The housing market in California is splintering into various broken segments. In one area, you have lower priced beaten down homes flying off the market like pancakes. Yet in these areas, you have to wonder what will happen once the major discounts and inventory run out? Next, you have mid-priced areas that are selling in low numbers but at relatively stable prices. This is the next market to tank because of the large amount of Alt-A and Pay Option ARMs hovering in those markets. These areas had a stronger buffer because of the structure of the mortgages but make no mistake, they will be coming down. And finally, you have the higher priced regions stalling out.

What we have here is the systematic dismantling of a decade long housing bubble. It would be great if we could predict with pinpoint precision how each market would unravel or when the bottom will be reached but when bubbles burst, they usually are messy. From some of the analysis I have put together for California, we will not be seeing any sign of a bottom until 2011. I have been making this argument for nearly a year and now we’re now seeing the story picked up by others:

“(The Press Democrat) Over the next three years, about two-thirds of the Alt-A borrowers in Sonoma County will see their payments jump sharply, according to First American CoreLogic. The trend will peak in the summer of 2011, the research firm projects.”

The next major story that is largely being underreported is that of the Alt-A mortgage market. Why this applies so directly to California is that over 50 percent of the $469 billion in toxic Alt-A mortgages are here in the state. The major problem of course is many of these Alt-A products are Pay Option ARMs that allowed borrowers to make minimum payments that negatively amortized and many now find themselves with higher balances in a state that has seen the median price fall by 50 percent in one year.

We’ve been hearing how the market is split up into many fragments yet how does this really look in practice? Today I want to give you three homes currently on the market in three very different cities here in Los Angeles County. The purpose is to put an actual face on the three markets currently dominating California real estate. We will look at the low, mid, and upper priced housing markets all within a thirty-mile radius.

Lower Priced Range – Compton

Compton California has witnessed each side of the housing bubble. During the boom, some homes in Compton were selling for $450,000 with only three bedrooms. Those days are now long gone. Our example home above comes from a zip code that has a median price of $137,000. This median price is a stunning 60 percent drop from only a year ago. Yet Compton is actually seeing homes sell. For all three zip codes in the city of Compton we saw 84 homes sell in the month of April.

The above home is 828 square feet and has 3 bedrooms and 1 bath. This home has been on the market for 404 days. Its pricing history offers us a glimpse into the subprime bubble boom and bust:

At the peak, this home sold for $310,000 so the current list price is 71 percent below the top market price. The current psychology of the market is such that people are saying, “what in the world were people thinking?” Yet that psychological thought normally stops in the lower price range. The same economic fundamentals apply to the mid-priced and upper-priced ranges yet people still have not come to terms with this reality for the higher priced areas. The Alt-A implosion will make this abundantly clear at the end of 2009 and into 2010.

So why are homes selling in areas like Compton? Because the price is starting to make sense for some. Take this home for example. Say you were an investor. For an investment property loan, all you need is 25 percent down. Let us run the numbers:

Sale Price: $89,000

Down payment: $22,500

Mortgage: $66,500

PITI: $490 (assuming 30 year fixed at 6 percent)

The going rents in this area are roughly $700 to $800 for a place like this. This would make total sense for investors right? Well that depends. First, you need to realize that unemployment in the state is at a record 11 percent and growing. Some areas are taking the brunt of the economic storm much deeper. Compton has a median household income of $30,000 so a family would actually be okay buying this place. Some counties in California are seeing unemployment rates rivaling those of the Great Depression:

CA Counties: Unemployment Rate

Imperial: 26.9%

Sierra: 17.9%

Stanislaus: 16.8%

Sutter: 18.5%

San Joaquin: 15.6%

Colusa: 19.1%

Plus, not many people have $22,500 laying around. Many investors do and as we know, many current buyers at the lower end are investors. This place lists that it needs some “TLC” so it is hard to say how much additional capital is needed to get it rent ready. Either way, this is a perfect example of what is moving at a brisk pace in this current market.

Mid-Priced Range – Mar Vista

Our next home takes us to the Mar Vista community in L.A. Many people in the Westside, especially professionals look at Mar Vista as a starter home location. Yet the starter home was largely out of reach for many professionals. This is where the Alt-A mortgage products stepped in to fill the gap. A $2,000 mortgage payment sure sounds a lot better than a $4,000 mortgage. Plus, by the time you need to sell in 2 or 3 years, the home would be worth so much more that you wouldn’t need to worry about those nasty toxic mortgage recast payment shocks. That is, until the appreciation party stopped.

This above home is something that we will be seeing a lot of in the next 6 to 18 months. The above home is a 958 square foot home with 3 bedrooms and 1.75 baths. The location is the Palms, Mar Vista community of L.A. This home has been on the market for 16 days and we have already seen one price reduction from $625,000. The current asking price is $599,000.

Now I pulled up tax data for the current area and the median household income is approximately $82,000. So let us run the numbers for someone looking to buy this home today:

Sale Price: $599,000

Down payment: $119,800

Mortgage: $479,200

PITI: $3,269 (30 year at 5.25%)

So what is the take home for a household income for someone making $82,000?

As a rule of thumb, you shouldn’t spend more than one-third of your gross monthly pay on your total home payment. So if your gross household income is $82,000, your top monthly payment should be at $2,277. That is why this rule works with the Compton home above. The take home gross of $30,000 per month is $2,500 so they can take on an $833 monthly payment. In some ways, the numbers are starting to workout at the lower end but are completely out of whack in the mid to upper range. Because of the Alt-A mortgages in these areas, many sellers are hoping to snag another buyer so they can exit. Yet as you can see from running the numbers, it simply does not make sense. In fact, you can work yourself backwards from the actual PITI to see what income would need to support this home:

PITI: $3,269 x 3 = $9,807 or $117,684 / annually

This is where the major disconnect occurs. Ironically, the subprime product actually had a usage in the market. It was designed for those with a poor credit history to buy a home with a much higher rate. Now I disagree with subprime loans merely because they were pumped out by unscrupulous lenders but they had a much cleaner design than toxic junk superhero Alt-A mortgage products. The Alt-A mortgage was purely a mortgage designed to operate in a bubble. It was crafted for continuously booming home appreciation. It was never meant to be a long-term mortgage. It had a life expectancy of 3 to 5 years for the most part (aside from Wachovia’s horrendous 10-year Pick-A-Pay craptasic loans).

The bottom line is the mid-range market cannot move at a brisk pace without these toxic mortgages reemerging. The reason sales are falling in these areas is because no fool is willing to pay the higher price. Sure, you’ll have your handful of sales each month but this will largely be gone in the upcoming months with the tsunami of notice of defaults that hit us in Q1 of 2009. This assures us more inventory for the next year. While the lower end is flushing out inventory with sales, the mid to upper range sells a handful of homes while a pipeline is simply building up.

For example, in our area above 13 homes sold in April and prices are off by 28 percent on a year over year basis. As you can see from our basic math, some sellers are pricing home at bubble level prices. Until prices fall back in line with local family incomes, this housing downturn will continue to unfold in California.

Upper Priced Range – Santa Monica

Our final stop takes us to a prime location in the Westside, Santa Monica. Now you need to realize that these areas will always have more buyers than sellers simply because they are in niche locations in very desirable areas of L.A. County. But that doesn’t mean prices won’t fall. Before I discuss the home above, let us look at the pricing action:

Now as you can tell from the above, even in Santa Monica sellers are having to drop their asking price. This 4 bedroom and 3 baths home is selling for $1,395,000. It is 1,923 square feet in a desirable area. Now Santa Monica has very unique income statistics:

Now let us first run the numbers on this home to see what income is needed to support this house payment:

Sale Price: $1,395,000

Down payment: $279,000

Mortgage: $1,111,600

PITI: $8,001 (30 year fixed jumbo 6.25% and 20% down payment)

Now using our 3 times rule we get:

$8,001 x 3 = $24,003 or $288,046 / annually

Take a look at the income stats above. Of the 45,843 households that currently live in Santa Monica, only 12.8% make over $200,000. With this home, we need an annual household income of nearly $300,000. Here again you see the major discrepancy of the current California market.

Investors buy homes for a few reasons. You buy for what many call “CAT” – cash flow, appreciation, and taxes. In many other states, investors like myself buy for cash flow where you can buy a home and get it rented and the tenant will cover your mortgage payment and expenses. This is something unseen in California for over a decade. We are now seeing a few homes like in Compton and the Inland Empire that are cash flowing. Yet many of these out of state properties will never appreciate like homes in California. The final reason is for the tax benefit.

Now you need to remember for this entire decade 90+ percent of California investors bought for appreciation. No one really cared about the cash flow and the tax benefits never came into the equation because many were selling properties off in a short period. Now what happens when you have the opposite of appreciation and prices still remain stubbornly high? You get our current market. Yet the lower end was like this in early 2008 and look at where it is now. The mid range will show significant signs of weakness later this year and finally, you will see drops at the upper range. With our state budget in a mess and more cuts coming, there is no reason to believe the “A” from appreciation will be coming back anytime soon.

Did You Enjoy The Post? Subscribe to Dr. Housing Bubble’s Blog to get updated housing commentary, analysis, and information.