Will the real buyers please stand up?

The level of actual buyer-occupants in sales volume is the critical indicator of long-term demand, not total sales volume.

Obstacles confronting the end user

Where have all the buyers gone? Speculators are currently crowding the market, giving the false impression that demand is up and the real estate market has grown hot once again. However, their interference is merely creating a temporary aberration in sales volume of single family residences (SFRs), not likely to last beyond 2012.

Speculators have more in common with a seller than a buyer, as the seller essentially assigns the speculator the task of locating a later buyer who will occupy the same property. Thus, the speculator limits his position in ownership to the right to re-sell the property – the instant he can locate that user-buyer. As a result, speculators are surrogate sellers, who by design will put the property back into the MLS inventory hoping for a quick flip (and a juicy profit).

The obstacle blocking user-buyers (and therefore demand) is multi-faceted:

1) Recent foreclosure is perhaps the most virulent infector of buyers. Foreclosed homeowners, and those with the negative effects of a short sale blemishing their credit report, must suffer a period of financial penance, during which their access to home financing is severely limited, marked for exile as if by a scarlet letter.

During this period of arrested access to credit, the buyer cannot purchase a new property with purchase-assist financing, and thus cannot create demand for housing. These buyers must first become tenants and sit on the sidelines until this period of financial stasis has passed, and only then reenter the home ownership market.

Thus, this massive segment of the California population is essentially refused entry back into the real estate game until they’ve spent the appropriate time in the penalty box, much to the detriment of the broader recovery (and agent fees). These recently foreclosed individuals may be desirous of properties, but are incapable of purchasing until they emerge from the baptismal waters.

And there are plenty more foreclosures to come. The current number of trustee’s deeds recorded, the first stop of the foreclosure process, is still 50% higher than the peak experienced in 1996 near the end of that recovery period, a point we have not yet begun to reach. Thus, California has a considerable amount of time to go, somewhere in the vicinity of four years – well into 2016.

2) The upgrade market is hindered. In order for the vast majority of owners to upgrade their property, they must first be able to sell their current property. With an estimated 2.5 million homeowners underwater in California, this simply is not an option – unless they are able to negotiate a short sale with their lender (after which they would still have to contend with the FICO score stigma described above).

The restrained trade-up market not only affects underwater owners, but also those with little to modest positive equity. Those with a loan-to-value (LTV) ratio just below 94% (100% less 6% in transactional expenses) are reluctant to sell until prices rise, as the cash proceeds they would realize on the sale would be di minimis, essentially wiping out whatever money was drained into the house during their years of ownership.

Thus, no-equity homeowners are left with zero funds for a down payment on a replacement home and are unable to reenter the market as buyers.

These types of buyers must be warehoused, seasoned with age like a fine wine before they can be harvested to reenter the ownership market. Try 15 years in the barrel with no likely help from asset inflation,apart from the standard consumer price inflation of around 2% annually based on wage increases of potential buyers.

3) Decreasing labor force participation (LFP) rates and a stubbornly low employment rate. With little demand for labor, there is correspondingly little demand for housing. Without employment, purchase-assist financing is next to impossible to obtain as unemployed borrowers will never pass muster with lender’s re-discovered loan qualification standards. Thus, the documented unemployed, and those who have given up looking for employment in comparable numbers, cannot contribute to demand.

4) Competition from cash-purchase speculators. Of the limited supply of end user buyers, many intending to purchase a property are outbid by all-cash investor purchasers, negating (at least temporarily) the organic demand the end user commands.

Speculators typically have financial weight in the form of instant cash or hard money loans to throw around when submitting an offer. As a result, they are able to offer sellers a more seamless closing as there are no financing contingencies and the physical condition of the property is of lesser interest to them. Thus, these speculators swoop in and thwart the dictates of real demand, even if an occupant- or investor-bidder presents a higher bid, but with the typical and necessary financing contingency.

Ultimately, the speculator gets the property with the hopes of selling it back to a buyer (perhaps ironically the same buyer he entered into the bidding war with) at a higher price.

Conjuring demand, in theory

With the deficit of demand we’ll soon experience-  once speculator interference subsides going into the second half of 2013 – what external changes can be enacted to summon demand from end users?

Fundamentally, before buying a home, buyers must first be employed. There can be no demand without money, and no money without employment (at least for the vast majority of the homebuying population).

Consumer confidence and collective optimism must return. Just as the paradigm shift of this Lesser Depression upended the erroneous belief in ever-rising real estate prices, buyers everywhere must get over the trauma of recent homeownership losses and be given a reason to regain their trust in real estate ownership. While recent memory may still be tattooed with visions of plunges in equity, or worse, foreclosure, confidence must (and will) be restored.

Again, time will be needed to get there.

Credit given to the first tuesday Journal Online — P.O. Box 5707, Riverside, CA 92517.