The State of Real Estate

by Fred E. Foldvary

Some financial writers believe that real estate in the USA is still headed down. They say many residential mortgages are going to be reset to higher interest rates, causing another wave of defaults. They say that commercial real estate is still falling, and that will push the economy into another downturn. They say high unemployment will keep the economy depressed.

The facts indicate otherwise. Recessions always bottom out despite rising unemployment. What pulls the economy out of recession is economic investment, the production of capital goods, just as what makes the economy fall is a big decrease in investment. During the recession, the costs of production fall. Land values, rental rates, interest rates, and labor costs fall, so investment becomes profitable again. The economy would come roaring back if higher taxes and credit constraints did not keep growth suppressed.

In order to understand where we are in the real estate cycle, we need to examine, as they say in calculus, the “second derivative,” the change in the rate of change. Commercial real estate is still falling in some place, but the falling is slowing. The second derivative is positive. For example suppose the commercial real estate price index has the sequence 100, 70, 50, 40, 40. The price would be falling at a slower rate: 30, 20, 10, 0. The change in the rate of decline is a positive 10, going from minus 30 to minus 20 to minus 10 and then to a zero change.

The Mortgage Bankers Association reported that in the last quarter of 2009, vacancy rates increased and rentals declined. But property sales increased, and property prices have stopped falling. Moody's/REAL commercial property price index went up by 3.6 percent. Commercial mortgage originations rose also. In the Southwest, including California, residential real estate prices are now rising. Elsewhere, where prices are falling, they are falling more slowly.

Some financial writers say real estate will fall because the Federal Reserve has stopped buying mortgage-backed securities from Fannie Mae, Freddie Mac, and Ginnie Mae, after having bought one fourth of the mortgage bonds. This intervention by the Fed has propped up mortgages, since banks can sell mortgages to Fannie and its siblings, and then these government-sponsored enterprises can package them to sell to the Fed. The Federal Reserve creates money when it buys bonds and other debt, so if the Fed kept buying mortgage derivatives, it would continue to greatly expand the money supply. But the real estate market has anticipated the ending of this Fed action, and speculators believe that if the real estate market falters again, the Fed would jump back in.

An effective way to reduce loan defaults is to reduce the loan amount to below the principal or equity in the property. A positive equity will give the owner an incentive to continue the loan payments. A lender may not wish to do this if it believes that the property value will be rising in the future. But many “underwater” homeowners believe it will take many years for their property value to rise above their loan, so they have a strong incentive to stop paying. Banks are increasingly willing to provide loan reductions.

There are various private and governmental efforts to deal with loan defaults. HOPE NOW is a private association of counselors, mortgage companies, investors, trade associations, and insurance companies organized to help homeowners who are in distress. The loan modifications by HOPE NOW are twice those of the government's Home Affordable Modification Program (HAMP).

The coming higher inflation will lift real estate prices and bail out the borrowers who have not taken part in these programs. The smart money is already buying real estate. Partnership and private (non traded) REITs (real estate investment trusts) are buying properties and providing loans. With bank savings accounts paying almost zero interest, the high yields of mortgages are increasingly attracting investors.

Entrepreneurs are also providing equity sharing. Instead of getting a loan, a homebuyer will get a financial partner to share the purchase. The co-owner gets a rental and share of the price appreciation.

The government is seeking to pull up real estate and the economy, but its net impact is more negative than positive. The government is doing very little to reduce credit constraints. For example, a small business could raise funds by selling shares of stock, and by creating bills of exchange to pay its expenses. But such securities require registration with the SEC, the Securities and Exchange Commission, which can cost several hundred thousand dollars. Minor temporary tax reductions do little to offset permanent taxes on labor that reduce employment.

The government could jump start the economy with a radical tax shift, eliminating taxes on wages and capital while drawing public revenue from land value along with charges for pollution. Many homeowners who are paying a mortgage also pay high taxes on wages, and would have a net gain. For those who would have a net loss, the government could buy the land value and the portion of the mortgage based on land value, and then lease the land back.

The government could issue special land-value bonds, backed by the payment of land rent, to pay for these purchases. The mortgage problem could be solved by having the government buy the land and lease it back. The contracts would leave the land-use and land-transfer decisions with the owner of the building.

These are radical policies that would stop the real-estate boom-bust cycle. But government officials don’t want to do this, because their purpose is to give land value to big owners. This fact of life is what welfare state “liberals,” pseudo-progressives, and intellectually corrupt “leftist” economists also miss, as they hack away at the financial sector and ignore the real estate subsidies. Almost everybody is booing the financial sector and cheering on the real estate sector as we once again start a new boom which will inevitably result in an even worse crash.

This article first appeared in the Progress Report, www.progress.org. Reprinted with permission.

Dr. Fred Foldvary teaches economics at Santa Clara University and is the author of several books: The Soul of Liberty, Public Goods and Private Communities, and the Dictionary of Free-Market Economics.