. This matters little for high-end markets, however, as prices are screaming downward whether the government likes it or not.

What few media outlets are covering is how the upwards spreading of the housing infection will affect widely reported home-price data, and thus the psyche of the American home buyer. This is a subject I mentioned back in April, but now that the trend is becoming reality — as the Case Shiller Home Price Index registered its first monthly increase since 2006 — it warrants revisiting.

As defaults and foreclosures bleed into the high end of the market, buyers gain the upper hand in price negotiations as sellers become desperate. These forced sales will turn illiquid markets liquid as buyers that have been locked out of these expensive markets begin to scour the landscape for opportunities. As sale volumes pick up, so too will the average price of the homes eventually sold, since this will shift the distribution of transactions included in the broad averages towards more expensive homes.

This isn’t just some statistical anomaly: As broad measures of housing data show recovery, behind the curtain, individual submarkets will be telling a vastly different story. To be sure, the Jumbo market makes up less than 3% of the total housing market, but if it’s your market, that makes it 100% of the housing market that matters.

By ANDREW JEFFERY

This post first appeared on Minyanville.

Price discovery. It sounds simple enough, right? If you separate out its component parts, you have “price” — the amount buyers are willing to pay and sellers are willing to accept — and “discovery” — the uncovering of that price.

But price discovery — a term which is bandied about in all corners of the financial markets — has a meaning far deeper than this cursory analysis.

In a financial sense, it’s defined as the point at which the free market — the natural interplay between supply and demand — converge on a single point where buyers and sellers can find mutual ground. There, you have price discovery.

In a practical sense, it happens every day; each time an economic transaction occurs. Coffee at Starbucks (SBUX) costs more than, say, coffee at any other establishment on the planet, because consumers have determined they’re willing to pay a premium for it. Starbucks, for its part, has generously sprinkled its stores on street corners around the world, matching supply with this persistent demand. The price, even though most of us scoff at the mere thought of forking over more than $4 for some contrived, flavored coffee-like drink, is what the market will bear.

So why then do financial-market participants make such a big deal about “true price discovery” in trying to analyze specifically when and where markets will bottom? The key is in the definition.

Let’s examine the housing market to see why this distinction matters, and how the dynamics effecting price discovery are so important.

Homes, unlike cups of coffee, are rarely bought and sold — other than when entire neighborhoods are turned over (which seems to happen with frightening regularity). But buying or selling a home typically involves uprooting one’s family, hauling boxes across town (or across the country), switching schools, changing jobs, and otherwise disrupting the flow of life.

When talking about the housing market, most pundits and so-called experts typically focus on the demand side of the equation. How low are interest rates? Did Wells Fargo (WFC) just tighten its mortgage guidelines? Are property values increasing or decreasing? How is the job market doing? On a more personal level, getting married, having kids, changing jobs, seeking out a slower (or faster) pace of life, or looking to trade up into a better school district or bigger home can all lead buyers to jump into the market.

Sellers, on the other hand, are typically hard-pressed to sell. Many of the same circumstances (jobs, retirement, family, etc.) lead a seller to enter the market, but leaving a home and the emotional attachment therein, is an extremely difficult decision to undertake without a very compelling reason.

In the current housing downturn, as social mood has swung violently towards risk aversion and shorter time preferences, the decision to sell one’s home has effectively become that of necessity, or nothing at all. In other words, the vast majority of sellers on the market right now are forced sellers — those who don’t have any choice.

So what does this all have to do with price discovery?

The destruction of a widely held economic belief — namely, that housing prices only go up –has thrown the interplay between supply and demand out of whack. Couple that with insane leverage, abnormally low interest rates, virtually non-existent underwriting guidelines, and massive government intervention in the form of Fannie Mae (FNM) and Freddie Mac (FRE) that caused the recent boom, and in reality, the fundamentals of supply and demand have been wonky for years, if not decades.

As these imbalances are worked through and the weakest hands are forced to fold, markets are slowly starting to heal. And even though massive loan-modification efforts and foreclosure moratoria are once again throwing true supply and demand out of whack, the free market is a powerful force: Certain real-estate markets around the country are beginning to show signs of healthy stabilization.

Price discovery is emerging, as housing prices return to more traditional measures of affordability where buying begins to make just as much sense as renting. To be sure, there’s a fear of losing equity as prices tumble, but the emotional pull of owning a home is, and always will be, a powerful force. Other markets, however, have a very long way to go.

Since founding Cirios Real Estate, I’ve spent a dizzying amount of time looking at local housing markets in California. And in trying to identify trends on a neighborhood-by-neighborhood, street-by-street basis, I’ve found one trend that’s 100% consistent around the state. And although California is a rather unique case, I know enough about markets around the country to be confident this is true there as well.

Markets that have seen the most extreme home-price declines are the ones where owners faced massive amounts of negative equity and foreclosures ran rampant. Virtually every sale in these markets over the past 2 years has been the result of a seller being forced to sell.

On the other hand, markets where job losses have been less severe have seen prices ramp up less severely during the boom; schools are better and fundamental desirability is higher. Sellers have broadly had the luxury of holding out, hoping the market would turn before they, too, would be forced to put their home on the market.

When there are no more forced sellers in a given market — or at the very least, the proportion of forced sellers and non-forced sellers returns to more normal levels — healthy stabilization can occur. And in order for this to happen, years of froth and excess must first be worked off. This can happen via 2 methods, which Toddo often discusses when analyzing the stock market: time and price.

Time can heal wounds as demographics shift and new buyers enter a given market, or low prices can bring investors out of the woodwork to snap up underpriced homes.

There isn’t some magic formula or complex property-valuation algorithm (sorry Zillow) that can determine where a given markets is in the bottoming process or where the best real-estate investment opportunities currently lie (to be sure, they’re out there). But with careful analysis of individual markets, trends can be identified.

Submarkets where price discovery — that is, the process of returning to an environment where natural supply-demand fundamentals can thrive — is further along pose a far smaller risk than those markets where sellers have been hunkering down, hoping the maelstrom would blow over their quiet streets.

So while pundits argue over whether the housing market has “bottomed,” we can all ignore their drivel, knowing this is a meaningless statement. Price discovery doesn’t happen on a national scale; the massive and disjointed real-estate market is made up of thousands of tiny micro-markets, each of which is at a different point along the highway of price discovery.