Market Report: February 2008

The year started slowly but there were plenty of fireworks by the end of the month. Buyers are looking around but still loathe to leap into the market. Those on the fence should pay attention to the political events of the past few weeks. A new consensus has developed and there is a common general agreement not to let real estate twist in the wind. Part of this relief package is already in place with two historical rate cuts in just over a week. But there will be more.

Black Tuesday Revisited

These are heady days for our local newspaper folk. A rocky economy, the presidential race and the implosion of home values makes great front page fodder. This unending cornucopia of stories and eye-catching headlines has even relegated our ongoing foreign adventure to journalistic Siberia. The pace and content of these stories illustrate that our comfortable and stable post-war world has vanished along with the afternoon newspaper.

But for pure drama nothing beat the late-January turbulence in the financial markets. A plumber in Utah stops making payments on his house and that leads to a Dutch investment fund collapsing in value. The financial markets suddenly realized the scope of the sub-prime debacle and rushed the exits. The selling was intensified by the news of a French rogue trader, but that was merely the spark for the sell-off. The Fed Chair, not wanting to be seen as feckless, reversed course and served up an unprecedented and unscheduled rate cut of three-quarters of a point. Spurred by the decline in the GDP during the fourth quarter, Mr. Bernanke cut rates another half-point eight days later. He is thinking inflation is better than recession.

He clearly has abandoned his and his predecessor's predilection of managing the economy by the use of small measured cuts or increases applied ever so judiciously. The sledgehammer approach temporarily calmed the markets even though Mr. Bernanke has possibly painted himself into a corner. If his tactic fails and the markets panic again, what more could he do given the rising importance of the Euro?

The Euro is muscling in on the dollar's turf as the world's dominant currency. In the past the greenback commanded a 'safety premium' in relation to other currencies. This allowed Mr. Greenspan the freedom to nudge the fed funds rate, following the dot.com bust in 2000, to 1% and the prime rate to 4% by 2004. The rules have changed and money more readily flows to the best returns---interest rates in America have to be set closer to those in the other industrial countries.

Local real estate appears to be insignificant when compared to the scope and importance of global financial markets. The irony here is that it could be argued that the housing swoon was the butterfly that flapped its' wings. The sub-prime mortgage problem and subsequent financial melt-down is nothing more than the cumulative effect of individual homeowners defaulting on their mortgages. Plenty of blame has been assessed and more will be passed around as the full impact of this colossal mistake becomes apparent.

Someone Turn on the Lights

I find it curious that the Fed and the pols were previously content to allow the business cycle to punish residential real estate. Following the events of January, however, the debate has shifted and there is a growing political consensus that the problem must be attacked from the bottom rather than the top. This is a political year and the pretenders to the throne are paying attention, either by conviction or necessity. I am a major fan of deregulated markets and personal economic responsibility but there are times when a new set of rules must be imposed after the fact. Will the three-quarter point rate reduction and the still being debated economic stimulus package help that plumber? I do not think it will be enough. More serious measures will be required to stop the unforgiving cycle of foreclosures and dropping prices.

There are as of this writing many such proposals being debated in Sacramento and Washington. Any meaningful solution will involve some form of wealth transfer from financial institutions and their stockholders to individual borrowers. The former profited greatly over the past three or four years by creating and selling the sub-prime mortgage. Now they have to give some of it back but in the long run this will cost them less money. It is not in anyone's interest to create a secondary wave of defaults this year as mortgages adjust in the wrong direction. The exact form of this do-over will be debated and decided soon. There will be no social nor economic good that will come from this situation if left to unbridled free market forces. The lesson of the Great Depression still resonates; the bottom half needs purchasing power.

The Time is Now

I am betting that there will be some package of economic relief and mortgage restructuring that will curtail the erosion of home prices. The real estate market will respond to significant rate changes. Also looming is a change in the conforming loan limit. Currently at $417,000, this amount (the rate on conforming loans is cheaper than non-conforming mortgages) is fine if you live in Iowa. The current proposal would increase the limit to $725,000 in high cost areas.

If you are financially able there is nothing but opportunity over the next two years. Because of this belief I am putting together a limited partnership to purchase a pool of residential properties using an index-based acquisition system. The fund will buy properties that meet strict indexing criteria in certain sub-markets. The core philosophy of the fund is that the nadir of the real estate cycle is not a fixed point in time but rather a period that is measured in quarters. The hard reality of replacement costs (read inflation) and population growth will do the heavy lifting for this venture. The desire to own real estate is in our social DNA and the San Diego premium is still valid. I think most of the bad news is out so it is time to run against the tide even though there is still one unanswered question. No one knows the exact extent of the financial damage that will result from the subprime crisis. Our political leaders and the Fed have committed to a course of bailing out the housing sector. This change alone is a clear signal to move forward.

Click here to see Jim's past Market Reports. You can also download Jim's 26 page research paper on San Diego County apartments.

> Send me complementary, custom MLS listings
> Contact Jim Scott for more information or with comments at jimscott@sqre.com