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New Homes Sales, Market Slowdowns, and Investor Irrationality: Looks like its Time to Face a Correction

Tanking new homes sells should have real estate flippers and small investors worried. Today KB Homes reported a loss of $149 Million. Additionally, CEO Jeffrey Mezger remarked in the Wall Street Journal, “We can’t predict when market conditions will improve,” essentially ensuring investors conditions will not improve next quarter. Homebuilders have been feeling the pinch for over a year now, but it is finally getting serious.

Surface level analysis of the problems with homebuilders points to signs of a tanking real estate market and excess supply of new homes in some markets. Given the choice between a new home and a “used” home, most consumers will choose the new one. Additionally, homebuilders have the power to offer incentives like upgrades, favorable financing, and lower prices to move their inventory. Investors in hot markets that are cooling will find it hard to compete with institutions like KB Homes, Toll Brothers, Lennar, etc. This will make it tough to move, even the nicest flip.

Furthermore, this situation definitely signals a slowing in the real estate market. Despite what many have been saying on the Realtor/NAR front, investors and agents alike should be preparing for a real estate slow down. KB Homes sites access to capital as one of the mitigating factors affecting home buyers among other factors. This access issue will affect buyers, as well as more aggressive investors, who opted for no money down loans.

The deeper analysis suggests all of the negative news will eventually affect the market sentiment on real estate. Over the past six months the real estate market has seen the collapse of the subprime real estate market, issues with commercial and investment banks, mortgage rates rise, and issues with homebuilders. At some point investor and consumer confidence in real estate has to be affected by all of this news. While this news may not be the tipping point, investors should be asking how much more can the market take?

Investing is part fundamental and part irrational. At times the market seems to go 90/10 one way, and at times those proportions flip. As more negative real estate news emerges and as fundamentals weaken, the market has a tendency to overreact. These overreactions create great investment opportunities; however, it’s never fun to be on the downside of irrationality.

In part this is why the National Association of Realtors constantly insists on being up beat about the real estate market. It’s in everyone’s best interest to think happy thoughts about real estate despite the change in fundamentals. As an investor I would love to keep the market up as long as I can, but at some point all this negative news will turn investors and consumer sentiment negative. When it does, investors need to be prepared to react quickly. This could mean lowering rents, becoming more opportunistic, raising investment standards, or simply taking some time out of the market. Planning for a softer market now could save investors a lot of future headache.

Related posts:
  • At last, the truth…
  • Market-Basket of Homes: Values up 0.33% in June
  • Silver Lining of Real Estate Market Correction Hiding In Plain Sight

  • 8 comments

    8 Comments so far

    1. Robert Kerr June 28th, 2007 12:57 pm

      Excellent posting, Michael.

      RE: “Looks like its Time to Face a Correction”

      Don’t count on that. There seems to be quite a backlog of unsold optimism still out there.

      Amazingly, U.S. analysts have been ignoring the red flags for a full year now, even the $3B Bear Stearns subprime bailout didn’t cause any eyebrows to be raised.

      Just this week, BIS publicly warned of the possibility of a global depression from the current credit glut, but no one seems to be paying attention.

      It’s surreal.

    2. Rob Green June 28th, 2007 3:29 pm

      I agree that nationally things are on the downward trend. However, there are still pockets of real estate values that are climbing at double-digit rates. Utah real estate values have continued to climb near 17% in some cases. It appears as if we are the “osmotic center” for the rest of the nation.

      What concerns me though is that the national trend doesn’t just seem to be a regular cooling down in the market. The failure of the subprime lending arena I think adds a much larger anchor to a slowly sinking ship. I am concerned that even in the remaining few “hot markets”, the foreclosure rate will be exacerbated by this problem and the cool in the market will last much longer than the normal downturn in the real estate cycle.

      Does anyone have any good sources to cite in regards to this potential problem?

    3. Chuchundra June 28th, 2007 3:29 pm

      As some looking at the RE market from the perspective of a prospective buyer, I can say that seller optimism about pricing knows no bounds. I look at the MLS listings for my area of interest almost every day and I just have to shake my head at some of the prices I see listed.

      I’ve even started a blog to document the process, since I expect that, if I’m waiting on the sellers to get the reality of the situation, I’m going to be waiting for some time to come.

    4. winjr June 28th, 2007 8:14 pm

      “The deeper analysis suggests all of the negative news will eventually affect the market sentiment on real estate.”

      A superficial analysis suggests that market fundamentals have already deteriorated, with more to come. National inventory of existing homes is 4.43 million, an all-time high. Months of inventory is 8.9, highest since 1984, which means it’s worse than even the recessionary early ’90′s. YOY sales have been declining for 17 months straight.

      Dude, this market has already started its descent on the downside of rationality.

      Reading this post reminds me the saying, paraphrased: “If you’re sitting at the poker table, and you don’t know who the sucker is … you’re the sucker.”

    5. Michael Cook June 28th, 2007 9:23 pm

      Winjr,

      While you put some interesting stats out there, there are clear counterpoints to your statements. Look at the strength of the commercial real estate market and the strength of funding private equity has been receiving (though even this is starting to crack). Additionally, a fairly good job market also keeps people optimistic.
      I am certainly not saying I think the people pointing to the above factors are right, but they are trying to make a case to keep real estate afloat.
      The “sucker” comment could be quite applicable in a few months (perhaps even now?).

    6. winjr June 29th, 2007 8:44 pm

      “Look at the strength of the commercial real estate market and the strength of funding private equity has been receiving (though even this is starting to crack).”

      Unfortunately, commercial real estate construction tends to follow residential, with a lag. After all, who needs another shopping mall in Maricopa County when 50 homes enter the foreclosure process every day?

      http://tinyurl.com/3bw32n
      (Graph courtesy Calculated Risk)

      The quarterly GDP stats issued at bea.gov show a trend in commercial real estate that isn’t one I’d be relying on if arguing that the real estate market is peachy-keen. Here’s the rundown on fixed commercial real estate investment for the last 4 quarters:

      06Q2 – +20.3%
      06Q3 – +15.7%
      06Q4 – +00.8%
      07Q1 – +04.8%

      And, of course, fixed residential investment has been a nightmare, as we’re all aware:

      06Q2 – -11.1%
      06Q3 – -18.7%
      06Q4 – -19.8%
      07Q1 – -15.8%

      And who here doesn’t think that commercial real estate lending standards weren’t loosened up just a tad in the last 5 years? When the spreads on bonds backed by commercial mortgages start to blow out, and they will, the commercial sector will slow even more.

      Why do you think Sam Zell sold out?

      If you’re arguing that those with a vested interest in keeping real estate values at present levels do their level best to cheerlead their market, I have no quarrel with you. But if you’re positing that “negative news” (which is, after all, a number slope that just keeps pointing down) WILL lead to a softening of the market, I’d say your position isn’t rational. The market already has softened, substantially, and the numbers don’t provide much room to insist that matters won’t worsen.

      “The “sucker” comment could be quite applicable in a few months (perhaps even now?).”

      Absolutely now, and probably a good number of months ago. Just ask anybody trying to unload just about anything that’s been purchased since 2005.

    7. Chris June 29th, 2007 9:09 pm

      My thought is, so what? The market goes up and comes down. If you plan on being in real estate a long time you will see many different markets. As for this market when and where it bottoms is anyones guess, but it will, then it will come back.

      The real queston should be, how will this affect your business? How will you use this to your advantage?

      Remember “Buy when blood is running in the streets”

      I smell blood…

    8. Robin July 5th, 2007 10:20 am

      In Vero Beach Florida, about half of the number of units in our neighborhood, Pointe West, are vacant, corporate-owned, or are in pre-foreclosure or foreclosure. Most of the vacant or foreclosed homes are KB Homes. According to a local realtor, KB marketed the homes to a list of house-flippers, and when the homes were sold, KB packed up and skipped town. Now the vacant homes are sitting with construction problems. I rented one and found the sewage draining onto the sidewalk a few days after the we moved in. Because the home sat vacant for more than a year, it was no longer on warranty after KB split. The county had to repair the sewage problem. It amazes me the number of vacant homes in this community. After four months of happy renting, we were served with foreclosure papers. Now we have to move and the owner wants us to move within a week or two so he and his realtor can short sell the house. I told them we have rights and can remain up until the time the new owner closes on the property. The market in Florida is so bad right now I think even at the great price it’s being offered, it still won’t sell. This situation has made a lot of people into losers. Sad