• cost per square foot (replacement cost); and
• income analysis methods.

Numerical alchemy in a median price for all

The attractively simplistic application of a “mathematical abstraction,” as in a median price or a comparison of median prices over time, will never produce a useful result when applied to an asset as unique and variable as a parcel of real estate. The overall median price also gives an erroneous representation of the market. The rate and extent of changes in property value prices varies dramatically both within and between low-, mid- and high-tier properties.

While values for low-tier properties generally change quickly and dramatically, as depicted in the charts above, high-end properties are slower to react to the rise and fall of the general market. Different tiers often move in opposite directions, and when upward or downward price movement occurs, each tier experiences a different percentage of price change.

A median price is nothing more than a line bisecting the total of all sales prices; one half above, and one half below. It never represents the price movement of any one property. The formula of median home price must be dumped in the trash bin of bad ideas for setting values — just ask any real estate appraiser, economist or agent who has had to explain why the listing price needs to be reduced if the property is to sell when the seller has just read about a rise in the median price in the local newspaper. [For more on the agent’s role in correcting homebuyer misconceptions, see the May 2011 article, Financially illiterate homebuyers in distress – agents to the rescue!]

For more accurate and refined data that gives a reasonably meaningful picture of market pricing, tiered pricing charts like those shown above offer a more sensible source — but not the best.

Return to sanity

Now that the housing price bubble of the mid-2000s has burst, we need to know more than ever about the economic factors that cause real estate prices to decline quickly or slowly. Also important is whether those factors affecting price can help us predict the speed at which different segments of the California real estate market will recover.

When Japan’s real estate market collapsed in 1991-1992 following its last financial crisis, prices dropped in both residential and commercial real estate, and continued to drop for a decade, dragging government-supported banks (i.e., improperly supported banks) with them.

However, when Japan’s commercial real estate prices fell, they dropped dramatically faster and further than prices for owner occupied residential real estate. If the Japanese crisis-reaction precedent is the track our government stays on, we can expect similarly dilatory results in our own real estate market.

Two factors called price persistence and illiquidity are listed in a report entitled Asset Price Declines and Real Estate Market Illiquidity: Evidence from Japanese Land Values, by John Krainer of the Federal Reserve Bank of San Francisco (FRBSF). Price persistence is the tendency of listed prices in owner-occupied real estate to resist change, staying high even when the market for resale homes has dropped, a condition more commonly called sticky pricesA seller's irrational reliance on past home pricing as a basis for setting current pricing, downward price rigidity or the money illusion.

Illiquidity refers to the corresponding inability to cash-out on the sale of property, one factor in a vicious cycle which causes price stagnation and inhibits recovery from a financial crisis and recession. Greater liquidity, when buyers and sellers can easily obtain money and get rid of property at agreed upon prices (read: market prices), leads to a more volatile market, for better or worse. In the case of a market collapse, home prices are unable to stabilize — bottom out — until property pricing comes to reflect cash values. On the other hand, price persistence (sticky pricesA seller's irrational reliance on past home pricing as a basis for setting current pricing) of sellers can cause property values to remain artificially inflated long after a collapse has occurred.

Search frictions and debt overload hindrance

The reluctance of prices to adjust quickly to real financial conditions in the real estate market is attributed to two causes. The first cause is the difficulty of finding a property through a gatekeeper such as a broker, agent or builder, and then agreeing to an appropriate price, called search frictions.

In the hunt for a home, these search frictions make it far more difficult for properties to change hands and prices to adjust to current market rates. This prevents deals from being made then making a deal is what everyone has in mind. Thus, these frictions hinder the speedy resolution of a financial crisis, and work to the future detriment of the multiple listing service (MLS) environment.

The second cause of this lag is the crippling load of debt underlying so many California homeowners which makes leaving a property (for those who must relocate) more difficult, one cause of an enduring recession, called debt overhang. Excess mortgage debt on a property forces buyers and sellers to ascribe distorted values to the real estate, part of the money illusion driven by property debt.

Restabilization of real estate market pricing and sales volume to meet the current economic reality, a prerequisite for the commencement of a recovery, will be almost impossible until the mortgage debt overhanging property owners can be matched to, or reduced to less than, the property’s value, called a loan cramdown modification. [For more on the need for this policy change, see the January 2010 article, Cramdowns, cramdowns, cramdowns!]

Ultimately, negative equity homeowners are forced to become more financially rational. The FRBSF’s study indicates that if a shock to real estate fundamentals occurs, such as the artificial increase in homeownership funded by the recent subprime mortgage boom, then the steepness of the initial homeownership price drop in the recession and the speed of homeownership’s eventual price recovery both depend upon the prices brokers choose to set for a property’s dollar value.

Property caravans serve a useful purpose

When brokers can broadly agree upon an appropriate price, property values will reset constantly to their basic worth — cash values — without prices and sales volume rocketing to the artificial heights of a housing price bubble or the artificial lows at the bottom of the bubble’s collapse. Thus, the historical (long-term) trend line of property prices will be more closely maintained from year to year; boring, but better for the livelihood of all involved.

However, the combination of search frictions and mortgage debt overhang tends to make property owners reluctant, or simply unable, to sell for the property’s fundamental value (the “true cash value” of the property at any given time), especially in owner-occupied residential real estate.

Instead, sellers keep their homes on the market longer, hoping in many cases to avoid default, fishing for the rare buyer who might be willing to pay a higher price. Seller’s agents in high-end properties tend to pander to these instincts. This leads to price stagnation, in which the rise and fall of prices is unnaturally prolonged: not a good thing, since it greatly extends the length of a market collapse, as it did in Japan in the 1990s and Mexico in the 1980s — and appears to have done in California’s high-end properties that, with the exception of the Bay Area, are suddenly much lower (and replete with foreclosures). [For a comparison of CA housing policy with those of other major world nations, see the June 2011 article, US homeownership: an international perspective.]

If only we could stick to a cash price

Japan’s financial crisis of 1990 included a collapse in both commercial and residential property values. Income property prices were especially volatile throughout the collapse, ultimately falling faster and deeper than owner-occupied residential prices, but bottoming sooner. Owner-occupied residential real estate, which had a much higher variety of pricing and a greater burden of debt, also eventually fell catastrophically, but less dramatically.

The difference in price movement is because income producing real estate is more easily evaluated (by capitalization rates (cap rates), income flow, and replacement costs) and typically less burdened by high loan-to-value (LTV) debt ratios so equity remains to be worked with. These conditions of ownership make it easier for buyers and sellers to agree upon an appropriate rice; thus, providing the owner with the ability to cash out — greater liquidity.

The relative ease of income property evaluation makes that part of the real estate market a more exciting and less predictable field, as cap rates can change dramatically, altering market values in a moment. Conversely, owner-occupied residential property moves slowly and steadily with sticky pricingA seller's irrational reliance on past home pricing as a basis for setting current pricing, sellers not reacting to the market forces existing at the time. The historical reality of market implosion.

As the FRBSF report points out, real estate pricing often fails to correspond to objective reality. The discrepancy between the prices that homeowners set and the prices homes actually garner in the market is attributable to the human factor. Outrageous bubbles become more outrageous, and collapses become more devastating, due to a common set of irrational beliefs about market behavior. The most dramatic example of market fallibility took place in the very recent past — the Great Recession of 2007.