My 1st Million At 33 - yes, you can do it too

California is one of the biggest state in the USA. The dynamics in CA can been seens as a microcosm of the entire US (actually CA is almost 1/6 or more by GDP). Since I’m most familiar with the state of California, my discussion will be mostly drawn from events in California, even though similar dynamics is playing out in other regions.

Currently, there are two obvious trends, all hitting the headline of the newspaper:

1. Sale volume in housing market is down dramatically. Housing market is no longer rising on the average.
2. Residential rental market is picking up steam. Rents are rising at a much faster clip, many at 6% to 7% annual increases.

All these come as no surprise to me, since I have specifically stated different strategies for different people in my Unconventional Strategies in This Housing Market back in June, fully expecting this unfolding scenario.

If one can understand how things are the way they are today, one can better anticipate what could come next.

The sale volume is down big because there is certainly a change in the sentiment of the participants, especially in the overall real estate investing segment. A very significant part of the sale volume is due to second home buying, and purely investor buying. The exact number is hard to tell, but my guess is probably 20% to 35%. Some of the CA real estate investors have gone out-of-state for better values. Some of the investors are stopped by rising short-term interest rates. The late investors are bleeding cash probably on the monthly basis, which is forbidding them to flip their last home trade for a profit. It’s one “trade” gone bad, and the game is slowly over for them. Some certainly pocketed good profits previously, and can get out less scathed, or have a better holding power. But many of them may have spent significant portion of the profits that were earned in previous trades, and a trade gone back means no more home-flipping income.

In any case, whether it is because of voluntary or forced retreat, investors no longer participate in the same fervish way as before. This is the most obvious from all the national home builders reporting dramatic rise in the cancellation rates (cancelled by home-flipping investors, and/or cautious would-be home owners). What’s left in the housing market is the remnant of new stupid investors and normal home buyers. However, with volume going down, it pretty much means that price cannot be pushed up through a more fervent buying process anymore. Prices will be determined by other factors.

That is the current price environment. However, price alone does NOT tell the whole story. If you buy any stocks, you know that there are really three prices: transaction price, and bid/ask. In the real estate market, the asking price is the most visible. Transaction price come out with maybe two months lag. However, only sellers can see the bidding price. In the stock market, market makers will balance the bid/ask, and try to facilitate the marketplace by putting out a transaction price closer to the dollar-weighted price of all bid and ask prices. In the real estate market, the real estate agents and brokers perform the same function. They won’t get paid if there is no transaction, and therefore, first and foremost, they want to bring the buyers and sellers to come to the same term in price. Why is NAR telling sellers to tone down sellers’ expectation in price? Because the bidding price is actually WAY LOWER on the average than the asking price, and these agents can only make transactions happen by bringing down the price (and not the other way around). Even the new homes are having all sorts of incentives and discounts which in effect lower the actual asking price.

So what is happening is that ask price is probably slightly down to 10% higher than last year, while very few transactions go thru to the advantages of sellers because of greater fools and never-ending lies from real estate agents, and increasingly more transactions go thru in the advantage of buyers. There are not more transactions because there is a BIG spread in the bid/ask price. If you have such things happening in the stock market, you will call that as “illiquid” or less liquid market, which also translates into lower transaction volume.

Once you take the average of all completed transactions, the price is about flat, since the sellers were expecting 10% to 25% higher in price than last year.

Rents were depressed partially because of more new homeowners who “shouldn’t” be homeowners due to zero down payment or extremely low mortgage payment from the negative ARM or interest-only ARM. Now the same factor is working in reverse to the advantage of the rental market. For the first-time home buyers, it is becoming tougher for them to either come up with a hefty down payment or qualify for a higher mortgage amount.

Besides, the bulls in the real estate market is right all along in that both job market remains strong, while population (+ all new immigrants) growth is steady. By default, it means housing demand. And if the housing demand is not going into the housing market, then it must go into elsewhere, in this case, rental market. Many places, like Southern California, have rental vacancy rate of less than 4% (or 96% filled). It practically means that it’s all full since you are always bound to do some cleaning up inbetween move-ins. And what that means is Pricing Power for the residential rental market.

Yes, rents are going up more. And unfortunately, they will keep going up at a faster rate than general inflation rate or CPI. It will go up until two things happen (forget about factors due to housing market for now):

1. People start to move out of California.
2. Business cannot find their employees at the salary wage that they want to pay, and start to move out of California.

I’m not saying that both of the above will happen. What I mean to say is that the growth of both population and job opportunities will probably go down to match what is happening in the rental market. Essentially, all markets will find their equilibrium point. It is hard to say what is the final equilibrium which is a dynamic balance anyway. However, things will only happen slowly. Average people’s ability to forecast the future is limited. When there is some change, they simply ignore them, and expect things to stay the same, until the change becomes a consistent trend. I don’t expect most people to move out of state, but rather coming in less, or through attrition due to various reasons.

At the same time, for the expanding business and the new business coming into California, they may be in for a surprise (if not already). It will become harder and harder to find skilled workers (or even unskilled workers for that matter) willing to accept the same salary level as before. Workers will demand a higher pay because of a higher rent, either because of necessity or because of expectation. Turnover rates will be higher. Competition for workers will be tougher. So for the businesses, they only have two solutions: pay more, or move out. Some of them will definitely pay higher, while the ones that cannot afford to pay more will move out. It is like Darwinism, survival of the fittest.

In the meantime however, workers will trench down first and take up the rental rate increases on their face, while businesses will simply expand slower with lots of unfilled job slots (until they raise the wages). The bulls in real estate market are right about the growth. But the markets ADJUST. And the adjustment is certainly that growth will be forced to slow.