“My Two Cents” - Guest Commentary - Fred Carach 7/11/2008

Today we are told that the real estate crisis is in the 8th or 9th inning. I don’t think so. The  3rd inning is more like it. I have a rather a unique insight on the problem. For thirty years I was a State Certified General Appraiser. That means I was licensed by the state of Florida to appraise everything from a chicken coop to office towers. I guess you could say I was there at the creation.

Those who champion a quick recovery are quick to trot out trite statements. The one I find the most amusing is the one that proudly proclaims, “that you can’t lose money in real estate”. the other one is that, “they aren’t making any more land and therefore it is a sure thing”. The quick recovery proponents foresee a V-bottom recovery. In other words after hitting bottom the market will immediately bounce strongly upward like a rubber ball that has fallen from a great height. I think an L-shaped bottom is far more probable. I think that after we hit bottom we will bounce along the bottom of the L for possibly five years. Beyond that point my crystal ball becomes very dark. What everyone appears to be missing is that in every type of investment transaction except for real estate there are only two decision makers. The buyer and the seller and if they agree the transaction takes place. In real estate however for a transaction to take place four players have to agree. And this is what everyone is missing.

It is not surprising that everyone is missing this important fact because for fifteen years the other two parties did nothing more than to rubber stamp the deals that the buyer and seller had agreed to. The other two parties to the transaction are of course the lender and that weird creature that no one knows anything about the real estate appraiser. The function of the lender is obvious. The function of the real estate appraiser is not so obvious. In theory the function of the appraiser is to estimate the market value of the property. So that the lender can recover his investment if the buyer defaults on his mortgage. And in olden days when lenders, that is the banks warehoused their mortgages this is actually how it worked. That world came to an end when mortgages were converted into securities and then sold all over the world. The lenders simply pooled these mortgages into financial instruments called MBS (mortgage backed securities) and sold them to increasingly clueless parties all over the world.

It is amazing how disinterested lenders became in honest estimates of market value once they knew they could dump these mortgages on the unsuspecting and the clueless. The appraiser now had a new function. His new function was to rubber stamp the decision of the buyer and the seller. And woe to the appraiser who did not rubber stamp the deal. I spent my last fifteen years as an appraiser having mortgage brokers point a gun to my head.

Now let’s see how things worked before the crisis. Lucky seller has found a fool who will pay $30,000 more than the property is worth. The appraiser tells the lender that the sale price is $30,000 too high. The lender couldn’t care less because he knows that his mortgage will he believes be lost in the 5,000 other mortgages that are being pooled and sold to some clueless bank in Europe. No one will ever be the wiser. He casually informs the appraiser that if he ever wants another appraisal assignment from him he will rubber stamp the deal. The deal is rubber stamped.

What is even more important however is that this new sale is now regarded as a “comp” or comparable sale by appraisers working in the neighborhood. This new higher sale now bleeds through the neighborhood and results in higher prices for all comparable properties in the neighborhood. This powerful engine for increasing real estate prices was at work throughout the great real estate boom. Contrast that happy state of affairs for the seller to what happens today to lucky seller who has found a buyer willing to pay $30,000 more for his property than market value.

Our lender is now drowning in foreclosures. The last thing he can tolerate is to foreclose on another over priced property. He will inform the lucky seller that under no circumstances will he underwrite a mortgage for one dime more than the appraised value. Under the new world order the appraiser has also found a reason to develop a backbone he now knows that almost all appraisals are now being reviewed by an independent appraiser. There is nothing that will make an appraiser more cautious than the realization that his appraisal is being reviewed by another appraiser. Outside of the industry very few people have any idea of just how difficult it will be to raise real estate values as long as these conditions exist.

But it gets worse. It gets far worse. For real estate prices to advance it is first necessary for non homeowners to be able to purchase starter homes. For the first time in decades these young, first time purchasers are being told that they have to have a down payment. The horror of it! These pampered darlings have never saved a dime in their lives and they are now being told that they have to come up with a down payment of 10% or more. When you tell them this they look at you as if you have lost your mind. In reality what this means is that a large chunk of  people who would have qualified to purchase real estate before the real estate crisis are now frozen out of the market.

Then there is the FICO score crisis. During my career the magic number was 620. Anyone who had a credit score of 620 or above could qualify for a loan. Today for the first time that score has been raised to the 660 or 680 range. There is nothing that will tell you how terrified lenders are today than this statistic. For most of the last twenty or thirty years lenders were beating the bushes looking for borrowers and constantly lowering their standards to get them. Today they are kicking them away. And this is happening at a time when the credit scores of the American people are in a death spiral from an avalanche of foreclosures and bankruptcies. Perhaps another 10%-15% of potential buyers are now frozen out of the market who would have qualified prior to the real estate crisis.

The ugliest reality of course is that the median income American family cannot afford to purchase the median priced American home. Most Americans today could not afford to purchase the home that they live in. At the peak of the boom the median priced home sold for about $230,000. The median American family can afford to pay up to $175,000 for a home using tried and true mortgage parameters. Since booms and busts almost always overshoot I suspect that the slow, relentless, decline in housing prices that we are experiencing will not end until the median priced home is selling for somewhat below $175,000. As this is being written the median price American home has fallen to about $195,000 not too far from the $175,000 requirement. I think we could reach $175,000 sometime in 2009.

But I can’t for the life of me see how we can have sustained price increases as long as terrified lenders and real estate appraisers refuse to cooperate. Sellers can rant and rave all they want to. They are not going to get their price. At least not in the next five years. Let me repeat myself, sustained price increases in real estate are very, very difficult to achieve without the willful cooperation of the appraiser and the lender. As I have stated what makes real estate unique among all investment categories is that what buyers and sellers want is irrelevant without the concurrence of the lender and the appraiser.

Fred Carach is the author of the recent book "Forty Years A Speculator". If you like the essay you will like the book.   The book may be purchased here.           

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