Wednesday, February 22, 2012

THE REAL ESTATE CRASH PART 3: History of the Bubble

Before I tell you what happened to that little house on Laurel Street that we bought in 2004 and frantically tried to sell at the end of  2005, I'm going to tell you a little about the history of the real estate bubble from my prospective.
Our Apartment house today, we don't own it now.  A mansion in 1890.

As I began this series of blogs, I said that in the 1890's  many Victorian Mansions were built. Most people could not live in a house of that size. Most people could not even live in a 2000 sq foot house. They couldn't pay for it. If you look in the older neighborhoods where houses were built clear up in to the early 1960's, you will see houses of about 1000 square feet to 1500 square feet.

But from about 1990 until the real estate crash all kinds of people were building and buying houses like those Victorian Mansions.

So how did we get so that so many people could afford a 2000 to 3000 square foot house?

Rob Painting the Apartment House - 1960's.
A doctor's home in the 1960's was a one story 2000 square foot home. That was after he had an established practice and had been working for 15 to 20 years. I know that because I used to tutor two doctor's children.

In the 1950's a family had to save for a down payment, usually for many years. Banks required from 20 to 30% down.

Real Estate prices are caused by supply and demand. If there are a lot of buyers, prices go up.

These are 2 bedroom 1 bath tract homes in 1949. Sold to GI's on the GI Bill. 

The most important item that kept houses small, and kept prices relatively low was that only the father and husband could get a loan. Also in the 1950's  banks red-lined (bankers drew red lines on maps in certain neighborhoods) certain areas that they would not loan in, usually minority neighborhoods. The banks thought that people in those areas were not good risks. Banks seldom loaned to minorities.

The GI bill was the first  step in the 60 year real estate boom. Returning World War II Veterans could buy one of these two bedroom homes above for $7000. and only about $200 down. They still had to save that down payment.  Minimum wage began in 1938 at 25 cents per hour. It was raised in 1950 to 75 cents per hour.

Slowly in the 1960's it became improper and  illegal for banks to discriminate against minorities or to red-line neighborhoods. That created a large influx of qualified buyers, greater demand, and prices began to rise. But not too quickly because a large number of homes also entered the market  from those red-lined neighborhoods, so the supply kept up with the demand.

Prices were still kept lower because not all the income of the household was counted.

Tom, Fixing a Floor in the 1960's.
Still, only the male head of the house was the qualifier. His wife didn't count and usually didn't even fill out an application.

Bankers began to see in the late 1970's that they could make more money if both husband and wife were added together to make a higher qualifying income. The loan could be bigger and the couple could afford a larger house. By the 1980's real estate prices really took off. They doubled, and tripled in only a few years, and the wife was locked into the market. She now had to work to keep making the payments on the home. That increased demand even more. As her income grew the families thought they could afford  larger and larger homes.

Then came the relaxation and liberalization of marriage, so that even an unmarried couple could have their incomes added to qualify.

1990's Tract homes sold with 5% down. Mansions in the 1890's. Mansions again.
Through most of this time the supply of houses and the demand did not match. More houses were wanted than could be built, so in the 1990's a great building boom began with the larger houses being built in neighborhood after neighborhood, and government regulation even required banks to lend to less and less qualified buyers.

By the middle of the 1990's it became the common thought that home prices just kept rising and would forever, like it was magic or something. Investors would buy a home only to try to sell it in a few months or years at a higher price. Flipping.

Flipping became popular, even having TV infomercials sell the idea over and over.

There was no worry. For fifty years home prices kept rising, rising and rising.  Why would they ever stop rising? It became a world wide custom, part of our culture. It was popular belief and almost everyone believed it. A home became an investment, not a place to live because the price would always go up.

After only a few years of ownership, without even an appraisal, a homeowner could get a second mortgage for as much as he paid for the house. People ran out and bought all kinds of stuff. Some bought more, and more homes, pressuring the market to rise more and more.

Real estate agents pushed houses on investors who couldn't even hammer a nail, women who had never changed a toilet, and younger and younger families, who had never had to repair even a broken window.

Working on a Fence in the 70's
Loans were so liberal that a couple who had little investment in each other, no marriage, only a few months together and even minimum wage jobs could buy the same small house that their grandparents had to save, and save, and save for the down payment. They could get 105% of the selling price loaned to them with  only a $1000 down payment, and that only a deposit that real estate agents convinced sellers should be returned if the buyer didn't go through with the deal.

Absolutely no buyer responsibility.

So much demand. We know people who had to create a resume, like for employment, that they would present with their down payment and offer, so they could be considered for a home because there were so many buyers. That was 2004, 2005 and 2006.

Then some of the short term loans began to come due. Banks had sold mortgages in bundles all over the world, and investors bought them up with the same zeal that home buyers were buying, except that an investor didn't just buy one mortgage, he bought parts of many. Real estate would never stop going up they thought, so the belief was that there was no risk.

It was like real estate was on cocaine. The economy had an addiction  for rising real estate prices.

Supply and demand were finally balanced, but the loans demanded that prices keep rising. Some loans had to be refinanced, but because the property hadn't risen in value, the equity was not there. The owner could not refinance, and he could not pay the balloon payment at the end of the mortgage, so the foreclosures began.

The balancing point  actually hit  about the end of 2005, just when I was trying to sell my little house. I saw it and finally realized what was happening.

A crash was coming. It did and prices dropped, they are still dropping. Government officials, financial writers and real estate agents still believe that real estate is only in a slump. Don't believe it.

I just read today, February 22, 2012, that home sales were the highest in 1 1/2 years. Don't believe that indicates home prices are rising again.

It only means  the number of home sales has risen. since one and one half years ago. That's because the prices are still dropping and investors, and home buyers think they will rise again, or they want a home to live in. There cannot be an increase in demand because so many buyers are permanently out of the market. They never could afford to own a home in the first place, and the market finally realized it.

At the end of the article Lucia Mutikani says, "Distressed properties, foreclosures and short sales, which typically occur at deep discounts, accounted for 35 percent of overall sales last month, up from 32 percent in December."

Our Little Rental 2012 - Now
So today, almost six years after we began trying to sell our little house, sales are still motivated by what financial writers call deep discounts. I don't think so, not discounts. A discount is a price lower than the regular price. Then after the discount the price goes back up.

I think real estate prices are still reaching their real bottom  prices, not "discount" prices. Or in other words one third of the sales were because of extremely low prices compared with the peak of the boom. 

Few people have realized that the peak of the boom was actually an addiction high. An addiction to continually rising real estate prices by the entire real estate market.

I'll tell you more about that in the next edition and how we  finally came out on that little house  sale.

Monday, February 20, 2012

50 Years Ago Today: John Glenn, First American to Orbit the Earth

Fifty years ago today, on February 20, 1962,  I was in Orick, California picking up dry cleaning on a dry cleaning route. Three days per week,  I went from Eureka to Orick, picked up the dry cleaning from homes and businesses and returned it the next trip.

I drove up to a restaurant in my blue Volkswagen bus where I usually picked up some cleaning. There were all kinds of cars and pickups around the place, and some men inside yelling.

"What's going on," I thought, then remembered. John Glenn was scheduled to circle the earth  on this day, but it was too crowded for me to go in. I didn't know his name then. I paused and sat in the car for a few minutes, then left and continued on the route.

The United States was behind in the space race. A Russian had already circled the earth.
Dorothy, me, Theresa & Robby around 1962

I watched as these things happened, but was too busy trying to make enough to live on to get too involved. I had dropped out of College a few months before. It took me all winter driving around picking up dry cleaning to realize that it was a dead end job.

There was a recession going on in Humboldt County, but in the spring of 1962 I began  training to be a banker at Bank of America. When I decided that I needed a better job, I started stopping every Tuesday and Thursday at the bank in Arcata. I went in to see the manager. The first time he said there were no jobs, "There's a recession now. Come back later."

Grandma Shoemaker, Tommy, Robby, Theresa and Grandpa Shoemaker
I went back at least once every week. I realize now that the manager meant in five or six months, but I kept going in and seeing him. After a few weeks he said, "We do have a training program," so I worked for awhile for $300 per month at the first level of training which was a bank teller.

It wasn't long before I realized that banking wasn't for me. A guy came in and cashed his check. He had worked a double shift and was very tired. At the end of the day I was balancing my cash and discovered I was $500 short. After about two hours of checking and rechecking I discovered it was that guy who had worked a double shift. He lived in Blue Lake. I had given him $500 too much in change. His check was for something like $3000. which was a lot of money in those days, probably $30,000  in today's money. I called him, and he came right in and brought me back the $500.

 "Whew, that was really close," I thought. There was probably no way the bank could have gotten their money back, and in those days the teller had to make up everything over 50 cents.

I decided to look for another job.

We lived at Freshwater in our second purchased home. Dorothy was 19 and I would be 21 in a few days. We had three children.

Tuesday, February 14, 2012


We had listed our little two bedroom house, had one offer and it fell through. But our real estate agent said we'll get another offer. We had bought it only two years before for $65,000 and our last offer was $154,000. I was certain that the property was not worth that much because I could only rent it for $500 per month.

I took these pictures today, Feb. 14, 2012
Now my tenants had moved out, leaving us with a $600 loss per month, plus the taxes and the insurance and any maintenance.

There was going to be more maintenance. I was sure of that.

This was January of 2006. Real estate prices were way too high. I was sure of this because every where I looked, rental prices were still less than my estimates of what the payments were. A lot less.

Real estate value and real estate prices are two different things. Real estate is a commodity that fluctuates with supply and demand. The price can go way higher than the value. The value is what it is actually worth to an individual. Most people cannot tell the difference.

I always calculate the value of a piece of property as the amount about 100 times the actual monthly rent that I can get from the property. That is not the way real estate appraisers value a property. They hardly take into account the amount of rent that is paid. In fact they often discount it completely.

Appraisers only count the supply and demand. As far as appraisers are concerned the amount of rent has little to do with the appraised value. They are only looking at what it will sell for in the market at that specific time.  So an appraiser can be way off of the  real value.

That is  reason number one for the crash.

So if you live in a home that, let's say you pay $1300 per month payments including the taxes and the insurance, my value for that property could be no more than $130,000, but if you could only rent it for $900 per month then the value to me could not be more than $90,000.

But I would never pay you $90,000 for your property unless you gave it to me with no down payment and  only a $600 per month payment. I would rather pay you $60,000.

That's because I already made the mistake of buying a $50,000 property for $64,000 which I now had to get rid of quickly because I felt the market was beginning to drop.

I had these rules up to about 2004 when I decided to buy that little piece of property.  I was actually anxious to buy it, nervous that I would miss getting a piece of property when prices were rising so quickly. That's a dangerous sign. It means I was being influenced by the speculation of the times.

It was  the only property I ever had put a relatively large down payment on. Almost all, if not all, of other purchases were for almost nothing down, but this time I did it. I put $16,000 down.

This is the back view.
That means that our $500 payment that we were making was on about $49,000 which did meet my rules, except that I had put that $16,000 down, but my value was about 100 times what I owed. I thought of it as a lost down payment and felt okay, especially since prices still seemed to be rising in 2004. At least I could almost make the payment from the rent.

The first rule of investing is to never count on appreciation for profit or protection against loss.

That is reason number 2 for the crash.

People were depending on appreciation to actually make their payments on their homes. They were thinking of their homes as an investment, and they would buy a large home with little or no down payment and a monthly payment that would only remain the same  for about five to seven years, if...... if the interest rates remained the same.

"It's all right," they thought. "We can always sell it for higher, or refinance it."

We have all been lucky about the interest rates. Interest rates have remained stable or have even dropped. But that has been forced by the government printing money, trying to stave off a real disaster.

After the five to seven years their loans had a clause that they needed to either pay a large lump sum or refinance it. Every one thought they could refinance their homes.

Study this current, February 14, 2012 description of the little piece of property that I've been telling you about (below) from an online company, and in my next post I'll tell you the rest of the story.

But if you'll notice, I think their estimate of the rent is still way too high.  I think it would only rent for $500 still today.

Sunday, February 12, 2012

The Real Estate Crash

The real estate crash was a giant bubble that began many years ago. It wasn't a business cycle.

Real Estate can't "recover."

I could never understand why in the late 1800's clear up until the 1970's, working people usually bought no more than one three bedroom home that was around 1000 to 1200 square feet, then all of a sudden they started buying what would be the same as an 1890's Victorian mansion.

The Apartment House today from Google Street View.
Dorothy and I  grew up in Eureka, California, an area with most of the houses as small or smaller than those I mentioned. Downtown there were many Victorian mansions, but most of them had been built in the 1890's and converted to apartment houses. We actually owned one of them. We called it, with originality: "The Apartment House," which is what I will call it throughout this blog.

It is no bigger than some of  the single family homes built  now in large tracts throughout California, built from 1990 to 2006, yet few people in Eureka could afford to live in a home the size of the Apartment House in earlier times.

How did all those relatively modest income folks from 1990 to 2006 get to live in mansions and get on the road to owning them?

Tom, on the same porch above in the 1960's.
Dorothy and I have been buying, renting, and sometimes selling real estate since 1959, when we bought our first home. Over the years we have owned a total of forty-two rental and owner occupied units. In Eureka, California we owned ten, in Sacramento, 12, in Clarksburg, 10 and in the area we live in now ten. We have sold all but those ten we have right now, but I have been studying the real estate market from the inside, and it is clear that making money in real estate traditionally is not about buying and selling it, and it never was.

The whole world believed that you could buy a piece of real estate, work  on it a little  and then "flip" it for a good profit. This was dreaming while awake, and it worked for awhile because so many people began to believe it. So many people world-wide confused speculation with real investment.

Speculation builds bubbles. And bubbles always pop.

In 2004 we bought a little two bedroom house for $64,000. I thought that the price was too high, but it was still  close to the price that could make money by renting it, if one had the patience to only make one's money on the equity and slowly wait for inflation to bring the rent higher, but the entire real estate market was expanding itself rapidly inside that bubble, not caring if rents would make money.

The Apartment House about 1973. We were painting it.
A bubble is speculation gone wild. It is not real. It could not continue because even that little two bedroom house was too expensive for most of the people who live in its neighborhood. I had to rent the house for a little less than the payment. By the time the taxes were paid and the maintenance done it cost us about $100 per month to be the landlords.

That means that every month $100 goes into a hole and is hard to get back out. If I raised the rent to try to get that $100 back, no one would rent it. And this was happening when real estate was almost at it's peak, in 2005 and 2006.

"How?" I thought, "How can these people be buying these houses when they don't make enough to pay the rent?" They don't even think about the maintenance, or the taxes, or the insurance, so how can they imagine they can pay for these houses?

I drove through near-by neighborhoods where rows and rows  of giant 18th century mansions were being built (they looked the same to me), and those mansions were apparently being sold.

It just didn't make any sense to me.

News pundits, even now,  keep talking about when real estate is going to recover. How can it recover when it never got really sick? It isn't sick. It was high. It was the same as a junkie who spent twenty years on cocaine and finally realizes that he has to get off of it. He goes into a depression. Those highs weren't real. Real estate never should have gotten as high as it was. So it's not going to recover. People are just going to finally realize that you can't make money in real estate in two years, and your home is a place to live in, not a way to make a lot of easy money. Real estate is a long term commitment.

Me. Fixing a ceiling in the 1970's.
I decided I had to sell that little house. And I had to do it quickly, because it was becoming scary for me to keep it. The price of everything was going up, but rents were not, especially for 100  year old little tiny houses. My tenants were struggling to pay their $500 rent each month.

So I listed the house with what looked like a prosperous real estate broker. She was pretty, with high heels, glamorous make-up, big eyelashes, low cut blouse,  and a large friendly smile.

"I think somewhere around $100,000 would be a reasonable  listing price," I said. "It's only been two years since I bought it and that would make something around a $35,000 profit." I thought this was a high price.

"What!," she retorted. "We'll list it for $170,000. We can add all of the costs, repairs and everything to the cost, and it will be covered in the loan."

"We can what?" I said, "How can we add anything to the price?" I said.

"The bank will cover $105% of the selling price," she said.

"That seems illegal," I thought, but I signed the listing papers, unconsciously counting my profit.. It was November 28, 2005.

About two days later, she called.

"We've got an offer for $154,000, and I have a deposit." I still thought it was only worth about $100,000, if that. Really it wasn't worth more than I paid for it because I could only rent it for $500 per month.

I scrambled down to the real estate office and signed the offer, and the property was put into escrow. By December 27, 2005, all the documents were filed and it looked like it was sold.
We waited for the buyer's loan to clear. It was January, 2006. Then the buyer wanted her deposit back, because she couldn't get the loan. The real estate agent said we should give her back her deposit.

I said, "No! Why have a deposit if you just give it back?"

"That's the custom," she said.

"I don't like the customs now." I said, and I thought,  "Something is all out of whack."

I insisted, so we kept the deposit, but my tenants moved out because I had told them the property was sold. Now instead of just loosing $100 per month, we were losing $600, and we couldn't re-rent the property, because no one wanted to move in and then just be told to move back out.