It’s the demand, stupid!

This article series casts a critical eye towards the supply-side paradigm, and posits that in recessionary periods, and particularly during periods of zero-bound interest rates, the real estate recovery is propelled by demand from organic buyer-occupants – the end users of property.

For an analysis of how to nurture demand and obtain more buyers, see Part II of this article series, Where have all the buyers gone? to be published in the August journal.

“If you build or list it (and the government makes cash available) they will come”

To all those vociferous quibblers who proclaim the elixir to the real estate market’s ills is supply, listen up! While sales volume is temporarily propped up by speculators snatching up inventory, this is but a mini-boom in reported sales, and does not paint a picture of market realities one year hence (2013 and beyond as we ride out this bumpy plateau recovery).

Changes in the availability of real estate inventory, known as supply, inversely affects the price of property. Worse, in a recovery era of zero-bound interest rates as we have today, the market is not driven by supply – it’s driven by demand.

This truism will soon be felt around 2013, when the current speculator-fueled mini-boomlet subsides and the hot money finds somewhere else to park itself.

During the past 30 years, real estate sales of all types of property operated under supply side paradigm behavior. The supply side paradigm was a boon to the construction industry, listing agents and sellers as their jobs were made easier by the ever-enlarging availability of mortgage funds at constantly lowered rates for any entrant they were able to drag to the table for the closing of a real estate deal.

These roughly 30-year periods of dropping interest rates are known as seller’s markets. In a seller’s market, sellers command a high price, knowing that energized buyers with ready access to cheap money will always be available to continuously sop up the housing supply. If a property is built and offered for sale, it will invariably be sold since, under the supply side paradigm, there is always a demand for housing.

In stable or rising markets, the supply of available units for purchase is indicative of the health and momentum of the market. Under this market reasoning, so long as there is supply, as a matter of certainty, demand will equal (or likely exceed) it.

And the mantra continued: list, list, list and build, build, build.

The demand side paradigm shift

However, we are still stumbling over the washboard shaped recovery of what has become the Lesser Depression, forged by a massive and widespread financial crisis.

Though the speculator-propelled boomlet we’re currently experiencing has provided a false sense of hope for some, it is fleeting. This is decidedly NOT a seller’s market — or at least won’t be once the mini-boomlet crests. The supply-side way of thinking is ill fit to the forthcoming realities, a truth that will likely be in effect well into the next two or three decades of interest rate movement.

In recovery periods shackled – trapped – with zero interest rates, embracing the supply side paradigm is akin to donning a thick, thermal pelt after the ice age has passed. It is discordant to the point of being laughable (pun intended – Laffer curve), and resistant to evolutionary necessities imposed by the liquidity trap placed on sellers by zero-bound interest rates. You simply cannot escape ownership by raising or keeping prices high and waiting.

Proponents of the confused supply side paradigm claim to witness both multiple listing service (MLS) inventory slipping and prices dropping – two trends which cannot exist concurrently, in violation of the basic laws of supply and demand. If prices were going up, supply would then become relevant again.

Real estate price indexes going forward are, quite simply, a story of demand. Adjust your survival plan accordingly by giving ardent attention to the type of buyers you represent, or prepare for a bitter future ahead. California brokers take note, at your next monthly award ceremony to traditionally give public recognition to the agent who brought in the most property listings to the office, change the language of your award certificate to read instead, “Agent who contributes most to our forthcoming Chapter 11 petition.”

Organic indicator of demand

Before the level of buyer demand can be properly gauged, the factors which create demand must first be determined.

The only real indicator of long-lived organic demand is the end user of a property. Every builder of subdivision homes knows speculators are the death of his expansion into the next stage of development since they are not users, but usurpers.

The end user of a property is a buyer who will take personal possession of the property for a considerable length of time, as would a collector. Thus, the end user most frequently takes the form of a buyer-occupant, one who purchases property for use as shelter for his family or business, and takes steps to retain the property as a store of his wealth for as long as it serves the purposes of his occupancy.

In addition to buyer-occupants, long-term investors are also a key player in demand. Long-term investors purchase a property with the intent of renting it out to tenants to produce a steady income flow, a process also known as buy-to-hold. Thus, they are collectors at heart.

As with buyer-occupants, duration of possession is the key factor determining whether they are an end user of a property. It is purchases by these end users which reflect the true level of organic demand in a market – everything else is noise, temporary distractions and fluctuations which attempt to extract profits from the market, transitory actions devoid of any actual demand for the item being offered, i.e., long-term possession of the property.

Let’s do the math

But what about the obverse side of this ownership coin?

Absentee homebuyers, a group consisting of speculators and renovators (and true buy-to-hold investors) accounted for 28% of Southern California non-foreclosure-related sales in April, 2012, near the record high of 30%. In Northern California, absentee buyers made up 24% of homebuyers, down from a record high of 26%. Note the trend.

Critically, these percentages do not include the estimated one third of all trustee’s sales that were picked up by speculators.

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Thus, when you combine absentee homebuyers (and subtract buy-to-hold investors who are long-term income property owners) then add speculators at trustee’s sales, approximately half of all transactions effecting a change of ownership do not currently go to the end user.

Speculators, who by profession contend with a high degree of risk, come in two basic species:

• quick flippers, also known as hot money handlers, who add no value and invest little to no money in a property. Flippers purchase properties (mostly of the low-tier, distressed variety) with the intent of selling them at a higher price at a later date (and renting short-term if necessary to reduce their negative cash flow); and
• renovators who add value to a property before attempting to flip it.

Flippers rely solely on the upward dynamics of a momentum market, pocketing any price appreciation by sandwiching themselves between the seller and the ultimate end user of the property (read: the buyer-occupant or buy-and-hold investor).

Similarly, renovators add value to a property by rehabilitating it before selling it back into the market. Renovators frequently target damaged low- to mid-tier properties and improve them, bringing the property’s amenities and appearance to a level consistent with that of the surrounding neighborhood.

Editor’s note – Preferably, the improvements are not to a degree which over-improves the property so it becomes the most valuable in the neighborhood, as a renovator will find it difficult to recapture his investment.

Similar to flippers, renovators do not intend to hold and maintain the property for the long-term. Instead, they want to limit the length of time it is in their possession, typically 75 to 90 days to complete their renovation work, then immediately release it back into the market.

Unlike their quick flipper brethren, renovators contribute value to the property by returning it to a state fit for occupancy. Renovators also help the property avoid obsolescence by replacing fixtures which are out of date.

Speculator activity is not any part of demand

Speculators are not in the real estate game to acquire property for their long-term investment or shelter. Quite to the contrary. Like a day trader, they have no demand for the property, and similar to commodities dealers, do not take possession of it. They demand only the temporary use of title to the property as a tool to extract money from the market before the ultimate end user enters the equation and takes possession.

While the property is in the temporary hands of the speculator, it is effectively pulled from the market and unavailable to those who have an organic demand for it. Remember, speculators still have to find an end user buyer to purchase the property. Thus, the property will be returned back to the market for sale, as it was before, though offered at a far higher price. Thus, inventory is deceptively reduced below the level of demand.

Speculators are much like the unkempt agent who shows up late at a marketing session, Twitters until he makes his pitch, then departs, leaving nothing of value in his wake.

Speculators never intend to hold the property for the long-term, their involvement is kept to the shortest duration they can by design, much like a catch-and-release fisherman immediately returning his catch back into the water for the end user: the fisherman who will catch then actually eat the fish.

In terms of real estate parties, the speculator is more genetically similar to the role of a seller than that of a buyer. Even though the speculator purchased the property from the seller, what he is essentially doing is stepping into the shoes of the seller, a title he will officially don himself as soon as possible (immediately on a quick flip, or within about three months for a renovator).

Thus, the speculator isn’t really buying the property from the seller – the seller is merely assigning the speculator the resale task of locating the ultimate occupant-buyer at a not-too-distant future date, the buyer being the only party who actually has demand for the seller’s property. The speculator is a surrogate seller.

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Thus, to acquire the sense of demand, you must look for the percentage of all sales which are going to an end user, not those reported sales maligned by the “parking” of property with an intermediary. With this rubric in mind, it is clear that lack of demand, not supply, is the real long-term obstacle blocking California’s definitive ascent out of this economic morass.

Life-cycle of a speculator

The activities of a speculator are not synonymous with demand for real estate, and the second shoe of their distorting presence in the market is still to fall. When this time will come will be the subject of future conversations.

Speculators rely solely on an upward oscillating market to turn a profit on their investment. This means that in this bumpy plateau recovery, flippers will have a very long time to wait before a consistently rising market turns a sufficient profit to warrant selling at the dollar figure originally intended.

Thus, speculators who bought “cheap property” hoping for a quick flip at a higher price will have to adjust their modus operandi once they realize that prices will remain unstable through 2015-2016. Thus, these speculators will rely on their default fallback plan: hire a property manager (broker), rent the home and collect some income until they are able to unload the property on someone else. In this way, they will become landlords-by-necessity, a position which is not in any way consistent with their desired purposes for taking title to the property (or their skill set).

However, unlike before the Lesser Depression, they will find the market will not gain sufficient traction as quickly as the hit-and-run investor would like to resell at a profit (and function as a §1031). In their impatience, as soon as they sense even the remotest bump in the market, speculators, acting in improvised unity, will all try to sell their investment-turned-sour properties at the same time. This collective activity will likely occur within one or two years’ time.

This sudden flood of failed investment properties will be the second shoe to drop, and again exert downward pressure on the market. Ultimately, end user buyers must return at roughly double or triple the pace they’re at now to begin soaking up some of this excess inventory as it again saturates the market.

Editor’s note – For a discussion of where all the organic buyers have gone – and how agents can successfully pair with these buyers – see the upcoming Where have all the buyers gone? article to be published in the August 2012 edition.