By now you have heard about people losing a lot of money on housing purchases, especially those made during the recent peak years of 2004 and 2005.
Many in Las Vegas have lost hundreds of thousands of dollars on second home investments, but then they should be used to gambling. Many in Florida, the flipping capital of the world, overpaid and under-researched investment condos and got left with zero equity or less before they closed. They walked away devastating south Florida condo prices.
The dot-com bust of 1998 taught speculators that risk matters -- and all investments have risk. Some of these same investors turned to housing as a safer bet and in most of the country it is a safer bet with solid, long-term returns in excess of inflation. It will be a safer than average investment again, but first and foremost it is consumption-driven.
Fortunately, most San Diegans have owned their homes long enough that even with recent price declines -- sometimes by as much as 10 percent or more -- they are still in the black or above water compared to what they paid and more importantly, compared to the mortgage underlying the property. The bad news is that things are likely to continue to deteriorate in San Diego for a while, perhaps a year or more, before fundamentals start to drive prices back up.
Those markets where more naïve and sometimes exploited borrowers took on teaser rate mortgages and adjustable rate mortgages -- usually the lower-priced markets -- have also seen foreclosure rates escalate and prices fall. This will continue until those who can afford to continue to own their home remain and those who cannot are washed out of the system.
Politicians will propose many solutions, but they cannot print money for those stuck in contracts they cannot afford, and except for the case of fraud, ignorance will not allow those who can't afford to remain in their homes to do so. Some markets are doing just fine, especially those that did not witness the rapid run-ups and entry of investment-driven speculators and naïve borrowers.
What homebuyers need to understand, other than the terms of the mortgage they accept, is that housing prices in the long run must be driven by fundamentals and not by ill-informed speculators. Eventually the greater fool theory must collapse. While some flippers did well, latecomers to the "housing can only go up" party got burned.
On the demand side, home values are driven by incomes allocated reasonably to support home mortgage payments, property taxes, insurance and ongoing maintenance. Typically, a household should allocate no more than 35 percent to 40 percent to the sum of all these costs and no more than about 28 percent to the mortgage payment.
The only other way to support housing is via existing wealth, and here we observe that wealthy individuals come from all over the country and settle in San Diego for the quality of life. This is no different from rolling over the equity from prior home gains into the next house, further sustaining the high prices. These buyers tend to help sustain prices that remain unaffordable for most renter and younger households. Still, for many lower-priced markets -- and that means anything under $500,000 in San Diego -- income and fundamentals matter, and prices can't go too far beyond what people can afford.
On the supply side, the long-term values should correlate with the cost to build new housing. That is, higher costs will push up prices. At the same time in San Diego, a large portion of the cost to produce housing is land value, and land values capture the residual profitability based on the price supported by demand. Stated another way, long-term land values go up and down based on fundamental demand. In the short run, analysts using comps will over- and under-appraise the value of land by using history as a guide rather than asking what can people afford and what it costs to build: Whatever is left over is what the land is worth.
This tendency to believe that the highest priced comparable properties observed for a home or a piece of land over the last year without regard to fundamentals is one of the reasons real estate prices are sticky and take so much time to work out the price cycle swings.
When we bring in the psychology of the market, we must consider expectations. If households ignore fundamentals and simply assume that prices will continue to appreciate based on last year's rate, then the demand for housing skyrockets. This is because the appreciation rate during years like 2002 or 2003 will far exceed the cost of debt even at subprime premium mortgage rates.
This is investment-driven demand as opposed to consumption -- what can we afford -- demand and it is the root cause of bubbles and crashes in the housing market. If you time it just right and get in early and get out before others figure out that eventually prices are not sustainable, you can make a lot of money in places like San Diego. But most people will not be that adept at getting out, and what if they really need the house to live in? These consumers of housing that got swept up with the speculators or joined their ranks added to the painful turmoil felt by some today. Others see this as a chance to finally get into the housing market and for that we should applaud the drop in prices, since more affordable prices pay dividends for employers trying to retain help.
In the long run, appreciation rates should only exceed inflation by a small margin, unless we observe more severe housing constraints based on stricter land use controls and more difficult entitlements. Such constraints are up to politicians and you as voters. Severe land supply and water constraints will probably maintain high home prices for the foreseeable future.
So don't fret. Should we take a last-one-in-shut-the-door approach like many California communities, or try and sympathize with employers who would like to stay here if they can find employees who can afford the housing? There are two sides to every price change.
Miller is a professor and the Director of Academic Programs for the Burnham-Moores Center for Real Estate at the University of San Diego.