Wisest of the crowds

The US Commerce Department reported various housing data this morning that confirms the poor state of affairs in the US housing market. Specifically:

- Building permits for single-family homes in December were 10.1 percent (±1.6%) below the November figure and 25.3 percent (±0.8%) below the December 2006 figure.

- Single-family housing starts in December were 2.9 percent (±8.7)* below November and 24.8 percent (±1.3%) below the December 2006 level.

- According the AP, it will take 9.6 months to eliminate the backlog of unsold new homes at the December sales pace, the longest stretch of time since the month’s supply stood at 10.3 months in October 1981.

You can see the data and release at this Commerce website.

What’s really interesting is that the markets are shrugging this off. Take a look at this mornings prices of home builders, complements of Google Finance:

Ths homebuilders have been rallying since the market low reached the day the Fed lowered interest rates 75 basis points on an emergency cut with another 50 basis points expected TOMORROW.

Having said all this, markets ALWAYS move further and harder than expected. More problems seem likely without some extreme structural (read fiscal) or economic stimulus. The Fed seems to be doing its part. Will the Government in the midst of an election year?

The National Association of Realtors reported that their “Pending Home Sales Index” for July fell to its lowest level since the post Sept. 11, 2001 period as a result of tightening credit for Jumbo mortgage loans (loans over $417,000).

So what is this index? Directly from the NAR release:

“The Pending Home Sales Index is based on a large national sample, typically representing about 20 percent of transactions for existing-home sales. In developing the model for the index, it was demonstrated that the level of monthly sales-contract activity from 2001 through 2004 parallels the level of closed existing-home sales in the following two months. “

It seems that Three Stooges of the mortgage ecosystem, lenders (Curly), Wall Street mortgage underwriters (Moe), and mortgage buyers (Larry) all woke up after a night of drinking and decided never again (well, at least for a few weeks!) ! These Jumbo loans are NOT purchased by the quasi-government agencies Fannie Mae or Freddie Mac whose job it is to purchase loans from lenders so that lenders have the funds to make more loans - a mechanism to facilitate home ownership for average and lower income home buyers. Jumbo loans do not qualify so they must be either held by lenders or sold to investors via wall street. Since Fannie and Freddie have continued to support loans at the low-end while the high-end has lost free market support, Jumbo’s have shut down for the minority and have gotten MUCH more expensive for the majority. Not surprisingly, the Western part of the US, which has the highest home prices and presumably the most Jumbo loans, got hit hardest being down a whopping 20.8% to 82.3 versus 89.9 nationally.

Will this last? No way. This is a temporary disruption as people reorient their perspective to risk. Will the cost of jumbo’s (as a spread to treasury securities) increase? You can bet on it!

No not what you are thinking - not social, ethnic, or racial discrimination. Redfin discriminates on price. PRICE! The 60 minutes piece was a yawn for me personally but it does give Americans the right to start to push back. See the posts and comments at TechCrunch, Redfin, Inman, BloodHound for an early read. Whether it becomes a consumer zeitgeist or fades will be seen but the open question is this: will price variation become mainstream in american residential real estate?

There is an old economic idea called price discrimination that is popular with every micro-econ 101 student, and their professors, that says you reach more customers and make more money by offering variation in pricing. Its sort of definitional for anyone who believes in supply and demand. It works like this: when you go to see a baseball game, there are a 100 variations in pricing to meet everyones needs and to tap into every possible cross section of demand. For example, there are ticket prices for corporations who entertain in luxury boxes and ticket prices for those who mostly prefer a beer and some sun in the bleechers. Ticket prices for season holders and ticket prices for last minute shoppers. In short, EVERYONE can have their demand met for baseball. A small example with the mighty SF Giants here.

What would happen if every ticket was the same price? Mayhem and lost profits. Some people willing to pay more for MLB tickets will transfer their money to an underground marketplace that will use price discovery to allocate tickets. Meanwhile, people at lower price points will be shut out resulting in further lost revenues to MLB. Thats why we have pricing variation. Its better for everyone because everyone gets an allocation and the business folks maximize their revenues.
People might argue that the price variation exists is in the underlying house price and not in the intermediary execution price (brokers & agents). If that were true, then why did trading volume in financial markets explode when electronic execution came into acceptance? (For a slightly more technical explanation {very slightly!}, see my earlier post here).

Redfin discriminates. So do I. It makes sense and it is better for everyone. Many people have commented that Redfin basically passes their work load to external agents to facilitate their transactions and to make their business model work. I can certainly see how that might play out. But if the consumer is footing the work load “bill”, don’t they deserve to get a rebate? Don’t consumers deserve the right to choose their level of service? In the end I believe that consumers will still depend on full service agents because housing is complicated and its something we do rarely. But by offering price variation, we get to grow the pie. Anyone else out there a discriminator? Anyone else want to make more money?

The Washington Post has a hilarious (but real) article discussing the inside of New Century Financial - the sub-prime mess to end all messes that is now bankrupt. I first read about the article at Inman blog, entitled You WILL play ball. Below is a WP sampler:

“The stress in that place was ungodly. It was like selling your soul,” said Hardiman, who worked for New Century in 2004 and 2005. “There was instant notification to everyone as soon as you rejected a loan. And you dreaded doing it because you paid for it. Two guys would come with a bat, and they were all [ticked] off because you cut their deals.”

I have posted several times about the conflicts between the appraisers, lenders, and agents here, here and here. Bottom line is that it may be time for buyers to hire their own appraisers. This doesn’t represent a new expense but rather a disaggregation of a current expense. If a buyer uses cash, rather than having the costs buried in other transaction costs, than the buyers can control quality and appraiser can get on with their jobs with conflicts.

Also, we might consider the conflicts from the lending side as to communicating affordability to consumers. Does it make sense to expect a lender, who is commissioned based on the number of closed transactions, to actually protect the customers side of the equation? I suppose the logic is that its the banks money but in truth, lenders sell loans and loan agents get new jobs. So the buck gets passed, Wall Street just play the odds (and gets a commission), and the financially illiterate get stuck holding the bag. Nothing new from “big business” but certainly NOT something part of the new business models powered by the internet - including ours.

The solutions to these and other vexing consumer problems are being addressed by market forces. Entrepreneurs like us see this problems as opportunities to add value to people by being open and transparent about our businesses. We put people at the center of our model and drive everything to satisfy this focus. Gone will be the days when trapping and or tricking a customer into a piece of business is THE model. Gone will be the oligipoly’s upon which many incumbent industries are based. Power is being pushed down to people and the economics will follow. Selling your soul in sub-prime, or any other industry, is a dinosaur waiting to happen. A lot of other charts will look like the one below over the next few years.

Yesterday, Russel Shaw at Bloodhound Blog posted a note he received from a young person sniffing the real estate industry. Entitled “I’ll bring you a big basket of cash if you’ll let me sell your house for free” Shaw responds to the young persons overt question whether the industry is crowded and the covert question as to whether pricing can be used as a competitive weapon. Shaw tells the young person not to use pricing to differentiate (and yes there are too many agents). This got me thinking. If EVERY industry has price discrimination, why doesn’t housing? (yes there are firms like Redfin and FSBO’s but traction is light) This is not whether orange people get better prices than purple people. Not that kind of discrimination. This is you using e-trade for stock execution rather than Morgan Stanley. Does variation in transaction costs make sense for housing?

I am not an economist but here goes.

The graph above is what Shaw is saying. There is one price for transactions (or something like that) and that you should stick to it. An economist would say that given the demand at that price, sales will be S1. Lets see if we add new prices…..

So by adding new prices, we tap into a larger amount of the total demand. From an industry perspective, price discrimination (price variation) yields HIGER total number of transactions. This is why airlines use it. This is why software companies use it. This is why EVERYONE uses it. Ever clipped a coupon? Ever cashed in on frequent flier miles? This is price discrimination at work.

So the one thing to consider that might debunk this basic economic notion is whether the demand curve (in blue) is in fact oddly shaped. Lets take a look….

So if demand is the same regardless of price then Mr. Shaw is correct. In fact, if demand in the real estate industry is oblivious to transaction costs than Mr. Shaw and all the other realtors are bloody idiots for not raising prices. So I guess the question is this: is demand for housing sensitive to transaction costs or not? If it is, like most things, then everyone stands to be better off by offering differing levels of pricing (and service). If demand for housing is not sensitive to transaction costs…then put your orders in for those new german cars because margins are about to get much better.

Giddy up little doggy!

Ardell DellaLoggia of the Rain City Guide pens one the best pieces I have seen regarding housing valuations at a hyper-local level. Entitled Home Valuation “Tools”, Ardell goes on to detail how to properly value a property and how to seperate the value of the land versus the value of the house…an important consideration, often overlooked, in expensive markets where most of the value is actually land (I am talking to you San Francisco!).  Her analysis is deep so get a pencil out but the basic takeaway is that if you can determine the cost of land, and make adjustments for slight differences, you should be able to determine which houses are overpriced and which ones are underpriced.  Ardell finds a home that was torn down after being purchased and so was able to get a solid market value for land. Getting everything apples to apples is critical - and not easy.
Her analysis is not only thorough, but also demonstrates that housing valuation is a highly complex problem that has variation from property to property. In other words, it is very difficult to model and so AVM’s will largely miss the nuances. Naturally we at My-Currency have built our site for this very reason - to enable the local experts to shine and to collect these nuances both in detail and as an aggregated value in our prediction technology we call CrowdValue.

Joel Burslem continues to demonstrate his deep knowledge of tech by discussing how the real estate industry can leverage social networking sites like Facebook to broaden their network of clients and market their listings. In an article entitled Marketing Real Estate on Facebook, Burslem outlines five basic ways an agent can use social networks. Naturally, we agree with Joel. My-Currency is a vertical social network, a term I first read many moons ago at the blog Social Degree. The difference between My-Currency and Facebook is the difference between Walmart and Whole Foods. Walmart has everything but Whole Foods has only the best.

My-Currency is trying to be more relevant to users by focusing on, and aggregating, content specific to housing consumers. We give you all the tools you need to get inside housing problems. For a professional, it should prove a resource that demonstrates to your current clients authority while hooking and incubating future clients. For consumers, its an opportunity to share information and get professional advice - free. The site has all the basic building blocks in place. The open question is whether a vertical network will better serve consumers and professionals than a horizontal network. We obviously think so. That is not to say Facebook and their like are not of value. They are - use them! In fact, we will look to integrate with them and other parts of the internet ecosystem. Its just that we think focus, focus, focus will create better relevancy and better engagement with those interested in housing.

So when you want to purchase Tide Detergent go to Walmart. When you need a 25 year old bottle of Academia Barilla Balsamic Vinegar from Modena, Italy, go to Whole Foods. Do you, as an agent, want to be lost in aisles of Walmart like poorly selling lines of Tide detergent?

More news from the Commerce Department (pdf) yesterday - the number of homes sitting empty has increased fairly dramatically. Homeowner vacancy increased to 2.8% from 2.1% and rental vacancy increased to 10.1% from 9.5% versus the first quarter of 2006. That means that there are now almost 4 million units for rent, 2.2 million houses for sale and 7.3 millions units vacant for no apparent reason (dead cities?). When looking at homeowner data by area, cities increased 60% to 4% occupancy, Metropolitan Statistical Areas increased 45% to 2.9%, and suburbs increased 33% to 2.4%. Regionally, the South has both the highest rental and homeowner vacancy. The data below:

The Commerce Department released more data and analysis confirming what we know - that housing is dragging the economy. The economy grew just 1.3% (preliminarily) for the first quarter of 2007. From the press release:

The increase in real GDP in the first quarter primarily reflected positive contributions from personal consumption expenditures (PCE) and state and local government spending that were partly offset by negative contributions from residential fixed investment, private inventory investment, and federal government spending.

Here is a chart of GDP going back a few years:

As you can see, things haven’t been this bad since Q1 2003. The markets largely shrugged this off but home builders took it on the chin:

Most of the big names down around 3% but the index as a whole finished down just 1.52%

Looking for a great buy-rent analysis tool? Go no further the the New York Times. My friend Kevin Boer blogged about it here, and I have to further endorse this product. Very cool Ajax interface and has all the things you need to understand the issues. Warning! Do not accept their base assumptions, some of which are in “Advanced Settings”, “General”. The main value to a tool like this is playing with different assumptions so that you can understand the real drivers. I have inputted some assumptions below based on a friends analysis of spending $6,850 to rent a house that might ordinarily cost him $2 million in San Francisco (yes, these are real numbers…it is that expensive here!).

Three Key Assumptions:

- Housing Value increase 4% per annum

- Rent increases 2% per annum (San Francisco is largely rent controlled)

- Investment returns of 6.5%

You can see there is no scenario that allows one to buy versus rent. So what does it take to get the buy-rent math to justify buying? Well if you increase housing prices to 5% increases per year then you get a break-even point of 7 years and if you increase it to 6% then you get a break-even point of 3 years. Although I held investment returns constant at 6.5%, prices increases for housing coincide with general returns in assets so realistically I should probably be increasing investment returns with any increase in house price appreciation . Why is this relationship so important? Because when you have money tied up in your house, that money is no longer available to invest. If you are a crappy investor no problem. If you know your way around, this makes the math even more difficult. So if I increase investment returns to match my original assumptions of 4% appreciation and 6.5% investment returns (2.5% spread), then the following buy-rent trade-off emerges:

So buying is better after 5 years but the gets worse at year 15. Why? Compounding. It seems the real issue is what is the relationship between housing returns and investment returns…something I will blog about in the future.

What was my recommendation to my friend? Rent and look for a distressed seller.

Local Resources:

San Francisco Assessor-Recorder

City of San Francisco Rent Board