"It looks like foreclosures are here to stay!"
This cheery announcement headlines an all-points bulletin sent me by two alert citizens who think it's smart to call themselves the "TWO SHARP GUYS". They feel impelled to inform me that "banks need your help, homeowners in distress need your help, and the industry needs your help!" And after I fork over $297 to attend one of their seminars, I too can start mending holes in the social fabric. In fact, I can be darn helpful to my community. I may even get a park named after me.
Their message—that foreclosures are stalking homeowners and roiling the real estate landscape—is only slightly more opportunistic and hysterical than what you see in the mainstream media, and it's identical to what you'll find on the bubble blogs. In some areas there's a genuine crisis, and I won't downplay it. But I will give you some perspective on the current situation that I think you'll find useful. I also think that by the end of this article you'll find what I say shocking. At least I hope you do. Because some neighborhoods are staring real estate catastrophe in the face. We'll look briefly at the long-term implications, including whether the misfortunes of some are opportunities for others.
I emphasize the "current" in "current situation" because no one knows what it'll look like in a few months or years, although plenty of people claim they do and are having fun describing it. In any crisis, people with axes to grind, theories to prove and obscure grudges to settle come out of the woodwork with their apocalyptic predictions, get their fifteen minutes and scuttle back into well-deserved obscurity.
I'll turn down the heat and point out a few things I think may be helpful in understanding the situation, whether you're a buyer or seller. First I'll throw some numbers at you. Then I'll impart what I call "Big Lessons". We'll wrap things up with a war story or two, assess the effect of foreclosures on the mid-Peninsula real estate market, and finally speculate on their long-term impact.
There's no doubt that loan defaults have risen dramatically since early 2006, particularly in the sub-prime sector. The most recent Mortgage Bankers of America survey reveals that nearly 4.95 percent of all US mortgages in the survey were delinquent Q4 2006, up from 4.67 percent the previous quarter. Subprime delinquencies rose from 12.56 to 13.33 percent in the same quarter.
There's also no doubt that California's foreclosure numbers sound hair-raising. DQNews, one of the two most-quoted foreclosure trackers, thunders "California foreclosure activity jumps again" in its April 16 press release. "California foreclosure rates rising" volleys back RealtyTrac, the other most-quoted foreclosure tracker, in its April 18 press release.
DQNews says that filing of Notices of Default (NoDs), the first step in the foreclosure process, jumped 23.1 percent state-wide from Q4 2006 and Q1 2007, and skyrocketed 148 percent from Q1 2006 to Q1 2007. Q1 2007 NoDs "were a record in Riverside, Sacramento and Contra Costa counties". Contra Costa was one of two Bay Area counties to see Notices of Default rise more than 200 percent from Q1 2006 to Q1 2007; Solano was the other. RealtyTrac's top-ten "hardest-hit metro areas" nationally include six in California: Stockton, Vallejo-Fairfield, Modesto, Sacramento, San Bernadino-Riverside and Bakersfield. There's rejoicing on the bubble blogs.
But these numbers don't mean much by themselves, so let's put them in perspective. As DQNews says, "the numbers reflect wide regional differences". In other words, not every area is reeling from foreclosure shock. For example, the news that both Santa Clara County and San Mateo County notices shot up about 100 percent from Q1 2006 to Q1 2007 sounds dire until you realize that 100 percent is about two-thirds the state average, and that "mortgages were least likely to go into default in Marin, San Francisco and San Mateo counties" according to DQNews.
Some actual numbers will give you an even better perspective. Currently about 60 percent of homeowners who get a Notice of Default "cure" the default and avoid foreclosure, but even in the highly unlikely event that all 382 San Mateo County NoDs turn into lender-owned properties for sale, these 382 properties would comprise just 5.6 percent of total San Mateo County sales in 2006. And in fact, there wouldn't be 382 lender-owned properties for sale, because no one mentions that these 382 notices aren't 382 properties—they're 382 loans in default, which includes not only first loans but also second and even third loans on the same properties.
Next let's give you the same perspective on Santa Clara County numbers: 1058 Notices of Default would be about 8 percent of total county sales in 2006 if every notice a) was one property and b) ended up for sale by a lender. Past performance suggests that the actual percentage of notices ending up lender-owned and for sale is likely to be half—2.8 percent for San Mateo County and 4 percent for Santa Clara County—or less. The future may see an increase both in the number of Notices of Default and the percentage of defaults that end up lender-owned and on the market, but let's work with the situation we have. Taking it further is just speculation.
So let's add 2.8 and 4 percent, the absolute worst-case scenario for lender-owned properties in the current situation, to actual Q1 2007 inventories of the two counties. Santa Clara County would have had 4729 properties for sale, San Mateo County 1606. That's far more inventory than either county carried at the market's peak Q1 2005: 2762 (Santa Clara) and 906 (San Mateo). But comparing Q1 2005 with any other quarter is a little like telling me I'm not eighteen anymore; I'm not, but I still do okay. For context, let's augment Q1 2007 inventories for San Mateo and Santa Clara counties with the worst-case foreclosures scenarios I outlined above and compare those inventories to two recent Q1s that were indisputably lousy markets, Death Valleys among the soaring peaks. As the dot-com bust began to cripple home sales in Q1 2001, Santa Clara County inventory ballooned to 5294 properties, San Mateo to 1704. Combine the lingering effects of the bust with the economy-paralyzing ramp-up to Iraq and you have the perfect storm of Q1 2003: Santa Clara County with 6225 properties on the market, San Mateo 2068.
Some of you may have noticed that Q1 '07's augmented inventory including worst-case foreclosures is uncomfortably close—89 and 94 percent—to Q1 '01's bloated inventory. But remember that in 2001 we were hemorrhaging jobs and residents, while since 2005 we've been adding them. In addition, you may have read local economist Steven Levy's prediction that Silicon Valley will add 20,000 to 25,000 jobs a year through 2015. Even if the actual job numbers don't turn out to be that good, the general consensus is that things look pretty bullish for the local economy. This suggests two reasons why foreclosures have had minimal impact on home prices in most local neighborhoods. First, historically foreclosures are usually triggered by a household economic crisis, and that's less likely to happen when the local economy is healthy. Second, even if the "rate shock" caused by resetting adjustable loans triggers more foreclosures, as some suggest, a growing local economy supports a large pool of qualified buyers better able to absorb excess inventory and stabilize home prices.
I'm not saying "it'll never happen here", but there's another reason it's far less likely. DQNews adds that "The likelihood (of default) was highest in Sacramento, Riverside and San Joaquin counties". Put these higher-default counties together with the six "hardest-hit metros" I mentioned earlier and a pattern emerges that you won't see here on the Peninsula or in the South Bay: "many of (the hardest-hit metros) are ones with a high amount of recent new-home construction", says RealtyTrac. Five of these metros are in the Central Valley, where home-builders have been on a spree since 2003, as are the three higher-default counties just mentioned, Sacramento, Riverside and San Joaquin. In the Bay Area, Contra Costa County's soaring default numbers are most likely coming from the eastern part of the county where home values have plunged 14 percent according to a March 15 KGO-TV report as over-extended home builders slash prices so far they drive down the prices of resales.
Now we've accounted for all the California foreclosure hotspots except the Vallejo-Fairfield metro and Solano County. I have no idea what's happening there, but it's probably significant that after forty years in the Bay Area I needed a map to find Solano County and locate the sprawling metropolises of Vallejo and Fairfield nestled within it. Maybe this means I should get out more often, but more likely it means that these places are similar to eastern Contra Costa County: out-of-the-way areas on the periphery of the Bay Area that consequently lack staying power in a softening market.
Speaking of staying power, there's yet a fourth reason that most neighborhoods in my local market around Stanford University—in Menlo Park, Palo Alto, Mountain View and Los Altos—seem least likely to suffer foreclosure shock: what the stock market calls "flight to quality". These four cities (Mountain View is the newest addition) have a history of desirability . You can see this in their performance over the past two years as real estate has cooled elsewhere. I could retire if I had a nickel for every Fremont or San Jose resident I've met who wants to live in this area. Other mid-Peninsula or South Bay cities, even those not far from Stanford such as Redwood City and Sunnyvale, have much less "buzz".
So what does all this mean, if anything, to the Peninsula or South Bay home buyer or seller? Should you put off buying until bargain-priced lender-owned homes flood your favorite neighborhood, beating down prices by ten, twenty or even fifty per cent? Should you try desperately to sell today in order to avoid discounting even more deeply next month or next year?
As we'll see, the answer depends on where you now own or where you want to own, while the more extreme predictions of price drops look like more bubblehead wishful thinking. And since there's been much speculation on the effect of subprime lending, often identified rightly or wrongly with "predatory" lending, on homeowners of color, and on what its long-term effects will be, let's try to verify whether certain ethnicities and markets in this area have been disproportionately affected by foreclosure. According to an announcement released April 4 by a coalition of national civil rights groups calling for a six-month moratorium on subprime foreclosures, African-Americans have 52 percent of subprime purchase loans, Latinos 40 percent. And anyone who slogs through the Notices of Default filed at the County of San Mateo Recorder's Office, as I did recently, will confirm that homeowners with Hispanic surnames account for many and perhaps most local delinquencies. We'll define an affected market as one that shows a clear trend of a) declining sales, b) rising inventory, c) declining sales prices, d) declining absorption (I'll define this later) and, e) rising foreclosures.
To verify a likely correlation between ethnicity and foreclosure, let's compare the markets and Notices of Default in two pairs of ethnically contrasting mid-Peninsula cities or neighborhoods. Each contrasting pair of cities or neighborhoods will have one with a high proportion of persons of color and an adjacent one with a low proportion. The two ethnically contrasting neighborhoods are Menlo Park east of 101 (Belle Haven) and Menlo Park west of 101. The two ethnically contrasting cities are Palo Alto and East Palo Alto.
Here are the ethnic breakdowns for these areas, taken from the 2000 Census.
| Area | % Asian | Black or African-American | Hispanic or Latino | Pacific Islander | White |
| Belle Haven | <1 | 29 | 60 | 1 | 2 |
| Menlo Park west of 101 | 9 | 1 | 5 | 2 | 82 |
| East Palo Alto | 2 | 23 | 59 | 8 | 7 |
| Palo Alto | 17 | 2 | 5 | <1 | 73 |
Next are four charts, each showing an indicator of market activity in these contrasting areas over three recent quarters: Q1 2005, the peak of the boom in many markets; Q1 2006; and Q1 2007. I've stuck with Q1s for two reasons. First, we're just coming off Q1 2007. Second, it ensures that we're comparing apples to apples, because Big Lesson #1 seasonal changes in the market give each quarter of the year consistently unique performance characteristics.
I've further highlighted the differences in performance between these markets in two ways. First, I've separated the Palo Alto and west-of-101 Menlo Park markets into "entry-level" and "top end" since Big Lesson #2 these two price ranges often perform differently. Second, I've grouped Menlo Park's Belle Haven neighborhood with neighboring East Palo Alto (as buyers often do, in my experience) since Belle Haven is too small for meaningful statistical measurement.
Okay, let's look at sales first. As you can see, they're a mixed bag. Sales have plunged dramatically in the Belle Haven/East Palo Alto market, suggesting that there demand has dropped off sharply. But you'll also notice that sales have dropped off in two of the other four markets. As we'll see Big Lesson #3 sales isn't a foolproof, let alone good, indicator of market health.
Average sales price brings the differences into better focus. Prices in the Belle Haven/East Palo Alto market have fallen about 6%, while Big Lesson #4 prices have increased substantially in three of the other four markets, while one has seen them flatten. Yes, prices are still going up in some local markets. Yes, prices can move in different directions in different neighborhoods within the same city.
Inventory is where the differences between these markets really stand out. The number of homes for sale in the Belle Haven/East Palo Alto market leaped 151 percent from Q1 05 to Q1 07 while it declined in three other markets and flattened in another. Obviously homeowners in Belle Haven and East Palo Alto are far more motivated to sell. Homeowners decide to sell for a variety of reasons, but whim isn't one of them ("Oh heck, I think I'll sell my home today."). Obviously something big is happening. The only question—and it's a big one—is "what?". We'll get to this in a moment.
But what really points up the difference between these markets, in big flashing neon lights, is something called the absorption rate Big Lesson #5, an all-important indicator that tells us how balanced a real estate market is; in other words, whether it's a buyer's or seller's market. The absorption rate isn't rocket science. It's calculated by dividing the number of properties sold during a given period, in this case one quarter, by the total number of properties available during that period. But the absorption rate is invaluable, because it gives us a far better picture of a market's health than the more commonly-used (because more commonly-available) indicator, sales. Sales can be misleading Big Lesson #6 since declining inventory can drive down sales even in a rip-roaring seller's market. In other words, if a market has fewer homes for sale, fewer homes will be sold, even though demand for homes is healthy.
This situation—healthy demand for a declining number of properties—is Big Lesson #7 one of the hallmarks of a strong seller's market. That's exactly what's happening in two of the five markets shown. In two other markets, both sales and absorption are up, indicating an even stronger seller's market. But in the Belle Haven/East Palo Alto market, both sales and absorption are down. Way down.
So there it is. Five markets, going in three directions, responding differently to different market conditions. Not only that, the five markets are contiguous. You could start out in one, drive through three others and end up in the fifth in as little as ten minutes.
Makes a strong case for micro-markets, doesn't it? Yet the media and academics invariably throw all five micro-markets into larger grab-bag markets existing only for the convenience of outsiders who pontificate on real estate: the "national market", the "coastal market", the "western regional market", the "California market", the "Bay Area market", the "San Francisco Peninsula market" and the "mid-Peninsula market".
That's not a Big Lesson, that's a Huge Lesson. And it's a lesson some mid-Peninsula buyers are learning right now.
Kids, if you try this at home, bear in mind that the longer the period measured, the higher the absorption rate, even though the pace of the market hasn't changed. For example, Q1 2007 absorption for the Belle Haven/East Palo Alto market was 17 percent, low enough to furrow the brow of any seller or seller's agent. But it was a dead-on-arrival 7 percent for March 2007. In this area, a monthly absorption rate under 30 percent is officially a buyer's market. Anything under 20 percent is officially an extreme buyer's market. Anything under 10 percent...well, over the past ten years I've seen maybe a handful of markets with monthly absorption rates under 10 percent. Mostly ultra-luxury markets like Atherton and Woodside right after the dot-com bust, when the top end went through stock-option withdrawal and lost 35 to 40 percent of its value. Even then it happened rarely, and during the traditionally slow months. It's true that absorption in the Belle Haven/East Palo Alto market is usually lower than that of other mid-Peninsula markets. But I haven't seen a number that low east of 101 since the dark days of the early 1990s.
That's huge.
Plunging sales, soaring inventory, imploding demand. What's causing this quiet crisis in Belle Haven and East Palo Alto real estate? And why haven't you heard about it? Or to put it more accurately, why haven't you heard that real estate can be ice cold in one neighborhood and red hot only a few miles away?
Let me answer these questions with a short war story. Don't worry, I'll keep it brief. After that I'll serve refreshments and show you slides of my last vacation. "What's a slide?" (What's a "vacation"?)
Most of my business comes from Palo Alto, where I lived for years, and from Menlo Park west of 101, where I live now. But occasionally I cross 101 into Belle Haven and East Palo Alto. In fact, just last year I had a listing in Belle Haven. It was a formal introduction to that market—before that we'd just nodded briefly across the room—and it was a real education. It may be for you too.
When my listing came on the market last May, Belle Haven was coming off a decent spring. So decent, in fact, that we put the house on the market at $649k instead of the $629k I'd been recommending for months. Why not put it on at $629k anyway and hope for multiple offers? That's not how it works in Belle Haven. Besides, I felt good about the market. I felt great about the house. $1500 in new landscaping gave it curb appeal. We'd recarpeted and repainted. Sure, the house was old and small and needed repairs and updating, but that describes most of the homes for sale around here. I didn't just think we were in the ball game. I thought we had the bases loaded with our best hitter coming up.
Then...
weeks...
dragged...
by...
and...
more...
weeks...
dragged...
by...
and...
then...
even...
more...
weeks...
dragged...
by...
and...
the...
house...
would...
not...
sell.
It wasn't even being shown. Sure, I'd heard grumblings that east-of-101 agents wouldn't show the listings of out-of-area agents, but I didn't believe it. Money is money, and we were offering a healthy 3 percent commission to buyers' agents. But only four agents had shown up for broker's tour. Almost no one, agent or civilian, was showing up at the Sunday open houses. And the competition wasn't selling either. Not only was my listing a tree falling in the forest that no one heard. No one even knew the forest was there.
Meanwhile, ten minutes away on the other side of 101, homes in equal or worse condition were selling in a week to ten days at twice the price and with multiple offers.
What to do? Price reduction? Sure, I'd thought of it, but at this point it seemed like panicking. Belle Haven had always moved a little slower than other markets and, besides, a price reduction took away the negotiating room so important when selling there.
Advertise in the local newspaper? Sure, I was, except that my local newspaper wasn't Belle Haven's local newspaper. My local newspaper said it was Menlo Park's local newspaper, but looking at with Belle Haven eyes showed it wasn't written for Belle Haven. So what newspaper was? A Spanish-language newspaper kept showing up in my client's driveway, but what little real estate advertising it had was for East Bay properties. No one looked at this newspaper to find a Belle Haven house.
Put it in the open house guides? I did. Put lots of photos on the listing Web sites? I did. Put it on Craigslist? I did. And occasionally I'd get townhouse buyers through, tourists and bargain-hunters out to see what a west-of-101 townhouse price got them in a Belle Haven single-family home. They'd enter, they'd look, they'd refuse to talk to me and they'd scuttle out, never to be seen or heard from again.
Hold more open houses? Most of my competition wasn't holding any open houses. And since my Sunday opens were meeting what little demand there was on the week-ends, Saturday open houses looked like "work harder, not smarter".
Identify and develop an untapped market? Genius! Each Thursday evening I put out A-frames on a regional commuter route a few blocks from the house. Each Thursday evening tens of thousands of weary commuters passed those A-frames as they plodded home to Hayward or Stockton or Sacramento. Weren't they interested in slashing their commute time from hours to minutes? No, they weren't. The first Thursday I had a loan agent there to qualify eager buyers on the spot. The only guy who showed up was a loan agent.
Reduce the price now? Sure. Heck yes! Time to panic! Bring it down to $629k. Still the house wouldn't sell. No one's house would sell. Inventory began to stack up at an alarming rate.
But the buyers were out there. I knew that, because every once in a while I'd meet them. Almost always they had friends and relatives in the neighborhood. Almost always they'd hang out and talk to me, unlike the tourists and tire-kickers. Sometimes they'd invite their family and friends over and suddenly my open house would go from a morgue to a happenin' place. Once I had an entire extended family, maybe thirty people, in the front yard. Almost always they liked the house and felt comfortable in it. Always they liked the neighborhood and felt comfortable in it. And always there was some reason they wouldn't buy. But this was a good sign. I'd found my target market. How could I reach it more broadly? How could I get enough of my target market to go through the house to find someone who'd buy it?
With my Sundays quiet I had plenty of time to gaze through the 1950s-era picture window, watching neighborhood life unfold, and as I did, something stirred in the dusty recesses of my mind. Then one day I got it. I was watching a 2006 Bay Area version of the blue-collar Florida neighborhood I'd grown up in. Belle Haven was authentically "retro", a throw-back to an America most of us had forgotten or never known, part small town and part 1960s suburbia. West of 101 we seemed more willing to communicate with virtual buddies thousands of miles away than talk to our next-door neighbor. In Belle Haven, information was passed face to face.
A phone call to another client who lives in Belle Haven confirmed this. So far my usual marketing methods had reached every market except the one I needed to reach. Belle Haven expected me to tell them about the house up close and personal. Probably not door-knocking and cold-calling up close and personal, but I had to climb down off the Internet. My client and I made new bilingual flyers and he tacked them up in the local markets. I sent out a bilingual postcard to every one of Belle Haven's 994 single-family homes. And in an area where most buyers use 100 percent financing and need the seller's help to pay their closing costs, my client threw in a $20k credit.
A few weeks later the house sold. Did all that bilingual, up close and personal marketing sell it? I don't know. I do know that the buyer's uncle lives on the same block, that the buyer herself was renting a few blocks away, and that the buyer's agent was a real stem-winder who saw my listing's value as well as I did. Finally, somehow, it all came together.
Oh yeah, I almost forgot to tell you: as part of my marketing blitz, I did something I've never had to do before and will probably never have to do again: block out two days to call the eighty agents who'd done the most business in the area over the past two years to call and tell them about the great value my listing was, the generous credit the seller was offering and the full 3 percent commission he'd pay the buyer's agent. Those phone calls were a revelation. I discovered that relatively few of these top agents were local. Many worked out of the South Bay, a surprising number the East Bay. Some said they also worked the Central Valley (hold this thought). A few I knew, but most I'd never talked to. All were willing to listen, and some were willing to respond when I asked what they thought was going on in Belle Haven.
Here's what they said:
Only one of these five reasons relates directly to loans and, potentially, foreclosures. The others result from broad social changes, some new and unique to certain neighborhoods, some not. Yes, highly-paid highly-skilled jobs are coming here, but well-paid lower-skilled jobs are leaving. Yes, highly-paid highly-skilled workers are coming here, but their affluence drives up the cost of living, forcing the less-affluent out. Yes, lower-income people can improvise a way to live here in the midst of all this affluence, but the human cost is still high and for some it's getting old.
Let's wrap this up by focusing on foreclosures and how likely they are to be a factor in the real estate performance of the areas we contrasted a short while ago. To do this, let's go to the Web site one of the leading foreclosure tracking services I mentioned, RealtyTrac, and see how many foreclosures it shows in each area.
When I first searched RealtyTrac's Web site I had to wonder if maybe the two free-lance so-called Web designers I'd hired to build features for my site, features that worked just long enough for my checks to clear, also built RealtyTrac's search feature. I was also hindered by the fact that, unless you subscribe, RealtyTrac gives you the street names of properties in foreclosure but not their street numbers. But by using both its list and map functions I got useable results. You do need to be familiar with the area, because a RealtyTrac search will give you properties outside that area. A search for foreclosures under "Menlo Park", for instance, returned 66 results, while searching under Menlo Park's 94025 zip code returned 407, and in fact as of 4/22/07 there were 37 loans (remember, loans, not necessarily homes) in some stage of foreclosure within Menlo Park's city limits: 16 west of 101, 21 in Belle Haven. A search under "Palo Alto" returned 148 defaulting loans but this turned out to include homes with East Palo Alto and Mountain View street names. There were actually only 11 Palo Alto loans somewhere in foreclosure then, while East Palo Alto had 56.
Now let's give these numbers some context. First, since Belle Haven has no condos or townhouses and East Palo Alto almost none, let's compare only single-family loans in foreclosure. The numbers don't change much:
Before we go to the next step, remember that this is the number of loans in default in each city or neighborhood, not the number of homes with defaulting loans. That's an important distinction, because the number of homes is undoubtedly slightly lower. Now let's use RealQuest, a program based on county records, to determine the number of single-family homes, in default or not, in each area:
Okay, now let's do the math. Let's calculate the approximate probability of a single-family home in each area to have a loan somewhere in the foreclosure process:
Next let's deal with three properties that RealtyTrac's map locates just west of 101, on streets that run both east and west of 101. If we don't entirely trust the accuracy of this site's mapping feature, and give these three borderline location foreclosures to Belle Haven as the numbers suggest we might, then Menlo Park's probabilities of foreclosure are as follows:
These numbers confirm that both East Palo Alto and, in particular, Belle Haven have been hit hard by foreclosures. "Hammered" might be a better word, and still an understatement. We can't confirm that the subprime crisis has caused this crisis without examining each loan in default. But the census numbers tell us that African-Americans and Latinos predominate in these areas, and we know that these ethnic groups are more likely to have subprime loans, so we can say that the results strongly suggest a positive correlation between ethnicity, foreclosure and subprime loans. By themselves Belle Haven and East Palo Alto account for at least 77, or a staggering 20 percent, of San Mateo County's 382 Notices of Default. Belle Haven, a small community of less than a thousand homes plus a handful of small apartment buildings, accounts for a incredible 6 percent of San Mateo County's notices.
RealtyTrac's maps confirm this. The colorful comma-shaped markers used to mark properties in default blanket Belle Haven and East Palo Alto like birthday balloons. In contrast, the neighborhoods west of 101 have what look like a few escapee balloons blown inland by one of the Bay's afternoon breezes.
This is nuts. But is it unexpected? As my loan agent says, who was most likely to get burned when the lending industry suddenly opened the subprime faucet full blast and then just as suddenly closed it? People with no history of managing credit. People with a history of mismanaging credit. People who weren't really making enough money to qualify. People not sophisticated enough about "loan products" to know that perhaps they could do better than a subprime loan (although lack of sophistication about "loan products" isn't confined to subprime borrowers). Undoubtedly some and perhaps most of the borrowers who fall in these categories will hang onto their homes and end up owning something they otherwise would never have had the chance to own. But some are failing and others will, quite possibly in large enough numbers to make it harder for the rest to hang on.
Well, what if you're a what's-in-it-for-me kind of guy? Maybe you're a flipper or investor who'd like to know what kind of opportunities foreclosures will bring. Or what if you're a west-of-101 homeowner worried that this crisis will spread to your neighborhood. Or what if you're any homebuyer scared to death by the headlines?
My guess, based on working in all these markets at one time or another, is that the damage will be substantial but confined mainly to the markets where damage is occurring now. I'm not saying this makes it okay. I'm just saying that, while the foreclosure crisis will have a ripple effect outside these markets, it almost certainly won't take the entire real estate market down with it.
Why not? Well, if my first war story didn't answer that question, then let me share another.
In early 2001 the real estate market west of 101 was just starting a year-long slide that would see the average midrange home lose about 15 percent of its value, the average top-end home about 35 to 40 percent and an ultra-top end trophy property maybe 50 percent. Another agent in my office, a bright guy and an experienced investor, owned a Belle Haven rental. Knowing I'd just had a sale there, he asked me to help price the house before he put it on the market. I asked him why he was selling. After all, the problems we were seeing west of 101 were caused by the sudden disappearance of dot-com money, but dot-com money had never driven Belle Haven home prices. You're right, he said, but it's all inter-related. Now that dot-com's in the tank, the assembly-line workers who live in Belle Haven won't be getting overtime. In fact, they'll probably lose their jobs. Better get out now, he said, before it gets bad.
So he did. And here's how those five markets we compared a few moments ago fared in 2001 compared to 2000:
Yes, that's right, the Belle Haven/East Palo Alto market was the only one of those five to go up in value in 2001. The other four saw home prices slide. In other words, these five markets did the opposite then of what they're doing now. This is the second time you've seen the Belle Haven/East Palo Alto market march to a different drummer.
Except that it didn't and doesn't. It's the Silicon Valley midrange and top-end markets west of 101 that march to a different beat. Because while home prices plummeted in those markets in 2001, they rose throughout the rest of California. Belle Haven and East Palo Alto weren't the anomalies; they were typical of the larger market. Remember those agents who worked not only in Belle Haven but also in the Central Valley? That's the clue. The Belle Haven/East Palo Alto market is an outpost of normalcy, a more-or-less typical California market on the edge of an abnormal market, Silicon Valley. That's not to say, as some do, that Silicon Valley real estate is a pets.com-style aberration. It is to state the obvious, that Silicon Valley has different market drivers that not everyone understands or appreciates—yet they live in Silicon Valley because of the difference in quality of life those differences in market drivers make. Folks, you can't have it both ways.
Finally, what are the potential after-effects of the foreclosure crisis on neighborhoods like Belle Haven and East Palo Alto?
Prices in the Belle Haven/East Palo Alto market have already gone down about 6 percent from Q1 2006 to Q1 2007 according to my statistics. That's not surprising, considering the rigor mortis that's settled into that market. 6 percent is a significant but still modest price drop for any homeowner who has the resources to ride out a market cycle. Still, anyone who bought with 100 percent financing in 2006 most likely is "under water" (owes more than the house is worth). But since prices there are still about 8 percent higher than they were in Q1 2005, not many recent home buyers will find themselves under water. More worrisome are the homeowners who refinanced and took cash out. I've read but can't confirm that many of the defaulting subprime loans taken out in 2005 and 2006 are refinances, not purchase loans. In fact, according to the fair housing coalition release I quoted earlier, borrowers of color hold an even higher percentage of subprime refinance loans than subprime purchase loans.
This would seem to put to rest one question—that subprime purchase loans artificially fueled the last year or two of the boom—but raise another: why so many refinances? Are some subprime borrowers in danger of losing their homes today because they did what so many other homeowners did during the boom, pulling equity out of their homes for "debt consolidation", a new kitchen, a new Suburban and the other bells and whistles of consumerism? It's possible, but it seems more likely that many of these subprime borrowers were refinancing out of loans they couldn't afford into loans they only thought they could afford.
Now the subprime crisis is affecting buyers as well. I've read and heard credible reports that 100 percent financing is far more difficult to get than it was just a few months ago, which must be shrinking the pool of buyers for affordable neighborhoods, such as Belle Haven, where it was common. Certainly demand has nosedived in the Belle Haven/East Palo Alto market, and while this may reflect buyer "uncertainty", lack of access to credit will sideline even the most gung-ho buyer.
The irony of this subprime train wreck is that until recently the mainstream lending industry "redlined" (refused to lend in) neighborhoods like Belle Haven. Back in the day home buyers in those neighborhoods had no choice but to go to a "hard money" lender and pay a substantial premium, much higher than the current spread between prime and subprime rates. The Community Reinvestment Act of 1977 first put pressure on banks to do business in underserved areas, but it took a Federal Reserve Bank of Boston study in the early 1990s to encourage lenders to enter those markets. When I got into real estate sales in the late 1990s Bank of America was the only major lender to actively court the subprime market through its Acorn program. Although B of A seemed to do a high volume, overall the big lenders have never been major players in the subprime market. The recent boom in subprime lending came mostly from a relative handful of smaller lenders who by 2005 saw their pipeline of prime loans drying up, looked at the overhead they'd built since 2001 and, instead of downsizing, decided to tap the subprime market. Now they've left that market hanging by going back to more conservative underwriting guidelines or even, in some cases, going out of business. This pullback may explain why the Belle Haven/East Palo Alto market has lost proportionately more buyers.
Will prices continue to go down in neighborhoods like Belle Haven? With current buyer demand inadequate to absorb even normal levels of inventory, let alone the excess that market now has, any seller with a pressing need to sell will have to either cut her expectations or boost her concessions or both.
Will foreclosure sales just add fuel to the fire? I've always been skeptical of the idea that lenders sell foreclosed homes at steeply discounted prices, not least because this information comes from those furthest from the scene, academics and infomercials. According to The Wall Street Journal Online, "a study by First American Real Estate Solutions...found that (foreclosed) homes sold at a median discount of 14% of their estimated value in the first half (of 2006)." Money Magazine says that "a study of foreclosure sale prices in more than 600 counties nationwide in 2005...found that, on average, foreclosed properties sold for about 15% less than comparable homes". But Money cautions that "in states where real estate prices have risen the most, including Arizona, California and Virginia, foreclosed properties sold for within 5 percent of full market value". And in fact, one agent who claims to specialize in foreclosure sales says on his Web site that a buyer is far more likely to get a bargain dealing, not with a lender, but with a realistic homeowner anxious to avoid foreclosure and willing to walk away with some cash in his pocket.
This seems much more believable. I have a hard time seeing banks, or the contractors they hire to dispose of foreclosed properties, stumbling through the real estate market like ninety-eight pound weaklings getting sand kicked in their faces. It just seems out of character (and an invitation to a shareholder class-action lawsuit). I suspect that what really happens is that when a lender takes back a home in a place like Detroit, where serious long-term economic problems drive foreclosures, it's likely to see the writing on the wall—years of declining prices, vandalism to vacant properties—and cut and run. A lender may be willing to accept a price that's less than today's market value—and then again, maybe it's not less, since many foreclosures have been poorly maintained and perhaps even stripped—because it knows that today's discounted price is probably next year's market price, so why hang around to watch the inevitable? The average home seller doesn't know this, or doesn't want to know it, hence the perception that lenders give their properties away. And the perception probably helps lenders unload their properties. But where economic conditions are more promising, as in Silicon Valley, it makes sense that lenders would hang tough.
But even hard-nosed lenders need buyers, and with subprime credit tightening, who will they be? Part of the answer is obvious: buyers with higher incomes (or better able to document their incomes) and/or higher credit scores. What may have been lost in the subprime/predatory lending discussion is that plenty of buyers of color fit this description including, I suspect, many who bought in Belle Haven or East Palo Alto before the loan guidelines got so loose. Because if over half of African-American and almost half of Latino borrowers are getting subprime purchase loans, then almost half of African-American and more than half of Latino borrowers aren't. But it raises the possibility that these neighborhoods, so close to some of the hottest and most expensive real estate markets in the country, may see their character change.
The other part of the answer? Investors, not flippers but the long-term investors who were a staple of the east-of-101 market until rising prices tempted some to cash out while declining rents discouraged others from getting in. But that was then, and we've already seen rents rise about 15 percent since 2005. With the local economy economy adding jobs just as prices start going down east of 101, I think we may see investors cautiously re-enter this market. This could be a mixed blessing. Absentee owners are linked in the public's eye with the kinds of conditions—deferred maintenance, cars parked on lawns—that downgrade neighborhood property values and quality of life. On the other hand, a wave of investor interest might give home prices a floor.
Multiply one neighborhood or city by hundreds or thousands of similar neighborhoods and cities and it is, to put it mildly, interesting times we live in. And while interesting times may not be happening in your neighborhood, they may be happening in a neighborhood nearby.