This Reuters headline caught my eye tonight. According to the article Bernanke said "A widespread decline in home prices is a relatively novel phenomenon, and lenders and loan servicers will have to develop new and flexible strategies to deal with this issue." Novel unless of course you were alive for any of the previous declines, like say 15 years ago in the early 90's.

According to the news last week you would have thought the crisis had been averted, there is no current or pending recession, and unemployment is dropping. Yet in his prepared remarks Bernanke says (emphasis added) "High rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets, and the broader economy." Can have? Does he not get that we have been in record foreclosure territory for nearly a year - far exceeding all past experiences - and that based on current foreclosure data it is getting worse not better?

Readers of our CA Foreclosure Report have been well aware during that time, and our April CA Foreclosure Report, to be released next week, will once again show lenders taking back a record number of properties. At what point does this stop just being an academic possibility?

It has been very heartening to hear reports of strong sales activity again from local Realtors as affordability has begun to return to certain areas of CA. But the foreclosure crisis is far from over, and as the Fed apparently is just now realizing, it can have impacts far beyond housing. For those of you investing right now, be careful to keep an eye on cap rates and know that we may still have some interesting times ahead.

Sean

You search homes on an MLS based website looking at listing after listing. Some have pictures, some don't. You check out the new neighborhood websites and find details about schools and amenities. You fly around the neighborhood looking at values in Zillow or Cyberhomes. Yet with all the data available you are only part way to the truth about the neighborhood, the home and the overall value of your prospective purchase.

Here is what I mean.

The image above is of a neighborhood in Stockton called Morada. Though sliced in half by Highway 99, everyone shops at the same grocery store, and their children go to the same middle and high schools. Reviewing neighborhood and property characteristics on services like Zillow for instance, you might determine that the right side of Morada, made of largely older and smaller homes is less desireable. Aerial photos further support that impression through funky streets, no sidewalks, and reasonably dense housing. From this you may conclude the right side is not the place to be.

So you would think.

Enter the foreclosure story. On the left side of Morada is an overdeveloped disaster marked by many foreclosed homes. On the right side, long favored by locals, you have almost no foreclosures due to long term ownership and considerable equity. With this one picture the simple truth of desirability becomes clear.

33% of sales in CA are now REO (bank owned) resales. Many more are short sales, and almost as many foreclosure auction sales exist as all other sales combined. Without access to foreclosure data it is arguably impossible to "know a market", set sales prices, make purchase offers or advise clients properly.

Here is one neighborhood, divided by a highway, yet worlds apart when it comes to the truth about it's value, it's opportunity and it's story. There are thousands more just like it.

Sean

In the 90's quite a few foreclosure investors realized the best way to maximize income was to focus on rents rather than appreciation. One popular way to do this was to "reconfigure" homes to maximize the number of "legal" section 8 bedrooms. As a result, you'd find houses with part of the living room turned into an additional bedroom, masters bedrooms split into two, funky add ons, often built without permits and the like. The workmaship was always shoddy, and some of these properties became down right maze like in their attempts to increase rents

While buying foreclosures in CA's Central Valley at auction, where you often don't get to look inside the property before purchase that you can't always judge a book by its cover. After finding a few of these properties and talking to some of the "old-timer" agents I compiled a hit list of slum lords whose homes I simply didn't want. Amazingly as markets shifted to the seller side, these slum lords sold those dumps at incredible premiums only to have them inevitably end up at the foreclosure auction.

With prices off 40-50% in parts of the Central Valley we are quickly returning to a market where investors will focus on cash flow rather than appreciation. I cringe when thinking about all the homes that will suffer the chainsaw massacre of Section 8 "optimization".

Sean

I spend all day every day looking at, and working on, foreclosures. At times it can be downright depressing. Given that the primary cause of foreclosures is price declines, brought about by excess inventory, created in part by foreclosures, it is easy to see how the doomers argue that we are in a self-reinforcing death spiral with NO bottom.

In reality, nothing could be further from the truth. There is a bottom, Let me explain.

Nearly all residential appraisals are based on comparable sales—comps. Most commercial appraisals rely more on the cost basis approach to valuation, or on income capitalization. For those who think of homes as an investment, the income capitalization approach should make perfect sense. The idea here is that rents (income), minus expenses and divided by investment (sales price) equals the return on investment (capital). This return on capital is commonly referred to in the industry as the "cap rate", and should be considered analogous to the percentage return you'd receive on other investments like stocks or treasuries. So a commercial building with a cap rate of 6% on a $1 million dollar investment should be expected to generate a return of $60k per year.

If you look at cap rates for residential real estate by estimating realistic rental values it isn't hard to see we've had a problem the last few years. In my neighborhood houses that were selling for $850k at the peak rent for about $2k/mo. After deducting property taxes and insurance (assuming zero maintenance and zero vacancy), the cap rate is about 1.5%, or a "one and a half cap". Now let me ask you: How is this a good investment? You might want to answer "appreciation". But keep in mind that unless rents increase, rising prices only continue to lower the cap rate. Thus appreciation is fundamentally limited by the growth of rents or how bad of an investment one is willing to make.

You can quickly and easily estimate where the bottom might be in your market by looking at local rental rates, multiplied by twelve, subtracting taxes and insurance, and dividing by a reasonable cap rate. That, of course, begs the question of what a reasonable cap rate is. In my opinion it will vary according to the property. Perhaps as low as 2% for a trophy property in a fabulous location, to 12% or more in high crime rate areas where you fear for your life.

The one reform I'd really like to see before this mess is over is the death of the comparable sales appraisal approach. By tying lending limits to local rents, we can ensure that homes remain a great investment for everyone. In places like Stockton, where prices have fallen as much as 40%, cap rates are quickly becoming attractive. While inventories are still downright scary, agents are seeing a noticeable uptick in sales.

Perhaps a sign they are close to the bottom.

Sean

I'm frankly amazed every time I see another report from the National Association of Realtors given their recent track record (also here). You’d think they would throw in the towel and get out of the prediction business.

That said, the latest headline "Sales to Stabilize before Upturn in Second Half of 2008", might not be that far off - but probably not for the reasons they cite. To be clear, I see increasing foreclosures, rising inventories, and other ugliness ahead. But many that hang in there will find a silver lining. During the boom, folks like David Leraeh said that affordability was a "growing concern", while simultaneously forecasting future price increases. These two views, of course, are diametrically opposed. As we learned in economics 101, you can't increase price when people already can't afford the product.

The NAR needn’t have perpetuated this fallacy. For while many Realtors cling to the idea of homes as investments, in reality they are far better served by affordability. People want to be homeowners. Even as I saw the housing market disaster coming and sold nearly 20 properties, I couldn't bring myself to sell my own home though I was certain it would decline by 25% or more. Why? Well, I didn't buy my home as an investment, I bought it as a place to live -- one that I happen to really like. So while everyone is focused on the very real and serious pain that this correction is causing, the reality is that it has also created new, and more sustainable, opportunities for buyers, investors, and, yes, Realtors.

You'd think my Realtor friends in Stockton, Manteca and Modesto – communities at the epicenter of the housing shock -- would be near suicidal. Not so. Prices are now down 40%, and at that price you can actually buy rentals that cash flow. Renters can afford to buy with traditional 30-year fixed financing. Smart parents that thought neg-am ARMs were lunacy are now willing to help their kids with a down payment and traditional financing. And enterprising Realtors capitalizing on this new opportunity by letting buyers know they can help find bargains are doing just fine.
Not that things are great - but they are whole lot better for buyers and Realtors now that there has been a significant price correction.

If you are in an area where sales are slow, and prices have not yet corrected, you may want to secretly hope they do soon. And stop working against yourself by trying to convince everyone that your market is special and can't possibly go down. Buyers won't come knocking until you do. It is going to be a really hard transition for banks, builders, recent buyers, and owners that used their homes as ATM's, but despite the best efforts or legislators and regulators, only lower prices will get this market going again.

And don't buy into the message from doomers that prices have no bottom. They absolutely do. Largely determined by rents and cap rates.

More on that next time.

Sean