Galveston Economic Report
David Stanowski Publisher
Real Estate Bubble: Update
by David Stanowski
18 August 2009
"The future's uncertain,
and the end is always near."
My 2007 article warned that even though most home prices in Texas were growing slower than the U.S. average, which meant that they had less downside risk, Galveston real estate prices were growing much faster, which indicated that the local market could be forming a bubble. In a recent Quarterly Letter from GMO, Jeremy Grantham stated that his firm had studied 28 asset bubbles since 1920, and they felt that a reasonable definition of an asset bubble is any situation where prices deviate from the mean by at least two standard deviations. A new look at Galveston real estate prices reveals that, like many U.S. housing markets, they meet this definition of a bubble, because they have deviated 2.06 standard deviations, from their mean.
Should home owners, investors, and the City government be concerned by this new perspective?
It should be no secret to local homeowners and real estate investors that, over the last few years, the entire world found itself enmeshed in history's greatest residential real estate bubble. In most locations, the bubble peaked in 2005-2006, and has already declined 20-50%. So far, Galveston has alluded any serious price declines which makes many believe that the local market did not constitute a bubble, or that, if it did; it will never pop. This may be wishful thinking in the extreme!
Looking at the U.S. market since 1890, the following graph shows that the annual rate of change in housing prices from 2007 to 2008 was the worst in this entire data series! Prices were very erratic in the early years, which may have merely been due to collection and computation methods at that time, but settled down after WWII. The crash low in 1932 was created by a one-year price decline of 10.47%, but that was easily eclipsed by the 18.32% one-year price collapse in 2008! The size of this move confirms the fact that the current post-bubble housing crash is by far the worst in more than 100 years!
"The slowing rate of decline in home prices is likely to continue but the housing market is "still in an abysmal situation," says Robert Shiller, a professor of economics at Yale. ... [Shiller] says the housing market could "languish for many years," due to the "huge inventory" of unsold holds, "shadow inventory" of homes kept off the market by banks and other potential sellers, and "a lot of financial problems."
"Housing markets are very inefficient - and that is why it takes several years for prices to fall to a market clearing price." Calculated Risk
A recent nationwide Real Estate Agents Report detailed how 63% of transactions are now foreclosures, or banks taking a loss on the property (short sales), and another 27% could be considered done under some kind of stress; so only 10% are currently being made under "normal" conditions.
The following graph shows foreclosure activity growing from 75,000 per month in 2005 to 360,000 in 2009! The July foreclosure rate was up 32% from the already staggering level in July 2008!
Foreclosure Wave: Now a Tsunami of Sorts
With 1 in 8 Americans with a mortgage either in arrears or in the foreclosure process; 1 in 4 homeowners "upside down" on their mortgage (i.e. they owe more than the house is worth); 1 in 6 either unemployed or underemployed; it will be interesting to see exactly what sort of housing recovery we end up with. (from David Rosenberg)
Housing Inventory is still very high!
Second Quarter Negative Equity Data from First American Core Logic shows that 32.2% of all mortgages are now held on properties with negative equity, and 37.6% are close to negative equity. These properties have a value of $13.044 trillion, but mortgages of $10.148 trillion, leaving only $2.896 trillion (22%) equity!
In comparison, "only" 24.7% of all mortgages in Texas are on properties with negative equity, and 32.1% are close to negative equity. These properties have a value of $581.751 billion, with mortgages of $455.286 billion, leaving only $126.465 billion (22%) equity!
Commercial real estate normally lags residential, and this time is no different, but the crash in CRE is rapidly catching up to residential.
Unlike almost every other place on Earth, it is truly amazing that Galveston home prices actually made a new high in 2008; which finally pushed them to 2.06 standard deviations above the mean.
Normally, when volume fails to increase as prices do, the divergence shows a market running out of gas, and destined to fall. In Galveston, volume peaked in 2005, but the 2008 level may have been exaggerated by Hurricane Ike.
The dollar value of home sales, in Galveston, really accelerated in 2004 and 2005, which is another characteristic of an asset bubble, but then peaked and plateaued since then.
Typically, the momentum of price changes peaks before prices do. The next graph shows that the peak in the annual rate of change in prices occurred in 2005 which has created another divergence that also shows a market losing strength, and set up for a decline.
During the period of this study, the bubble cities of Phoenix, Miami, and Las Vegas posted standard deviations from their means of 2.30, 2.46, and 2.26 respectively; which has lead to declines from their peaks of 53%, 49%, and 53%, as of May of this year, and it is very likely that the bottom has NOT been reached in any of these cities!
Source: S&P Case-Shiller 1987-2008
Source: S&P Case-Shiller Monthly Updates
"A house is a money pit, but a vacant house is a liability. We have nearly 20 million of these liabilities all over the country and every one of them is looking for cash, whether it be for taxes, insurance, mortgage payments, condo fees, maintenance and repairs or basic standby utility service. With rising unemployment and declining rents, I submit that we are not at bottom yet.
Those who think the real estate bottom is in should look at real estate markets in Las Vegas, Phoenix or Miami/Fort Lauderdale. In Las Vegas, there is a huge condo complex called Meridian at Hughes Center located 2 blocks from the Strip. 2BR 2BA condos that sold for $540K in fall 2005 were going for about $120K at the beginning of 2009.
My uncle wanted to invest in a couple of units in January but I told him "not yet." I watched the units drop to $99K around March or April, and thought about buying one, but didn't. Today those 2BR units 2 blocks from the Strip can be had for $75K, or about 15 cents on the peak bubble dollar. Another Vegas complex I follow has units that sold at $191K in 2006 now going for $35K.
Is this the bottom for Vegas? Well, I lived there for 8 years, and I don't think the bottom is in just yet. We are getting closer, but the bottom will not be in until we see some of these properties going for 10 cents on the peak bubble dollar. I see similar price declines in Phoenix and Fort Lauderdale, and I think those cities are also getting closer to bottom but they're not there yet." Bob in Las Vegas
The deviations from their means have been more extreme in Phoenix, Miami and Las Vegas than in Galveston, but our city has met the criteria proposed by GMO, which may portend similar declines in the future. Galveston's mean price over the period of the study was $124,345, so a reversion to the mean would require a decline of 47%. Phoenix and Las Vegas have already dropped below their means.
In contrast, Houston's greatest deviation was 1.72, so it did NOT meet the GMO criteria for a bubble.
Source: Texas A&M Real Estate Center
Galveston is a City that has suffered through more than its fair share of natural disasters (hurricanes), but its most monumental set backs may have come from self-inflicted wounds. The Founding Fathers were world-class entrepreneurs who built a very prosperous city, but after their descendants lead an amazing recovery from the 1900 Storm, they couldn't find a way to make the Port drive the local economy back to former levels of activity and profitability. As the Port declined, and other businesses left town, the population began to dwindle, and the long downward spiral had begun.
Somewhere in this process, the powers- that-be decided that the answer was to become a resort town, and a residential building boom began. A large percentage of these new homes were built west of 61st Street, and were second homes for Mainland residents.
The City government was happy with the new residential building spree, because it increased the property tax that it collected which allowed it to add more employees, and to boost their compensation packages, but it did very little to help those who were trying to make a living in the City.
When property tax growth failed to meet their expectations for even further largess in the City payroll, they desperately searched for ways to jump start more building. Their latest scheme was Tax-Increment Reinvestment Zones which is a method to hand out favors to a few large developers to encourage them to build grand projects. However, since TIRZs trap any additional property tax in the Zones for decades, they just made matters worse. For the upcoming budget year, the City Manager wants to raise property taxes, on everyone in the City, about $1.8 million, which is almost exactly the amount now trapped in the TIRZs! Is this a coincidence?
The Truth About TIRZs
This is not a formula for building a prosperous economy that will provide good jobs for the residents, as the following graph demonstrates. The current TIRZ projects were in the planning and start-up phase from about 1997-2002, and as they have built out, look what happened to the employment level!
Building residential real estate certainly didn't cause the number of jobs to collapse, but it didn't offset the jobs that were leaving. In addition, the jobs that still remain are often not as good as the ones that the Port could have generated, if the City had concentrated its efforts in that direction; and focused on other business development instead of residential real estate. When will City leaders understand that you can't rebuild an economy with residential real estate? It creates very few permanent jobs, and very little additional economic activity.
It is always very difficult to get most people to consider any analysis that suggests real estate prices might decline, because everyone has been so brainwashed by the Conventional Wisdom that "real estate never goes down in price".
There are two main arguments used to refute any evidence of a possible post-bubble collapse in Galveston. The first one is that it hasn't happened, so far; so it won't. This may prove to be true, but the other way to look at this hypothesis is that the longer it takes to relieve the pressure from a bubble; the greater the eventual pop will be!
In addition, legend has it that Galveston is the closest beach community to the fourth largest city in the country, and beach property is in very limited supply, so there is far more hidden demand than can be measured by normal metrics. Of course, this argument ignores the history of places like Tokyo and Manhattan, where land is far more scarce, and needed mostly for primary homes and productive enterprises; as opposed to recreational uses and second homes.
Once the Japanese bubble peaked, in 1988, regardless of the demand, prices fell over 50%, and still have not launched any meaningful recovery. Demand is no antidote for over valuations!
"One of the most enduring cliches of the real estate industry is that properties in "prime locations" such as Manhattan and San Francisco "never go down." Nice idea, but wrong."
"Yes, real estate prices can drop in half; even in Manhattan!"
"In the last real estate decline in the 90s, Manhattan prices fell 40% nominally and 60% when adjusted for inflation."
"If you need more evidence, then read 100 years of Commercial Real Estate prices in Manhattan:"
"If we extrapolate from history--and we do have 100 years of data--then we can expect Manhattan property (in the current bubble) --yes, every "prime" square inch of it--to decline 40% to 50% in nominal terms and from 50% to 60% in inflation-adjusted terms."
Charles Hugh Smith
Two of the greatest attractions of Galveston real estate, i.e. the availability of historic homes and commercial buildings, and the ability to build new homes on or near the water can become liabilities when economic conditions change. Historic homes can easily cost 20-30% more per year compared to new houses due to added utilities costs, maintenance, and complying with historic codes in some areas. Add in higher insurance rates for property on a barrier island, and the demand for such homes and commercial buildings can drop quickly as the extra funds needed to buy and maintain these treasures dry up in a severe economic decline.
There are already far fewer people who want to live in historic homes compared to those who want to live in newer houses, so as the cost differential becomes more important, demand will probably drop until prices fall enough to generate renewed interest.
For those who want to live outside of the City Center, in newer dwellings, on or near the water; costs are also much higher than on the Mainland. Land, construction, and insurance costs are all higher than in "safer" locations. The dream of a beach house is going to be beyond the reach of more and more people as the economy declines. The nature of the real estate available on Galveston Island that makes it so unique and desirable, in the best of times, may make it difficult to attract buyers in the new economic reality.
In short, Galveston real estate prices may defy gravity for awhile longer due to supply demand imbalances and federal assistance post-Ike, but the probabilities favor falling prices. If the next leg down in the stock market begins in the next few weeks, falling prices could be here sooner rather than later.
Obviously, most homeowners and real estate investors do not like falling prices, but there are some owners on this Island that hold properties for decades, and even for several generations, so they may appreciate the lower property taxes that falling prices would bring. Such an event would certainly motivate everyone to aggressively dispute the assessments on their properties. However, lower property tax collections would put a lot of pressure on the City budget.
Falling prices could also make it easier to build back the local population if prices drop far enough to entice more people to leave their suburban Mainland homes to become Island residents!
Although it is much easier and more comfortable to assume that real estate prices will keep rising indefinitely, everyone living, and investing in real estate, on Galveston Island needs to begin considering a scenario that includes falling prices. It's better to be prepared for the worst, and be pleasantly surprised if things turn out better than expected, than to be unprepared! This is especially true with regards to the City budget!
Recourse versus Non-Recourse States
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