Correction and Real estate

We all know that the current correction started in the real estate market. Let us try to see why real estate makes the best place.

Real estate is much different than current money markets that we know. No two estates are the same. Even the two adjoining plots or apartments one above the other with exact specification are not identical. Their specifications always differ. Secondly, how ever matured the real estate market becomes, we can never be able to do as good price discovery as that for lets say stock market as the amount of transactions are way too less and discrete. Thirdly, rather than price being discovered through a auctioning process, it is mo decided by the agent as for all the limitations we have, we are (buyer and seller) dependent on the agent to help us with pricing. And most importantly, the agent is not doing trade in either buyers nor sellers benefit, but to his own. And earlier the transaction is triggered, earlier he will get his charges.

Last and probably the most important difference is that the underlining asset is something that we may not be able to part with. Lets say I own Citibank stock and the stock starts going down or up, I take a decision to sell it and the whole transaction can be done in less than a second. But if you replace stock with my home, I may be limited with all the restrictions like where to sleep if I sell it today. At least 50-60 % of the real estate properties are being used directly as against liquid assets like stocks. and that includes the open farm lands...

So what happens is that the real estate market reacts to news slower. Secondly, because it reacts to news slower, people believe that it does not react to news at all.

Now lets see why this correction actually started. With newer laws like SoX etc. in place, US government thought nothing could go wrong with the financial institutions. Actually even the financial institution heads thought that nothing can go wrong with their institutions.

We thought having closer data points is enough to do a good quality risk management. banks at a point in time were 16 times leveraged on the price of the real estate. In simple words if a real etate is worth 100,000.00 USD, then a bank would have given away loan worth of about USD 1,600,000.00 against it. I am not going to cover why this actually happened. But the fact of the matter is that the banks thought if they can track the prices and the paying capacity of the owner, they are better off.

Secondly, there were a lot of speculators who came in becasue of it. Now, if I can get whole of the real estate free (without investing a penny) and that the real estate prices are going up by more than 25% every annum, I would just need to go and buy... all I am asked is my salary slip!!!

Now, some intelligent investor starts selling all the real estate he has and as real eastate reacts to the news very slow, he has ample time to get off all the property he owns. And by the time it starts showing, others will also start following him.

Now those who are over leaveraged to make a quick buck cannot hold on to their losses, and the bank auctions his property at much lower rates. All the intelligent people in bank do not understand that they are doing bad for themselves while auctioning the property. Even a eight standard kid can tell you that if you auction a property at half the price, all properties nearby are going to go down by half. And if their prices go down, bank will have more and more defaulters. And that is where the spiralling effect starts!!!

Some intelligent people in banks did have insurance cover for the risks they were taking. Lets discuss insurance companies and correction in next post...