Ten Rules to Live By and the New Real Estate Market

1. Ten Rules to Live By and the New Real Estate Market Austin J. Jaffe, Ph.D. Chair, Dept. of Insurance and Real Estate, and Philip H. Sieg Professor of Business Administration Penn State University PAR Business Meetings Harrisburg, PA September 21, 2009

3. Introductory Remarks • Thanks for the invitation! • Previous Views of the Future • September 2007: There will be a “tough stretch ahead” • January 2008: Get ready for some serious pain • January 2009: Future will be challenging • Today, we see the beginning of new hope that the housing crisis is abating.

4. Introductory Remarks (cont’d) • Agenda for Today • Review of Past Predictions • Current Assessment of the Market • A Look at a New Vision of the Future Housing Market • I hope you find this interesting and helpful! • I hope there will be plenty of time for Q & A.

5. Review of Recent Predictions • Here are several of the actual predictions I offered on three past occasions to PAR. • I have included all of them from my January 2008 and January 2009 presentations (with no omissions!) • Given the evidence, perhaps my risky predictions today might be given a chance!

6. Prediction (September 2007) • “The next period for the PA real estate brokerage industry will likely be tough stretch if one is seeking significant price appreciation, rapid turnover of inventories or active growth in sales activities.” (If anything, I was being a bit optimistic.)

7. Predictions (January 2008) • 1. House prices will continue to fall until equilibrium is restored. (A bit bold at the time.) • 2. Lower interest rates will not lead to higher housing prices. (The seizing up of credit markets had begun.) • 3. Weak housing markets are expected to spread beyond sub-prime borrowers. (It had become apparent that the crisis was affecting the entire housing and credit markets.)

8. Predictions (January 2008) (cont’d) • 4. Declining sales numbers will bottom out only when inventories stop growing. (In retrospect, a public call to beware of growing supplies of unsold units.) • 5. Defaults and foreclosures will continue to grow but less so in Pennsylvania than elsewhere. [The recognition that PA housing markets are more likely to be “low beta” (less appreciation on the upside and less declines on the downside.)]

9. Predictions (January 2008) (cont’d) • 6. Enormous losses of real estate wealth are ahead from declining house prices. (Few of us, however, would have predicted the average loss of about 25%, with housing in some cities losing 50-60% as on today and the average PA housing loss of about 10-15%.)

10. Predictions (January 2009) • 1. House prices will continue to fall. (And so they have …) • 2. When rate of foreclosures slows, the housing crisis will ease. (In PA, foreclosures are accelerating.) • 3. When prices stop falling, confidence will return. (This is just beginning in PA.)

11. Predictions (January 2009) (cont’d) • 4. Low or falling interest rates will lead more to refinancing rather than to new purchases. (A common myth seems to be that low interest rates will revive the PA housing market.) • 5. Housing in Pennsylvania has its own, unique characteristics. (Thank heaven for our differences!) • Also, recovery to begin in 2009 and recovery will depend upon national politics, overall economy, and inventories.

12. Summary of Predictions • So, how did I perform since 2007? • It seems there was plenty of evidence to predict a set of outcomes which would have been unthinkable only a few years before. • Perhaps the magnitude of the changes were a surprise. • However, the basic story was fairly clear by mid-2007.

13. Assessment of Current Market Conditions • For example, this week, a Centre County real estate advertisement states: • “The present may be the best of times for first-time home buyers. Not only are home prices as low as they have been in years, but mortgage rates are at historic lows. In addition, the government is offering first-time home buyers a tax credit worth $8,000 .... The clock is running down …” • It is true that the tax credit expires soon (November 30th) but what will the future be for housing markets?

14. Assessment of Current Market Conditions (cont’d) • Let’s look at the recent changes in market conditions within the historic context of recent years. • House prices experienced rapid increases year-after-year since about 1995 until 2006. • By mid-2006, the “housing bubble” burst and the median prices fell for at least 24 consecutive months. • About three months ago, the downward cycle of price declines flattened out and prices have begun to stabilize and increase in several cities.

16. S&P/Case-Shiller Home Price Index (September 2009)

17. NAR’s Pending Home Sales Index • I

18. Now, Don’t Get Too Excited! • It is not clear where future prices of Case-Shiller or other indexes are headed. • Three months do not mean a major reversal is upon us. • However, the days of free-falling price declines may be over, at least in all but the weakest markets.

19. Some Things to Consider • Most housing markets continue to show historically large inventories, especially with foreclosures and abandoned houses. • Despite the rhetoric from some politicians, the economic recovery is very fragile to say the least, especially consumer demand. • Job creation is an illusion with now more than 6 million out of work.

20. Some Things to Consider (cont’d) • The Federal “economic stimulus” program ($787 billion) has worked but only to enable states to pay some bills and begin a few “legitimate” projects. • However, unemployment is nearly 10% and expected to rise in the months ahead. • The refinancing and loan modification programs have been only moderately successful at best by all reports.

21. Some Things to Consider (cont’d) • The rate of new foreclosures in most markets has dropped (although lagging PA has shown increasing foreclosures in a recent report). • Sales activities has increased a bit in recent months but worries persist with the expiration of the $8K tax credit. • Deficit spending (ala trillions) has become a growing concern since it is likely to lead to inflation and a weak currency.

22. Some Things to Consider (cont’d) • It is also clear that there is a surplus of housing which will hinder price formation for many years. • Even if household income and consumer demand begin to rise, the supply of houses due to defaults and foreclosures as well as abandoned properties will chill any serious warming up of house prices. • The times, they are a changin’ …

23. Ten Rules for the New Real Estate World • What follows is my tentative vision for a new real estate world! • It is consistent with recent historical developments and the current situation outlined above. • It is not, however, the same as the past.

24. Imagine • Imagine a world with three ownership forms: • a) Owner does not have the right to sell the reversion (as in usufruct property). • b) Owner has the right to sell reversion but must split 50/50 with the government (as in a SAM mortgage). • c) Owner has the right to sell reversion and keep the proceeds (as in a fee simple estate). • It is interesting to consider the relative values of these three ownership bundles.

25. Imagine • Now let’s include the deductibility of mortgage interest and the deductibility or property taxes for all three ownership forms. • It is clear that the prices of all ownership bundles would increase due to this special tax treatment. • However, the increase would likely be immediate and one-time only. • In effect, only current owners benefit from the tax reductions; future owners just pay higher prices.

26. Imagine • Suppose the probability of growth in house prices over the next several years is very low (near zero). • How will the absence of price appreciation affect the three ownership bundles (usufruct, SAM, and fee simple)? • With no growth possibilities, there is little difference between usufruct (0% claim on the future reversion), SAM (50%) or fee simple (100%).

27. Imagine • One could think about appreciation as an option. • However, with no expectation of appreciation, there will be little difference in value between the three ownership forms (i.e., the option value is almost worthless). • In a world of no appreciation, the primary motivation for owning housing is to use it whether by design or under existing market conditions.

28. Is This the Real World? • Today’s real market reminds us that without rising prices, the values of our housing bundles would not be much different from usufruct rights, even with mortgage interest and property tax deductibility or even one-time tax credits. • In a “no-growth, no-appreciation” real estate market, the game changes.

29. New Rules to Live By • Here are some new principles for the changed real estate market. • 1. The valuation of homes will no longer be a function of the appreciation potential (growth option in house prices). • Last month, Bob Shiller predicted that there would be only a 9% average increase in house prices through 2014. • Chris Mayer notes that housing appreciation typically has been only 1% above inflation over time. • It has never been a “get rich quick” scheme.

30. New Rules to Live By • 2. In markets where appreciation was a primary selling point, prices have sunk the fastest and declined the largest percentages. • Consider the speculation in Arizona, California, Nevada, and Florida. • The recent experiences were also fueled by reckless lending and poor underwriting. • 3. Mortgage interest deductibility has little if anything to do with the returns to owning since tax shelter is already capitalized into prices.

31. New Rules to Live By • 4. In the next several years, the market for residential real estate will be based primarily on the housing services available to its owners. • e.g., keeping warm/cool, a place to be safe, a place to entertain friends, a place to raise a family, etc. • This is what housing has always been about. • 5. Supply constraints on location will remain important. • e.g., best vs. other neighborhoods, limited ocean views vs. McMansions, unique locations, etc.

32. New Rules to Live By • 6. Thus, the decision to purchase a home will be based upon household consumption expectations and needs available from a long-term, depreciating, consumer durable. • Tastes and preferences will be more important than ever. • 7. The real estate business will live on and prosper in this new world since households will continue to spend large portions of their budgets on housing services.

33. New Rules to Live By • 8. The speculative fever and over-leveraging of housing budgets, especially by low- and moderate-income households, will largely be a characteristic of the “good ol’ days.” • 9. If inflation and inflationary expectations are low, mortgage rates can be low. If economic growth is limited, mortgage rates can also be low. • With large deficit spending, eventually there will be inflation. • With inflation, there will be pressure to raise interest rates and this will lead to higher mortgage rates. • However, there is no reason to expect real interest rates to rise.

34. New Rules to Live By • 10. Over time, nominal real estate prices will not likely change much (let alone real prices), but there will be an active housing market both for new and existing stock. • Housing will remain a major industry in the US. • New construction will not reach the mid-decade levels for years to come. • There is already evidence that the size of new homes is falling for the first time (down 7% in August 2009). • Also, most financing will be less exotic and credit scores will be more important than ever. • Risk assessment and management will be taken very seriously.

35. New Rules to Live By • Finally, I believe these conditions will lead to a new distribution of winners and losers in the residential real estate business. • The distribution of sales across associates will become more skewed (successful and experienced professionals will be enhanced). • Newcomers will have more trouble breaking-in to an increasingly competitive business. • Part-time players will struggle. • Knowledge about local markets and the physical dimensions of real estate will become even more important.

36. Listen to Wise Players • A week ago, my friend, Lorraine Spock from Centre County, wrote a piece entitled (or, stolen from The Wizard of Oz! ) “There’s No Place Like Home.” • Lorraine tells us that the American dream of ownership endures because: • “Families need a place to call home.” • There is “pride and community engagement” that comes with homeownership. • Owning a home “creates stability and has many social benefits.”

37. Listen to Wise Players (cont’d) • Lorraine tells us that the American dream of ownership endures because: • “People have a greater stake in what happens in their local area when they own rather than rent.” • Children of homeowners perform better in school. • Homeownership lowers crime rates. • Homeowners are generally healthier than non-homeowners. • “Homeownership is an investment in your future.”

38. Concluding Comments • The housing market will emerge from the current economic problems as a different type of institution. • But be reassured that this important aspect of American life is far from dead. • Real estate will remain one of the most important elements of modern life, even without expectations about rising prices. • It has always been this way, except in recent years; we forgot for a while what housing really is: an important, long-term, consumer durable!

39. Thank you for your interest and attention! There are no silly questions! We have time to discuss any of the issues raised here or any other real estate matters! Q & A …