This article describes the “sticky price” phenomenon afflicting sellers of real estate, and how it will affect the housing market during the recovery period following this Great Recession.
“Sticky prices” brought about by the recession
Consider an owner of a home located in a neighborhood which had its share of foreclosed properties during the depth of this Great Recession. He now needs to sell his property and relocate. The owner contacts a real estate agent about entering into a listing agreement to sell the house.
The property will show well as the owner made minor improvements to upgrade the property’s appearance and kept it in good repair. The listing agent asks the owner what price he would accept for the property. The owner feels the listing price should be the highest amount neighboring properties sold for during the recent peak in prices. He claims that home prices do not fall and never have since a home is a safe investment, and that the real estate owned (REO) resale prices are the result of forced sales which are not fair market values.
The agent’s comparable market analysis (CMA) prepared for the listing interview contains the three most recent sales in the immediate area, all of which are REO resales. Other privately owned homes are on the market in the MLS, but none have recently sold. With this CMA presentation, the agent is unable to temper the unreasonably high price the owner is seeking. However, the owner wants to list the property, and the agent simply lists it at the price the owner requests. [See first tuesday Form 318]
The property sits on the market, unsold for the duration of the listing. The owner will not consider a reduction in the listing price. Meanwhile, his property’s market value continues to adjust downwards under the reality of its demographic situation and the recession. The listing becomes shop-worn.
The reality of home prices in California
During this Great Recession, home prices throughout California have taken a nosedive in order to correct and bring them into line with the inescapable historical trend in real estate asset inflation – a parallel figure to consumer price index (CPI) figures. Property prices are time and again pulled back to trend lines by this fundamental law of real estate: homes and other improvements on land comprise only the efforts of labor, the supply of materials and the value of the land.
This trend line effect is especially noticeable in California, as the land here has a century-old premium already built into its trend line price, subject to variation due to population density and earnings within different locations. Further, California property is evaluated in terms of the US dollar which, in keeping with monetary inflation, will increase steadily according to the CPI figures. Thus, the trend line in values suggests whether actual sales prices at any moment overstate or understate the value of the property. Underlying all this are rents and a long-term capitalization rate, primary fundamentals for setting income property asset values (further limited by lesser replacement costs or comparable sales prices).
The current property price correction is still ongoing, and will take not months, but several years to complete. This time period from peak prices to stable prices is further needlessly extended due to sellers’ unwillingness to let the brokers and agents set the present value of a property. With prices set at market value, property can be sold in the current market rather than be left to stagnate on an ever-aging listing while property prices move lower or at best remain the same.
A home’s fundamental purpose is simply shelter, a source of wealth through equity buildup produced by mortgage payments in what is a compulsory saving program managed by lenders. All goes well if prices paid for properties do not exceed historical trend line values, i.e., they were not purchased during extended periods of excess in the economy.
The equally radical upturn in price increases experienced between mid-1999 and early 2006 did not come about in a day or two, but took seven years from the initial signs of irrational exuberance to the bubble implosion. Even in less severe real estate market corrections, sellers are the very last to capitulate to the downward price correction. Thus, sellers in their deliberate suspension of reality dismiss the fact of lower property prices and live in the illusion of prices paid in the past, also known as the sticky price phenomenon.
Agents: the best defense against a money illusion in real estate pricing
A home’s true cash value is presently limited to the amount of its replacement costs and the land price paid for the demographics of the location. Replacement costs for most properties are currently very cheap as there are more construction materials and labor than there are building projects, to say nothing about the availability of land. Likewise, as is the case with many distressed regions of California, neighborhood demographics are shifting from owner-occupied to vacant or tenant-occupied. This shift is accompanied by a downgrading of care in the upkeep of properties, which in turn contributes to the deterioration of a neighborhood and its property values. Add to these economic forces the recent glut of bank-owned properties in competition with existing homes for sale by solvent homeowners without a negative equity.
Understandably, owners with properties in such circumstances do not want to see the market factors as influencing the price buyers will pay for their property. It may be a matter of employing blinders, or merely a stubborn resistance to changing circumstances paired with an insistence in pricing a home above market in hopes of beating the odds. The agent must determine whether the seller understands the probable price an informed buyer with a competent agent would pay and is willing to accept a realistic offer, or if he is merely using the agent to search for that elusive unprotected and emotional buyer and score big time on a high asking price.
However, unreasonable expectations are created or allowed to persist when agents are not proactive in advising their sellers by providing their opinion of value and the reason why that value should be used to set the listing price. Instead, they most often passively enter into listing agreements and allow their sellers to dictate the illusory sticky price as the price they will go forward with to market the property.
While it is the agent’s job to get the best price he legally can for his seller, there is no benefit – neither in the form of a closed sale nor a broker fee – when the listing price is set too high for the market. The continual need to reduce the listed price to catch up with the market while marketing the property to too few or no potential buyers at the price sought wastes not only the agent’s time, but also the seller’s.
When sellers are truly ready and have a need to sell their homes, it is the agent’s job to market the property for sale at a price which will attract an offer within the first days of a 90- to 120-day listing period, and not the best price from years past or forecast as a price which might be paid by buyers during the next few years. This reality check necessitates a conversation between the agent and his seller if the agent is to break down the illusion of prices past and future and carry away a listing employing the agent to locate a buyer at present market prices. To get this conversation under control, it must be based on a review of a CMA worksheet prepared by the agent in advance of taking the listing. [See Form 318]
Discussing comparable property sales with a seller will provide the seller with the basis for a realistic notion of how his neighborhood’s property values are performing. The agent should also take care to explain the ramifications of pricing property above the market, e.g., there is more than just a slight chance that the listing will take longer to sell, maybe years. This information is crucial to a seller who is financially motivated to have a property off his hands. Some are; some aren’t. That is the agent’s job to determine.
Sticky prices and the jobless recovery = a flat line in housing prices
Predictably, sticky prices are only an issue when the market is moving downwards. Owners are, again, eager to raise prices when they think the real estate market prices are improving. However, agents representing potential sellers should keep in mind that although there has been some hype in the media about the median price rising during 2009, the median-priced home doesn’t exist: the median is a phantom number, a mathematical abstraction that does not reflect the price or price movement of any parcel of real estate, neighborhood or marketplace and the seller needs to understand that.
Remember also that this particular recession is in response to an aborted market correction which was just taking hold when the Federal Reserve (the Fed) dropped interest rates in what is now seen as a questionable response to the September 11, 2001 attacks. The ensuing boom in real estate was artificially created to thwart perceived potential financial disaster. A few years into that artificially-induced boom – so flush with easy credit and its speculative influence – it was taken for granted that the higher property values, the increased production and the steady creation of jobs were to stay. We now understand, as many did then, that they were not. In fact, this correction will take a strident step towards correcting that aborted 2001 economic adjustment and the artificial growth created after 2001.
House sale numbers have been aided by recent government intervention (in the form of tax credits to sell REOs and builder inventory and loan modifications to keep existing homeowners from foreclosure), but the crux of the housing issue (and indeed, the California economy) in the coming years will be employment. The high number of lost jobs in California which will take until 2015 to be regained will have an oppressive effect on the recovery, keeping it from the typical upward climb. Instead of a typical W-, V- or U-shaped recovery, this recovery will be a checkmark-shaped recovery, rising slightly from the bottom of the recession as occurs in a bungee jump, and then flat-lining for several years. [For more information regarding the shapes of a recession and recovery curves, see the November 2009 first tuesday blog entry, Divining the future: the letters game.; see Figure 1]
What does this mean for sellers and their sticky prices? As long as the unemployment and underemployment rates in the nation remain high and overtime hours remain low, sellers will see an effective ceiling on the prices they will be able to command for their properties. Buyers and tenants need jobs to pay for shelter. Instead of seeing an ever-higher improvement of prices, sellers will be faced with a second round of sticky prices – this time in anticipation of an improvement that will be long in coming. This is not your garden-variety Fed-orchestrated business recession designed as a temporary interlude to cool the economy and let it strengthen for further growth. Many of the real estate prices and jobs of the boom period may be gone forever, to be replaced with long-term employment in durable industries and services dependent on a steady-as-you-go economy which the Fed, Congress and the Treasury are most likely now to collaboratively engineer.
If this checkmark-shaped recovery settles in as anticipated, agents need to be prepared to once again take up arms against the sticky price and get pragmatic with their sellers. Unless their sellers can afford to wait out the long, hard road through years of flat real estate prices, agents should be aware of the factors which temper the price a seller seeks for his property on the current market:
- a second wave of foreclosures and REO properties is in the cards for 2010 and 2011, as a significant portion of the mortgages in California (even those that were modified) are delinquent and thousands of others are going to reset and go into default;
- potential buyers who currently hold jobs may become more reluctant to purchase if they remain unsure of their job status;
- consumer confidence numbers are still far below normal, despite the recent rise in confidence levels about future major purchases;
- the Home Valuation Code of Conduct (HVCC) creates one extra headache for both buyers and sellers should the value come in lower than anticipated (but agents and brokers are learning how to cope);
- speculators are making a comeback in the market and might again be creating rental neighborhoods which will create sagging market values; and
- if flat prices persist for a long period of time, buyers will no longer feel the competitive drive to buy as happened in the 1995 to 1997 period following the 1990 recession.
From another standpoint, agents should urge sellers who are serious about selling their properties to take advantage of marketing their properties to sell at realistic prices while the federal housing tax credits are still in effect for homebuyers who have not owned a home in three years.
California real estate agents and brokers, as the gatekeepers to our world of real estate, must bolster themselves for the long haul. This means taking steps to ensure their sellers’ goals are met. In a market such as this, that goal must be one which reflects the reality of real estate fundamentals; it should be one which highlights the sale of a principal residence, and not the cashing in of an investment. To stay ahead of the curve, agents must remain realistic about the conditions that surround them and encourage their sellers to do the same.