Prepare Now For The Ultimate Real Estate Opportunity

By Bob Prechter, Elliott Wave International
September 7, 2007

We all know that property values never go down. Right?

After the stock experience of 2000-2001 , people are saying, “Maybe stocks can come down for a few months from time to time, but real estate won’t; real estate never has.” They are saying it because real estate is the last thing still soaring at the top of the Great Asset Mania, but it, too, will fall in conjunction with a deflationary depression. Property values collapsed along with the depression of the 1930s. Few know that many values associated with property — such as rents — continued to fall through most of the 1940s, even after stocks had recovered substantially.

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The worst thing about real estate is its lack of liquidity during a bear market. At least in the stock market, when your stock is down 60 percent and you realize you’ve made a horrendous mistake, you can call your broker and get out (unless you’re a mutual fund, insurance company or other institution with millions of shares, in which case, you’re stuck). With real estate, you can’t pick up the phone and sell. You need to find a buyer for your house in order to sell it. In a depression, buyers just go away. Mom and Pop move in with the kids, or the kids move in with Mom and Pop. People start living in their offices or moving their offices into their living quarters. Businesses close down. In time, there is a massive glut of real estate.

In the initial stages of a depression, sellers remain under an illusion about what their property is really worth. They keep a high list price on their house, reflecting what it was worth last year. I know people who are doing that now. This stubbornness leads to a drop in sales volume. At some point, a few owners cave in and sell at much lower prices. Then others are forced to drop their prices, too. What is the potential buyer’s psychology at that point? “Well, gee, property prices have been coming down. Why should I rush? I’ll wait till they come down further.” The further they come down, the more the buyer wants to wait. It’s a downward spiral.

When Real Estate Falls

Real estate prices have always fallen hard when stock prices have fallen hard. Figure 16-1 displays this reliable relationship. 

The overwhelming evidence for a major stock market decline presented in Chapters 4 through 7 is enough by itself to portend a tumble in real estate prices. Usually the culprit behind these joint declines is a credit deflation. If there were ever a time we were poised for such a decline, it is now.

The Extension of Credit

What screams “bubble” — giant, historic bubble — in real estate today is the system-wide extension of massive amounts of credit to finance property purchases. As a result, a record percentage of Americans today are nominal “homeowners” via $7.6 trillion in mortgage debt. Two-thirds of them owe an average of two-thirds of the value of their homes, plus interest, and both ratios have been increasing at a blistering pace.

People can buy a house with little or no down payment in many cases. They can refinance a house for its entire value. “How can this be?” you ask. “Isn’t at least 20 percent homeowner equity required?” Well, sort of. Credit institutions are supposed to be penalized for lending more than 80 percent on an uninsured mortgage. But if they get it insured, which is generally not difficult, the limit can go up to 90 percent. With VA or FHA approval, it can go up to 95 percent. “Prime borrowers” can refinance for up to 125 percent of a home’s appraised value.

What if none of these exceptions apply? Real estate insiders on a quiet Saturday afternoon will tell you that many banks skirt the intent of laws aimed to ensure some homeowner equity in refinancing deals. For example, suppose the owner of a $500,000 home wants to refinance it at the full amount, but the bank is restricted to lending him only 80 percent of the value of the property, which is $400,000. If the homeowner wants the whole half-million anyway, the bank will send in an appraiser who magically discerns that the property is actually worth $625,000. Get it? 80 percent of $625,000 is $500,000. The homeowner has his 100 percent loan, the bank earns more interest, and the rules are satisfied. If you are creative, you can wangle even more than 100 percent out of a deal. The principle (and maybe later the principal) is out the window, and no one’s the wiser, at least until a bear market imparts wisdom.

The problem with these schemes is that their success and continuation depend upon continuously rising property prices. Once the bank extends a loan of that size, it owns the house at full value. Then, any drop in that value directly causes a drop in the value of the bank’s capital. By contrast, when the bank lends only half of the value of a home, its value can drop as much as half, and the bank can still get all of its depositors’ money out of the deal by selling the house. With these latest methods of “creative financing,” depositors’ money is utterly unprotected from market risk.

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Bank loans to home buyers are bad enough, but government-sponsored mortgage lenders — the Federal National Mortgage Corp. (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac) and the Federal Home Loan Bank — have extended $3 trillion worth of mortgage credit. Major financial institutions actually invest in huge packages of these mortgages, an investment that they and their clients (which may include you) will surely regret. Money magazine (December 2001) reports that the CEO of Fannie Mae “may be the most confident CEO in America.” Certainly his stockholders, clients and mortgage-package investors had better share that feeling, because confidence is the only thing holding up this giant house of cards. When real estate prices begin to fall in a deflationary crash, lenders will experience a rising number of defaults on the mortgages they hold. My guess is that the Treasury will lose the $7 billion line of credit that it is required by law to extend to these quasi-government companies and even more if it attempts a bailout.

Another remarkable trend of recent years adds to the precarious nature of mortgage debt. Many people have been rushing to borrow the last pennies possible on their homes. They have been taking out home equity loans so they can buy stocks and TVs and cars and whatever else their hearts desire at the moment. This widespread practice is brewing a terrible disaster. Taking out a home equity loan is nothing but turning ownership of your home over to your bank in exchange for whatever other items you would like to own. It’s a reckless course, and it stems from the extreme confidence that accompanies a major top in social mood.

At the bottom of the depression, banks are going to own many, many homes, and their previous owners will be out in the street. That’s not so bad; at least they got their money’s worth from the TVs and cars. It will be a disaster for the banks’ depositors, though, because there will be no one to buy the homes at mortgage-value prices. Depositors’ money will be stuck in lifeless property deals, marked down 50 percent, 90 percent or (as happened in the Great Depression) even more.

Credit expansion has supported real estate prices, but it is late in the game. The dramatic tumble in interest rates in 2001 has spurred a record number of home sales because financing rates appear low. Marginal buyers, who had waited on the sidelines, are finally taking the plunge. People around the country are nearly unanimous in thinking that this is their last great opportunity to buy a house. Naturally, it is the opposite: It’s your last chance to sell. The market is becoming as bought up as it can get, and there is little interest-rate ammunition left to win the battle for even more borrowers.

Some Things To Do

For more on the prospects for property values, please see Chapter 20 of At the Crest of the Tidal Wave. In the meantime, you can take the following steps:

• Make sure you avoid real estate investment trusts, which are perhaps the worst property-related investments during a bear market. Some REITs valued at $100 a share in the early 1970s fell to ¼ by late 1974, and most of them never recovered. REITs are sold to the public because the people who do the deals don’t want to stick with them. The public falls for REITs cycle after cycle. These “investments” hold up in the best part of bull markets, but they are disasters in bear markets.
• If you are in the real estate business, wrap up any sales deals you are working and get out of all investment real estate holdings that are not special situations about which you know much more than the market. In general, wait for lower prices to re-invest.
• If you hold a big mortgage on expensive property that depends upon massive public patronage, such as an arena, playhouse, amusement park, arts center or other such facility, consider selling it or subleasing it insured.
• If you are a banker, sell off your largest-percentage mortgages and get into safer investments.
• If you rent your living or office space, make sure that your lease either allows you to leave on short notice or has a clause lowering your rent if like units are reduced in price to new renters.
• If you have a huge mortgage on a McMansion or condo that you cannot afford unless your current income maintains, sell it and move into something more reasonable. If at all possible, join the 1/3 of title holding Americans who own their homes outright. Be willing to trade down to make it happen. See Chapter 29 for more on this topic.
• If you consider your home a consumption item, and you wish to keep it on that basis, fine. If you are just as happy renting your residence as owning, do so.
• At the bottom, buy the home, office building or business facility of your dreams for ten cents or less per dollar of its peak value.