Much has been written about the “Lost Decade” in the Japanese economy. In the 90s they faced the same decisions we face today, and we appear to be making the same mistakes.

Today’s featured property is a condo being offered for 55% off its peak purchase price; a new record for Irvine. It is our first 2001 price rollback.

Asking Price: $149,900

Address: 76 Lakepines, Irvine, CA 92620

{book1}

Turning Japanese — The Vapors

I think I’m turning Japanese

I really think so

Japan simultaneously inflated massive financial bubbles in real estate and stocks during the late 1980s. The slow deflation of this bubble and the general economic malaise that impacted Japan during the years that followed became known as the “Lost Decade.” The United States is facing a similar set of circumstances in the aftermath of the Great Housing Bubble. So far, we have been following the same policy actions as the Japanese did. Perhaps our officials have come to believe a Lost Decade is preferable to the next Great Depression.

Today, I want to demonstrate how easy it would be to have a similar result in our own housing market. By lowering interest rates to artificially low levels, the Federal Reserve hopes to stabilize the housing market; however, weaning the housing market off these subsidies will need to be a slow process to prevent real estate prices from taking another nosedive. Gradually increasing interest rates back to long-term norms will result in an erosion of buying power that prevents price appreciation. I want to be clear about the implications of this; we are not looking at a decade to get back to peak prices, we are looking at a decade of stagnate prices at the bottom. Real estate will not reach peak prices until 2032.

The Lost Decade

The chart above shows median home prices in Irvine stabilizing at

$450,000 in 2010 as interest rates bottom at 4.5%. To calculate a median home price, I needed to make assumptions about incomes, allowable debt-to-income ratios and interest rates.

The example above uses the most recent Irvine Median Household Income Data. At the end of 2007, the median household income in Irvine was $91,101. Due to the recession, I have assumed this will also be the median household income at the end of 2009. It might be higher; it might be lower. The historic rate of income growth between 1980 and 2007 is 3.6%. I assume that median household income will again increase at this rate starting in 2010. By 2019, this figure reaches $129,500.

The recent bailout legislation passed by Congress is a combination of workouts and government buy-downs to get borrowers debt-to-income ratios down to 31%. Previous bailouts failed because they only got the borrowers debt-to-income ratios down to 38%. The FHA has long term records showing 31% is as high as this ratio can go without significant increases in defaults. I have assumed debt-to-income ratios will be limited to 31% going forward. Also, I have assumed 30-year fixed-rate conventional financing; exotic financing will not be coming back any time soon.

The Federal Reserve’s policy of “quantitative easing” (aka printing money), is an attempt to drive down long-term interest rates like those for home mortgages. If the FED is successful–and for the short term they probably will be–mortgage interest rates could drop as low as 4.5%. The average interest rate since the early 1970s when the GSEs started keeping records is 8% (7.99% actually). I further assumed interest rates will rise once this economic crisis is over from an unprecedented 4.5% to the long term average of 8%.

I used Microsoft Excels handy solver tool to calculate the interest rate required to keep prices stable while incomes grew. The interest rate chart above shows interest rates going up about 35 basis points a year for 10 years. This puts interest rates back to historic norms of 8%. If interest rates can be eased upward at this controlled rate, and if incomes rise again at their historic 3.6%, prices will stabilize at $450,000 in 2009, and they will stay there for 10 years. After 2019, incomes have caught up with 8% interest rates, and prices begin to appreciate at 3.6% a year to match income growth.

In my opinion, this is a realistic outcome. Eventually interest rates have to go back up. When this crisis is over, the money the FED is printing will cause inflation to return. The Federal Reserve will need to raise interest rates to control inflation. If they do this too quickly, it would take the floor out from under home prices, and despite a high level of general price inflation in the economy, house prices would resume their descent.

When you look at these charts collectively, it suggests the Federal Reserve may allow inflation at levels higher than what is normally desirable for several years after this crisis is over. This will help the Federal Government inflate away much of the debt it is taking on with its stimulus spending, and it will keep a floor under asset prices, particularly housing. Note that asset prices will not be increasing. The consumer price index may increase significantly, but house prices will not budge. Also when you consider the impact of the long-term foreclosure crisis in real estate due to the resetting of adjustable rate mortgages, the FED has incentive to keep rates as low as possible for as long as possible, and house prices have resistance to upward movement.

It is difficult to be bullish with these market conditions. How exactly

would prices go up? Will interest rates stay at 4.5% permanently?

People can only increase their bids if lenders give

them the opportunity. Rising incomes provides the ability to bid prices

higher, but only at the rate of rising incomes. The long-term average

is 3.6 %, not exactly rampant appreciation.

them the opportunity. Rising incomes provides the ability to bid prices higher, but only at the rate of rising incomes. The long-term average is 3.6 %, not exactly rampant appreciation. Another way people can

raise bids is if they increase their debt-to-income ratio, and lenders

must allow this in their underwriting. With the history of defaults

with DTIs over 31%, it doesn’t seem likely that lenders will be

relaxing this parameter any time soon.

raise bids is if they increase their debt-to-income ratio, and lenders must allow this in their underwriting. With the history of defaults with DTIs over 31%, it doesn’t seem likely that lenders will be relaxing this parameter any time soon. Another way buyers can raise

their bids is through using exotic financing; we all know how that

turned out last time. I don’t see Option ARMs going to Subprime borrowers without verified income happening again, do you?

their bids is through using exotic financing; we all know how that turned out last time. I don’t see Option ARMs going to Subprime borrowers without verified income happening again, do you? The final way people can raise their bids is to

settle for less. Personally, I will not buy a tiny 1/1 condo like today’s

featured property when I can rent a nice 3/2 SFD.

If my assumptions are correct, and if events unfold as I have outlined, prices will bottom over the next couple of years, and they will stay there for a decade while both incomes and interest rates slowly increase. The “Lost Decade” that the Japanese experienced is not just realistic, it is perhaps a best-case outcome.

{book}

Asking Price: $149,900

Income Requirement: $37,475

Downpayment Needed: $29,980

Monthly Equity Burn: $1,249

Purchase Price: $322,000

Purchase Date: 7/12/2005

Address: 76 Lakepines, Irvine, CA 92620

Beds: 1 Baths: 1 Sq. Ft.: 932 $/Sq. Ft.: $161 Lot Size: 763 Sq. Ft. Property Type: Condominium Style: Townhouse Year Built: 1977 Stories: 2 Floor: 1 View: Creek/Stream Area: Northwood County: Orange MLS#: P658271 Source: SoCalMLS Status: Active On Redfin: 173 days Unsold in 90+ days Unsold in 90+ days

Beautiful 1 Bdrm Loft Townhome Over-Looking Bubbling Brook. Stand Alone

Fireplace in the Living Room; Breakfast Bar and Separate Dining Area.

Assigned Carport Parking. Walk-In Master Bdroom Closet. Spacious Back

Patio. Full-Size Washer/Dryer Hookups.

Check out the listing price history:

Date Event Price Mar 19, 2009 Price Changed $149,900 Feb 01, 2009 Price Changed $215,000 Nov 07, 2008 Price Changed $229,900 Sep 29, 2008 Listed $265,000 Jul 12, 2005 Sold $332,000 May 23, 2001 Sold $163,000 Dec 03, 1996 Sold $89,000 Sep 14, 1989 Sold $116,000

This property was purchased for $332,000 on 7/12/2005. This is a full year before the peak, so this property might have appraised for around $360,000 in the summer of 2006. The owner used a $265,600 first mortgage, a $66,400 second mortgage, and a $0 downpayment.

This property is listed at 55% off its 2005 purchase price, and it is below its 2001 sales price.

If this property sells for its asking price, and if a 6% commission is paid, the total loss to the lender will be $191,094.

Our housing market is starting to look like a Wal-Mart.

{book2}

I’ve got your picture of me and you

You wrote “I love you” I wrote “me too”

I sit there staring and there’s nothing else to do

Oh it’s in color Your hair is brown

Your eyes are hazel And soft as clouds

I often kiss you when there’s no one else around

I’ve got your picture, I’ve got your picture

I’d like a million of you all round my cell

I want a doctor to take your picture

So I can look at you from inside as well

You’ve got me turning up and turning down

And turning in and turning ’round

I’m turning Japanese

I think I’m turning Japanese

I really think so

Turning Japanese

I think I’m turning Japanese

I really think so

I’m turning Japanese

I think I’m turning Japanese

I really think so

Turning Japanese

I think I’m turning Japanese

I really think so

Turning Japanese — The Vapors