Speculation Nation

Submitted by Rich Toscano on March 1, 2005 - 10:22pm
For all the ink that is being spilled about speculation on the part of real estate investors, very little attention is paid to the "stealth speculation" perpetrated by people who, anticipating big equity gains, stretch themselves to the limit to purchase their own homes. This article examines both types of speculation, as well as the ugly aftermath should the expected gains fail to materialize.

Today's New York Times features an excellent article entitled Speculators Seeing Gold in a Boom in the Prices for Homes. Although it does not mention San Diego specifically, I highly recommend reading the article to get a sense of the mindless speculative frenzy that has overcome so many housing markets.

Unsurprisingly, the featured "investors" are entirely clueless. One couple is taking a $1,000/month loss on an NYC rental property, planning to make up the difference when they sell "in a few years." Another couple mentions being "killed" in the 2000 stock bust… and now here they are buying at the top again, throwing hundreds of thousands at condos in Miami, where 60,000 units are currently in development. A fellow Miami investor (who incidentally paid for her $270k hovel by taking a second mortgage out on her own home) states that, because her unit is close to the beach, she feels she will be "safe" even if the market drops.

I've always found this latter sentiment exasperating. No matter how explosively prices rise, people are unwilling to consider the possibility that prices could drop back to where they were a mere year or two ago, usually fabricating reasons like "it's near the beach" as in the above paragraph--never mind that the property was also near the beach a few years back, when people were only willing to pay half as much for it. No, these people say to themselves, the growth might slow but in the worst case things will flatten out for a while. What they fail to understand, among other things, is that the market has become unstable: it can go up, and it can go down, but it cannot flatten out for any period of time, because it is driven entirely by speculation.

The NY Times article examines speculation of the outright property-flipping genre, but there is a much less obvious yet more widespread type of speculation going on as well. Such "stealth speculation" is perpetrated not by landlords nor property flippers, but by many homebuyers who are purchasing their own primary residences with negative amortization loans, interest-only loans, and ARMs (the latter of which accounted for a staggering 80% of all San Diego mortgages in 2004) and stretching themselves to the limit in the hopes that they will have gained some equity before their mortgage payments inevitably increase.

Their intent is typically to sell at a nice profit before the mortgage reset ever occurs--how many new homebuyers have you heard say that they plan to hold on to the place for "2-3 years?"--but if they have not gained any equity when reset time comes? Owners who couldn't afford the higher payments might have to sell or be foreclosed upon. Even as this stream of new inventory hit the market, demand could cave in as people saw that home prices were no longer going up and the "get in while you still can" mentality abated. These factors could lead to price declines, and the price declines would lead to even more foreclosures and even lower demand, and the cycle would continue until homes were at or (more likely) below their fair market value. This is how bubbles have ended throughout history, and it's how the current real estate bubble will likely end as well.

How this plays out and over what timeframe is of course impossible to predict. But it seems unlikely that prices in manic real estate markets such as San Diego will flatten out for any significant length of time. In such highly speculative markets as ours, instability usually wins the day.

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