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Thursday, August 11, 2011

Fix Housing With More Foreclosures

The Obama Administration is soliciting proposals on how to convert foreclosures into rental properties. Being that some of us are housing experts by dint of our maintaining houses, let's address this issue.

It helps to clarify the real problem with residential real estate. It is its sharply declining value -- both the decline since 2006-07 and the next drop which I predict is likely due to a perfect storm of a glut of supply, eroding purchasing power, increased down payment requirements and generally reduced credit. Declining prices and eroding equity are the prime symptoms of this problem.

Any "solution" should recognize the problem and then move towards the solution, which implicitly involves some sort of government intervention to support existing -- or in reality, past -- real estate prices. The objective, from this perspective, is to preserve the asset value of current homeowners.

A true and objective view of real estate must question all tenets, including the maxim that real estate is undervalued. It is possible real estate was overvalued since the mid 1990s (in other words, for several years before the now-accepted "bubble" period), and that it may still be quite overvalued now! One knows not what "true market value" is, but remove all the artificial props and we will find that out...much sooner. The sooner real prices revert to their true free market norm, the sooner you have the conditions that foster genuine buyer demand.

Prospective purchasers will make an offer for a property when they perceive real value and a good deal.  This does not mean buying a home for 50 cents on the dollar, but it does mean having a fair confidence that prices will not continue to deteriorate for a considerable period after the purchase.   The latter condition is prevalent now and requires smart buyers to discount their offer price to factor in an anticipated future decline of anywhere between 10 percent off the current "fair value" and...whatever...the race is to zero. 

To get to a true "fair value" one must remove all government price supports, whether through favorable regulations, imposed moratoria on foreclosures, special subsidies for the FHA to allow it to subsidize or support homeowner mortgages, or temporary tax breaks. All of these supports involve encouraging purchasers to spend someone else's money and foster artificial price inflation on the theory that buyers will not mind knowingly overpaying when they are spending someone else's money.  All such supports involve a direct or hidden cost, benefitting prior purchasers, upon everyone else. These supports act in essence as wealth transfers from the taxpayers -- too often, those who cannot yet afford a house, and disproportionately young and poor -- to the homeowner class which is, more often than not, better off than its non-homeowning benefactors.

In short, real estate price support is inherently discriminatory against non-owners. It is a subsidy of the class who bought houses...often above and beyond their reasonable means...courtesy of those who often were reasonable, played by the rules and now must pay so others can enjoy what they themselves cannot.

However, such price supports do not help true price recovery.  They delay it.  In fact, if NO effort had been made to support housing in 2008, both the housing market and overall economy would have recovered by now. Instead, because of political considerations, the problem has been deferred, delayed and nibbled at, prolonging the agony of millions of unemployed, underemployed and others.

Real prices and values must be reached and re-established. Only then will true appreciation occur. Otherwise, all growth than occurs without hitting such values will be illusory.

Now, as to the Obama Administration's proposal, it would convert existing homes upon which payments are not being made into rental properties generating a modest income stream. This might stop foreclosures...but foreclosures themselves are not the problem with falling values. A foreclosure helps hasten the drop to true value. Preventing foreclosures, therefore, only stops the changeover in residents; however, any effort to keep nonpaying residents in a home is inherently inefficient and will destroy all value. You see, it sends the message that some -- the deadbeat class - can enjoy without paying for what other must sacrifice for. The lowest payment price -- the zero put up by the strategic defaulter -- becomes the default value...that is, zero. (See my earlier articles in the series, "Housing Going To Zero".)

All real estate that has value must produce a current "income" in one of three ways: income to the bank holding a mortgage, income to the landlord collecting rent, and income to the homeowner who owns the place free and clear and thus has income in the form of savings. The value emanates from the income -- and also from the aesthetic benefits of a nice home which get reflected in the price. Once a nonpaying resident gets "income" by being allowed to live rent-free, that reinforces the concept of real estate as not being something that can, or should, produce income. This diminishes the value of the real estate by uncoupling it from its income-producing potential.

Preventing foreclosures is a goal accepted as such wisdom that it is virtually a sacrament. We should do the opposite. Hastening foreclosures (done properly and legally) should be the proper objective. That would reaffirm the value of real estate's income potential, and the value of homeowners' obedience to their contractual obligations. While foreclosure sales are not desired because of the often-underwater sale prices, these houses most often would never reach the foreclosure stage if there were multiple bidders at a higher price.

The final concern over the Administration proposal is that it makes the government the de facto receiver of all these properties. The Administration's competence to generate, collect and preserve the income from these properties -- or select someone to do the same -- is far from proven. In all likelihood, the income potential of these properties will decline. As price is a multiple of income, the death spiral will be in place. We will have the same outcome that the Administration has purported to want to avoid.

Eric Dixon is a New York investigative lawyer with a background in securities and corporate law, election law, corporate governance and government and corporate investigations.  

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