Crash Positions II

An update on where Home prices are headed from here

     Earlier this year, in an article titled “crash positions” (link here), Bag laid out the case for a fifty percent drop in home prices. Much of the feedback received from that article was, to say the least, skeptical. For most folks, home equity is one of their biggest assets, and nobody wants to believe that asset will fall significantly in price, hence the skepticism. With that backdrop, today’s article will provide Bagholder’s updated thoughts on where we are and where we are headed in the residential real estate market.

Spoiler … it ain’t pretty. So buckle up and assume the crash position.

  One of the biggest homebuilders in the US is Lennar Homes. Their business model is to build entire subdivisions and sell off the homes within, one at a time. It is a pretty good business model in that it takes advantage of “scale” by building on one piece of property big enough for 1000 homes rather than building on 1000 different properties spread out all over town.  Fortune magazine ran a cover story on them last month on how sales are non-existent in a couple of their more significant projects, one in Austin and one in Las Vegas. To combat those slowing sales, Lennar does have a couple of tools at their disposal.

  Normally, offering free upgrades like customized flooring, better windows, or nicer landscaping would incentivize potential buyers to get off the fence and buy. But these are not normal times. Demand has been crushed, as interest rates on mortgages have more than doubled in the last two years, from under 4% to the current level of just over 8%. This equates to monthly payments 50% higher than just two years ago. The math is available below, but for now, know this: Financing 500k for a home was just under $2450 a month in principal and interest in 2021. That same payment today is over $3700 a month. Some wood flooring, bay windows, and fruit trees will not be enough to get potential buyers to swallow the extra $1250 per month.

   Since free upgrades are not enough to move inventory, the only remaining tool is to lower the sales price. Getting buyers back down to the $2450 a month payment of just two years ago would require selling those 500k homes for 330k. Worse yet, lowering the price to 330k would come at the cost of upsetting some very powerful groups, including:

1. Shareholders of Lennar. Their income statement shows that 330k is well below Lennar’s building cost. You cannot sell below cost very long and expect to stay in business.

2. Local governments who were led to believe they would be collecting property taxes on homes selling for 500k will not be happy if it turns out they can only tax a 330k selling price.

3. John Doe, the homebuyer who got in early on the subdivision paying the 500k, will not like seeing his new neighbor get the same house for 330k, as it means either a considerable chunk of John’s equity is now gone if he paid cash … or … assuming he put a 100k down and took out a mortgage for the other 400k, that mortgage is now upside down.

4. The banks holding John’s mortgage will now find themselves in the same position they were in back in 2008; as once again, homeowners will be incentivized to walk away, mail in the keys, and stick them with properties plummeting in price.

 

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It's time to take a trip to the Bagholder School of Business (BSB).

  Today’s exam will have only one question: If you were the CEO of Lennar, and the inventory in your subdivisions wasn’t moving even with free upgrades - what would you do?

  For those who recommend continuing on the existing path of offering upgrades and perhaps expanding the list of freebies to include things like security systems or no closing costs; Bag would point out that doubling down on what is not working is, according to Einstein, the proverbial definition of insanity. (Grade: F).

  For those who said “hold on to the homes,” hoping for interest rates to fall or for the market to come back, and then, when conditions are more favorable, sell off the excess inventory.  Bag would point out that “hope” is never a viable business strategy. (Grade: F).

  For those who said, “Lower the price, but not so low it will piss off shareholders, governments, customers, and banks,” This was the first option chosen by the current Lennar CEO. As evidenced by the Fortune magazine article referenced above, this did not work. While price cuts are part of the answer, they can’t be shallow price cuts. You don’t cut a puppy’s tail off one inch at a time. (Grade: D+)

  For those who said, “Piss off whomever you have to, lower the price to 330k, and eat the loss”, Bag would give partial credit. It is the right first step,  but burning bridges with banks and governments, with whom loans & zoning permits will be needed in the future, is short-sighted. It will make the business path forward very treacherous. (Grade: B-)

  To receive an A+ on this exam, there is only one correct answer. Many of you reading this are constrained by scruples, and thus lacking in the devious vision required to see the A+ answer in advance.  Solving Lennar’s dilemma requires both sleight of hand and a conspiracy of epic proportions. And, just like a finely tuned orchestra, everybody must play their part.

This is the A+ answer:

  Sell the homes for the 330k while at the same time keeping everyone involved (customer, government, shareholders, and banks) believing the home sold for the full 500k asking price.

Impossible, you say? Not if you have a penchant for numbers, a criminal mind, and co-conspirators who will gladly look the other way as they benefit from the charade. What both the A+ student at BSB and the homebuilder’s corporate suits understand is this:

Financing 500k @ 4.2% interest leaves a monthly payment of $2445

and

Financing 330k @ 8.1% interest leaves a monthly payment of $2445

Notice how the payments are the same. Also of note, the 8.1% is the current market rate for mortgages. The 4.2% rate was pulled from what Lennar is buying rates down to for new customers, according to the Fortune article. In short, they are selling homes at the current market price of 500k by offering last year’s mortgage rate of 4.2%.  NOW THAT should get some buyers off the fence.

There is, however, one fly in the ointment. It costs the homebuilder money to buy the interest rate down to 4.2%.  With current rates at 8.1%, buying a 500k mortgage down to 4.2% costs, if you can believe it, $170,000!! Ask yourself this: If a homebuilder sells a house for 500k but has to spend 170k to buy down the interest rate, did they really sell it for 500k?

No, of course not … just like calling my dog a cat, does not make her a cat.

But,

   1. The new buyer is excited to get on the 4.2% train, which left the station last year. He doesn’t recognize that he is signing on to pay 500k for a home on which the seller is netting only 330k.

   2. John Doe, next door, can keep living with his head in the sand, happy his new neighbor is paying the same 500k he paid.  Convinced by the “Comps” that his home is worth 500k, he will likely continue making the mortgage payment.

   3. The Banks will quietly collect their monthly check, happy to maintain their income stream on what is really, an underwater asset.

  4. Shareholders love it because Lennar can continue to post record sales every quarter. Their crafty accountants will gladly bury the 170k buy-down expense on their balance sheet, where it will likely go unnoticed for years.

  5. And finally, the governments who are supposed to be regulating this are only too happy to look the other way at this sleight of hand, as they get to collect taxes on a 500k house.

  In an effort to keep the gravy train flowing, the home builders, banks, and governments will all continue to conspire against home buyers by putting a 500k sales price on a purchase contract for a home, which in reality is selling for 330k. The moment they stop the charade and acknowledge the 330k the seller is netting is the true market value of the home, John Doe will wake up to the fact he is playing the fool in all of this, and it will be 2008 all over again.

Speaking of the 2008 crash…

   Let’s travel back in time a couple of years prior, to 2006. Back then, one of the hottest markets in the country was Bag’s hometown of Phoenix, Arizona. It was a mania Bag saw with his own eyes. Everyone was convinced home prices only went two ways: Up and Way Up. As the calendar turned to 2007, properties in Phoenix suddenly weren’t selling like they had in the preceding years. Inventory was piling up. By the end of 2007, the few homes that sold in Phoenix were selling for 25-30% discounts to 2006 prices. Homes in the rest of the nation, however, were still plumbing new highs. By mid 2008 though, the jig was up, and prices were crashing everywhere. Phoenix was, the canary in the coal mine.

The lesson to be learned from those days is the hot markets will cool off first - long before the rest of the country realizes the runup in prices is over.

  Fast forward to 2023. Two of the hottest markets for homes in the last few years have been Austin and Las Vegas. The inventory in those cities is piling up. The few homes selling in those cities are selling for steep discounts. Sure, Lennar might be calling the sales price of their homes 500k, but we both know from above that those sales are only 330k.

    The reality is, that the canaries of 2023 are Austin and Vegas. They are currently holding 33% off sales. Even still, according to Fortune magazine, Lennar is STILL struggling to move those homes. If history is any guide, and it usually is, the rest of the country will hold their own 1/3 off sales very soon. One last point worth mentioning about the crash in 2008 was it took five years for the residential real estate market to bottom out. The initial 1/3 off sales that first year was just the opening salvo. By the end, most of the homes in this country were 50% off, or more.

  While history doesn’t always repeat, it does, more often than not, Rhyme.

  In conclusion, it seems the Lennar’s of the world learned from history and the mistakes of 2008. Instead of just accepting lower sales prices, they roped in banks and governments to help perpetuate the illusion home prices are still at all-time highs. They have accomplished this by using interest rate buydowns to rig the “comps” market with false sales prices. Bag stands in awe at both their temerity and execution. It’s like watching a top-tier magician saw a woman in half. You know she is not being sawed in half, even when it looks like she is. Their rigging of the comps market has made it look like homes are worth 500k, when in reality, they are already 1/3 off and falling. For that, Bag would give the CEO of Lennar, an A+.