CALIFORNIA COMMENTARY : Real Estate Bubble’s About to Burst : Factors from the declining defense industry to the fading baby boom will soon bring on a classic crash.
The news from the state’s real estate markets has been worrisome for several months, with the market slow and prices dropping about 3% statewide. But because California has never had a prolonged decline in real estate prices, people have been conditioned to think that prices will keep going up, despite this temporary dip.
It’s true that favorable economic trends in the state once kept propelling prices skyward. For most California homeowners, that house accounts for 60% to 80% of total net worth.
But homeowners in other areas that have suffered price meltdowns know it can happen in a flash. Just look at the Detroit Rust Belt; or Texas, Oklahoma, and Denver, areas still suffering the Oil Belt bust; or the depressed Midwest Farm Belt-- or, more recently, New England.
Conditions are building in California for a similar meltdown that will make 3% look like nothing. They include:
--The faltering defense industry. Since World War II, more defense work has been awarded to California than any other state. It’s one reason that during the past decade alone, California’s population increased by 26%. But as the nation reaps its “peace dividend,” California will surely suffer the most as defense contracts wind down and military bases are closed.
-- Tax selloffs. Since the tax law of 1986 was passed, taxing capital gains at the rate of ordinary income, many property owners have waited for these rates to be reduced before they sell property that has appreciated significantly in value. If federal budget negotiators settle on a capital gains reduction, which is entirely possible, more properties will be added to the already saturated market.
-- Retirement selloffs. As the population of this area ages, many retired folks are learning that they can enjoy a much better life if they sell their expensive California homes and move to lower-cost areas. They can invest their hundreds of thousands of dollars in capital gains, $125,000 of which is tax-exempt for sellers over 55. If prices start to come down, even more will sell to protect the value of one of their major retirement asset--the equity in their homes.
-- Mega-mortgage burnout. A lot of recent home purchases have involved mortgages in the $300,000 range. These require monthly payments of almost $3,000 and are frequently assumed by two-earner couples. If a recession slows business, on top of defense cutbacks, some families may find it impossible to pay off their mortgages. Others may simply find it undesirable to pay if their mortgages begin to exceed the market value of their homes.
-- Overseas buyer slump. Yes, foreign capital has been buying up California, especially the Japanese. But to the extent that a lot of Japanese wealth is based on their stock market, the sharp drop in the Tokyo exchange may reduce demand for our real estate.
-- Debt saturation. The high level of debt in America--consumer, business, mortgage, and government--is keeping the money supply tight. In addition, the end of the military buildup and its companion federal debt spiral could bring on a deflationary period that would erode real estate values.
-- Market shrinkage. Only a small percentage of Californians who don’t already own homes can afford to buy one. And the population wave of the baby boom has peaked, which will further diminish the pool of potential first-time buyers.
-- The environmental factor. Environmental protection is now getting priority over further job creation. Some areas of the state are adopting policies that may discourage new businesses.
Clearly, the caution light is flashing. There is no reason to be surprised that the savings and loan industry collapsed or that the junk-bond market has disappeared.
As any student of financial history knows, markets are prone to periodic excesses. When the balloon is inevitably pricked, the latest comers to the party lose most. If only Donald Trump had heeded this advice six months ago.
