In the Wake of the Real Estate Bubble

Our nation has just experienced an historic drop in the market value of real estate. The so called “Real Estate Bubble Bust” has wiped out trillions of dollars in perceived value in real estate and has resulted in a gross devaluation of both residential and commercial real estate. The vortex of price deflation has caused an escalating number of foreclosures that is unprecedented and has cast a pall over the fundamental U.S. economy. Many of the stop-gap and band-aid “relief” measures undertaken by Federal officials have proven to be wholly ineffective. The impact has been felt at every level of real estate investment in every region. While those areas that experienced the most rapid growth in the decade prior to the “bubble bust” have been hardest hit, even those areas where there was limited growth and much more moderate price increases have suffered as buyers have disappeared from the market amidst raised borrowing standards combined with a perception that real estate no longer represents a “positive investment in one’s future.”

The Phoenix/Maricopa County real estate market represents one of the epicenters of the current real estate value crisis. By virtue of the region having benefitted from one of the fastest growth rates in population in the decade prior to the bust combined with price appreciation of up to 20% per year, the market was ripe for a fall, and when the tide turned, prices dropped like a row of dominoes. As values continued to erode speculators bailed first, followed next by financially distressed homeowners unable to keep up with their interest only and adjustable rate mortgages amid falling wages and growing unemployment. These property owners have been followed by “strategic defaulters”, those individuals that could afford to continue their payments but are opting to walk away from their investments in light of the costs of keeping the property compared to the expected time required for the asset to appreciate to its former value. The availability of Arizona’s consumer/investor friendly anti-deficiency law, which essentially makes most real estate borrowing non-recourse, has made sacrificing one’s credit rating an attractive alternative to being saddled with hundreds of thousands of dollars of negative equity in an asset whose value appears to be falling with little prospect of recovery.

In many ways, the real estate bubble was a product of its own success. Real estate prices had proven to be fairly resilient over the course of modern history and long term investment in one’s home had proven to be the single largest, and most profitable investment, that most Americans made during their lifetime. However, the advent of new loan products such as “home equity” loans that allowed borrowers to borrow amounts in excess of the value of their property for such “investments” as credit card refinancing and vacation funding turned home ownership into America’s largest casino. More and more homeowners bet that rising home prices would “cover their losses” as they continued to “eat” their home investment by tapping into perceived equity. Mortgage brokers, home builders, appraisers, bankers, real estate agents and even the federal government (via no money down home ownership programs) all joined on the bandwagon while preaching the more you owed, the richer you were! No one wanted to admit the emperor was naked since we were all too intoxicated on the liquor of easy credit with no downpayment required.

As with the bursting of any bubble, the markets tend to over-react with the acceptance of the belief that Chicken Little may very well have been right, and the sky is really falling. For many investors and homeowners the analogy is indeed true, as their financial flooring has collapsed, and they have had their homes foreclosed and have been forced into bankruptcy to seek protection from their remaining creditors. This reality is reflected in the number of bankruptcy filings in Arizona where the pace of cases exceed 40,000 per year in 2009 & 2010. Many of these debtors have left multiple properties in their wakes which are being dumped on the market in numbers far exceeding the pool of available buyers. Banks, unable or unwilling to stem the rising tide of defaulting loans are delaying foreclosures in an effort to avoid being saddled with the costs associated with maintaining their real-estate owned inventory of housing. Vulture investors with available cash for immediate purchase of distressed properties are finding banks willing to unload properties for fractions of their prior value in an effort to move these properties off of their balance sheets. Federal bailout programs and guarantee programs provide incentives for banks to take their losses now and move on, but have done little to help distressed borrowers that want to remain in their homestead.

For many of us, when, and even if, the real estate market will make a comeback is difficult to predict. However, I firmly believe that real estate will make a full recovery, and in my estimation the issue is how long will it take to fully recover. Given the extent of federal borrowing to fund the various stimulus programs, the Federal Government will continue to issue trillions of dollars in federal debt to cover these costs. Since the besieged taxpayers are unlikely to accept significant tax increases and due to the difficulty if not impossibility of government curtailing spending, the only logical way out of this mess is to stop many of the government restraints on inflation so as to let inflation come roaring back. The benefit to the government is that it will be paying off its 2008-2010 debts with inflated dollars which will come at a cheaper cost. A resurgence of inflation will inflate underlying asset valuations which should reverse the downward spiral of real estate prices. Investors will seek to invest in hard assets such as real estate in order to keep pace with inflation. In some ways this may sound like “Bizarro World” where the federal government actually is courting inflation, but inevitably I believe this scenario will begin to play out in the very near future. Just like when the dam on Tempe Lake broke, and the beautiful lake disappeared over night, we may see a new albeit, like a new dam, slowly inflated so as to bring life back to a desert land. Stay tuned! JIM CARROLL

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