A Deflating Bubble Tale:


I have a contract to buy a new town home for $800,000, but recently I learned that since I signed, the builder has reduced the price of the same type of town home by $100,000. I have a closing coming up and will be sitting there with a house which has already depreciated before I move in. If I put it on the market, will I get $800,000? Should I stay for a while or rent it out? I am confused and frustrated!

The answers are pretty obvious here, but this is a great example of the complete craziness of the housing market over the last few years: someone is plunking down $800,000 for a townhouse, and now that the builder has cut prices to $700,000, thinks that he still might be able to get $800,000 if he puts it on the market. Are there people out there who really took all the cocktail party talk that real estate "never goes down" seriously? Are there people out there buying $800K townhouses so naive as to think that someone will pay them $800K because they paid that much, even if anyone can buy the house next door for $700K? Mindboggling.

UPDATE: This phenomenon explains why, for example, inventory can be absolutely exploding in a city like Phoenix, but prices have only gone down marginally. Sellers think they should be able to get as much as their neighbor got in July, when there was less than half as much inventory; flippers think they are entitled to at least break even on their speculation. So sellers ask unrealistic prices, buyers sit on their hands, and inventory grows. Eventually, reality will set in as some sellers will need to sell for whatever the market will bear, and prices in Phoenix will plummet.

A Blogger:
BTW, here was the advice columnist's answer:
Depending on where you live, it's not very likely -- though certainly not impossible -- that you'll be able to sell your townhome for $800,000 any time soon. . . .

History (and inflation) have shown us that hot-gone-cool markets almost always heat up again.
1.29.2006 1:13am
Wintermute (www):
I may pick up one of these at or after foreclosure. These bubble prices are nuts. I was deeply in real estate before law; and my dad before me. I was talking to an old school friend and mortgage banker once about people we knew in the biz who had folded. His comment was, "I guess they weren't conservative enough."
1.29.2006 1:22am
Ted Frank (www):
This is less a tale of a bursting bubble than one of the sad state of economic education in this country.
1.29.2006 1:29am
Ross Levatter (mail):
Question to the lawyers: What's the penalty for backing out of a housing contract after signature but before closing? I (not an attorney) always assumed the deal's not complete until closing. If the penalty is less than $100,000, the above-described person faces an ethical dilemma...
1.29.2006 1:43am
Ted Frank (www):
There's no ethical dilemma; if the contractual remedy for backing out of the contract is $X < $100,000, then the economic reality of the contract is that it is really an X-dollar option to purchase a condo for $800,000 minus X.
1.29.2006 2:39am
Bruce Hayden (mail) (www):
Agreed. You would have to see the contract to see what happens if the buyer backs out. In CO, we had the option of specifying either liquidated damages or specific performance. Usually, the seller can't enforce such, since buyers rarely can buy without a mortgage (or equivalent), and thus typically prefer liquidated damages. On the other hand though, it is often in the buyers best interest to have specific performance (imagine the situation of rapidly increasing property values, and the incentive, absent specific performance, for a seller to bail when the value of the property goes up beyond the liquidated damages). Thus, here, you often see specific performance as the remedy when the seller breaches, and liquidated damages for the buyer defaulting.
1.29.2006 3:41am
volokh watcher (mail):
Here's my advice to this poor schnook:

Call your lender. Tell him the property's value no longer will support the loan, which the builder's advertised prices will confirm. Then ask the lender to cancel the financing, because the loan-to-value ratio required by the loan contract will be violated.

With no financing, the buyer should be able to (1) cancel the town-home contract, or (2) renegotiate.

It's gotta be better then his present course of action.
1.29.2006 7:52am
nk (mail) (www):
I suppose that I am engaging in cocktail party talk too (I'm drinking coffee though) but you see this more with condos and townhomes than with detached residences. With condos and townhomes the value is dependent on the market with the three primary factors being desirability of location, construction costs in that area and the availability of money (savings in hte hands of prospective buyers and loans at reasonable rates.) With "real" real estate, anywhere outside a blighted area, you have the price support of the value of the land itself. A decently sized lot will get you your money even if your buyer is looking for a tear down to put up six condos or his dream McMansion. Even if he is not looking to do this he will also be assured that he could resell in the future to someone else who is.

As for the case at hand, I would negotiate for a price reduction or litigate. A $100,000.00 is worth going to court for. My state is pretty mainstream and considers home purchases consumer transactions. It departs from traditional contract law in making sure that home buyers and borrowers do not get cheated. I imagine most states are the same way. I believe that even traditional equity would not grant speciffic performance or forfeiture to the Seller with a 12.5% disparity between price and value. Moreover, was there a mortgage contingency clause? If the real estate does not appraise at the contract price, the lender is not likely to grant the loan and the contract will be null and void as long as notice is given to the Seller.
1.29.2006 8:13am
Stephen Macklin (mail) (www):
Of course the whole notion of there being a market to sell to someone who wants to develop a property pretty much falls apart if that developer has friends at city hall. Then the town will just take the property and cut you a check for less than market value and give the land to the developer.
1.29.2006 9:20am
peg (mail) (www):
David, in answer to your questions about what people think about real estate, the answer is that even very intelligent and competent people seem to go bonkers when real estate is involved - particularly their own home.

As a realtor, you would not believe some of the comments I get from folks. "We should get such &such a price because we <b>need</b> it." (I always wonder, then why not shoot for the moon? Why stick to only what you "need" - why not pay for the kids' college educations at the same time?)

People seem to believe that real estate appreciates somewhere between 8% to 30% annually - irrespective of what salaries, interest rates, and construction figures have been. Many are utterly incapable of dispassionately recognizing the faults of their own home. And yes - they can be wholly illogical when it comes to values. A townhome almost identical to their own is going for $700,000? So what! If <i>they</i> paid $800,00 for <i>their</i> own place, then <b>surely</b> someone somewhere will also pay that much!

It's that bad.
1.29.2006 9:57am
chris (mail):

I am so glad to see a Realtor who knows that a house is worth only what you can get for it. I remember selling a house for about $200,000 about 10 years ago. A Realtor I was interviewing asked "How much would you like the house to eventually sell for?" I responded, "seven million dollars" and just sat there watching the puzzled expression of the Realtor. After a long pause, I interjected "I want to get as much for it as I actually can."

Many (although certainly not all) Realtors seem to be of the opinion that if you are just willing to leave the house on the market long enough, you can get "your price." A neighbor's house has been on the market for over a year and empty for over six months while all sorts of other houses have been selling. The owner is a Realtor.
1.29.2006 10:29am
David Sucher (mail) (www):
What interests me is why the author of this post seems to have his own investment in proving that there is an enormous bubble throughout the nation and forecasts with glee that disaster is just around the corner.
I hear advocacy for a bubble rather than mere observation.
Just wonder why. Still a renter and looking to buy?
1.29.2006 10:36am
davidbernstein (mail):
David, I'd much rather believe that housing prices will go up 20% a year forever; I'd join the ranks of housing flippers, make several million dollars in a few years, and retire to a Carribean island.
1.29.2006 11:02am
davidbernstein (mail):
Oh, and just so I'm not seen as implicitly endorsing the rest of David's post, I don't believe that I've ever forecast "disaster," nor expressed any "glee" about the softening market, much less about what would happen if a "disaster" scenario came true.
1.29.2006 11:12am
peg (mail) (www):
I might add, however, that while one can see broad patterns vis a vis bubbles - what is going on in one market need not at all be occuring in another. Even in my metro area (Mpls.-St. Paul), some specific areas are tremendously slow and prices are coming down a bit - while in others, demand is still high enough that prices do continue to rise.

Supply and demand always calls the shots, whether it's houses or widgets.

And Chris - while I wish I could sell every home I list for $7 million; alas.... I'm only able to get what buyers are willing to pay. Somehow, what the seller "wants" or "needs" does not figure into their equation!
1.29.2006 11:20am
Bruce Hayden (mail) (www):
The point that many real estate brokers and sales people tell you that you can get your price if you wait long enough brings up an interesting point made in Freakonomics - that real estate sales people have every incentive to sell your house as fast as they can, and thus tend to undervalue it for quick sale. The authors looked at the difference between what properties sold for when sold by real estate sales people, and when the real estate people sold their own houses, and, no real surprise, their own homes stayed on the market longer and sold for more.

What seems to be missed often in rapidly appreciating markets is that sitting on a house may make economic sense. 2 1/2 years ago, I resold my house in Phoenix. It went up somewhere around 15% in the three months it took me to get it back, clean it up, and resell it. But my mortage payments, etc., were maybe 1/3 of that. And, then, it continued to appreciate for the past 2 1/2 years at almost that same rate. Even with an MBA and a real estate broker's license for almost 20 years, I didn't do the math, and sold much too early. But my broker got me excited, and I took the first legitimate offer I got. Despite her being a friend of mine, I do wish I had read that chapter in Freakonomics first.

Note though that I am not suggesting that everyone sit on their properties all the time. I think that you have to be very careful if you do. Every market is going to cool eventually and it is IMHO worse to get stuck on the wrong side of the crash. Much better to leave some money on the table, instead of potentially losing $100k as here. But Phoenix 2 1/2 years ago is much different than D.C. today (even then in Phoenix, you could buy a 3 year old 2,000 sq. foot detatched house for under $200k - now it is over $300k for the same house).
1.29.2006 11:38am
David Sucher (mail) (www):
Local "price supports" are the un-discussed issue in housing values.

No one can be sure of the future but for the Seattle market -- and for any other market with similar elements -- there are two secular trends which act as defacto "price supports" for housing:

1. "Growth Management" and its urban containment boundary line, as well as all the other land use restrictions, which limit the supply of land;
2. Our local inability to deal with transportation and congestions etc etc which offers a tremendous advantage to centrally-located properties.

These factors will be with us for many decades. ("Peak Oil," among other factors, will only intensify the demand for in-city and close-in subuirban housing.)

When you add in the limits to growth offered by mountains and sea, and the enormous political power of a middle-class which sees no problems iwith restricting housing supplyh, I think you have the makings of a fairly stable market, albeit with some ebbs and flows.
1.29.2006 11:43am
John (mail):
A few comments:

1. If there was financing, the lender is committed, and changes in market value will not relieve it from its duty to lend. Any effort by the buyer to get the lender to withdraw its financing so as to get out of the purchase contract would breach the buyer's good faith obligations under that contract.

2. Like all contracts for real estate that I have seen, this doubtless provides for a forfeiture of the buyer's deposit--usually 10% of the price--as the sole remedy of the seller in the event the buyer does not close. So the buyer could default, forefeit the 80K, and buy a new house for 700, thereby saving 20 on the whole deal. Of course, that option would also be a bargaining chip to negotiate something with the developer.

3. Prices change fast in real estate--up or down. How many of us have heard of some friend or friend of a friend who bought something and six months later sold it for a 25% profit? Welcome to New York City! Well, prices go down as fast. The facts described to not indicate anything cheesy to me, however unfortunate they may seem to the buyer.
1.29.2006 11:47am
btorrez (mail):
Let me reiterate what Mr.Hayden said above and maybe make a new point. I just sold my father's place in south Texas. The broker suggested a below market sales price and we had an offer in about ten days for about 15% below the asking price. Despite the broker's advice to take the first offer, I held out and got close to the asking price but wished that I had waited or had been firm with the broker from the start and suggested a higher asking price. It is important to remember that generally real estate trades within a range of value for similar properties in similar locations, so if the guy next door had a three bedroom, two bath, split level, etc and so do you and there have been four or five sales of similar properties in the last several months for $150K to $200K, chances are your property is going to fall somewhere within that range. Bottom line, there is your value.
1.29.2006 11:53am
The seller who hold their property longer don't get their asking price; they get their asking price minus the additional financing and tax costs, which can be substantial.

What this means in practice is that in a market where housing costs are rising faster than mortgage interest rates, it is a good strategy to hold your house until you receive the amount "you want." If the rising market lasts long enough, you will get your $7 million. The problem is that in a declining market, holding your house longer is the worst possible real estate strategy.

The real estate bubble is a lot like the 90's stock market bubble -- a lot of people who thought they were really smart and really tough deal-makers will turn out to be idiots rescued by a "rising tide that lifts all boats." I don't think we should be surprised at irrationality in the real estate market, because we've seen the same things in stocks and other abstract financial instruments which lack the emotional ties of your home.
1.29.2006 1:06pm
A. Zarkov (mail):
In the mid 1990s I was looking to buy house in the San Francisco Bay Area in areas like Oakland, Orinda, Lafayette, Danville etc. It was a buyers market in the sense that inventories were high, and property just was not selling. On the whole, I found sellers amazingly irrational. They seemed to have no concept of opportunity cost (remember interest rates were much higher then). A lot of empty houses sat around for years, with the sellers unwilling to make compromises on price. I remember one seller had a house that wouldn't sell and he took it off the market, spent $100,000 putting in a new retaining wall, and then brought it back on the market asking $100,000 more. Now he had an even more overpriced house that wouldn't sell! My Realtor took me back to the house I didn't like and extolled the virtues of this new wonderful retaining wall.

Unless you are in a rapidly appreciating market price your house to sell quickly. If your asking price is too low, the buyers will bid it up. Starting off at high price, and lowering until you find the market is a bad strategy. When a house lingers unsold, buyers tend to think there is something wrong with house, and it ends up selling for less than what it would have gotten if priced right in the first place. Now I'm looking to buy again. Only this time it seems like we are near the top of a bubble (at least in certain areas). I could easily over pay unless I'm very careful. I think it pays to continue renting for a while.
1.29.2006 1:52pm
tefta (mail):
We actually experienced a bank declining to give a mortgage to buyers because they said the house was overpriced. We went along with it and lowered the price (there was no broker involved) because unless somebody came along with cash, we couldn't hold out for more money.
1.29.2006 6:24pm
peg (mail) (www):
I'm not so sure that John is correct about a lender being committed to lend. Lenders want to know that the underlying value is there. If strong evidence (with another appraisal, perhaps?) demonstrates that the value of the property has declined substantially, then I would think it surely possible that the lender might back out.

I actually have had this happen to me; a lender becomes concerned about a project, and either demands more money down from the buyer, or will only lend with a lower price tag. Either way - most residential contracts allow for a buyer to back out if funding cannot be secured.
1.29.2006 6:36pm
Well, maybe Professor Bernstein has expressed a little glee about his housing puts. That was a little gleeful. Congratulations to him.
1.29.2006 8:15pm
Patrick C (mail):
In Los Angeles after the aerospace industry tanked in the early '90s, housing prices fell because there was a huge oversupply and no buyers. Why buy a home from someone else when you could go down to the next subdivision and buy a new home for the same price? Housing prices began to go down and people walked away from their mortgages, rather than pay $500K for a house that was valued at $350K. Banks failed because they had to write down so much bad real estate loans. So, dramatic declines in property value can happen, but it usually takes something equally dramatic such as the end of the Cold War and the consequent tanking of the aerospace industry to cause it to happen.

To A Zarkov: It probably made sense for the Orinda sellers to hang onto their property and wait for the market to improve, since their property taxes were probably pretty low thanks to Proposition 13. They would have lost out selling a house at $750K that they could have sold for $1.5M just a few years later.
1.29.2006 8:33pm
Conrad (mail):
John legal analysis is, ahem, somewhat lacking.

The buyer may certainly, without violating any duty of good faith, inform the bank of the material fact of a substantial change in the market value of the house. Indeed, if the lending agreement permits the bank to withdraw in the event of a material change in circumstances, he probably has a legal obligation to do so.

If the lending agreement does have a material change clause (and I'd be amazed if it didn't -- imagine, e.g., if the borrower lost his job prior to closing, would the bank leave itself open to having to still lend), then the bank may obviously withdraw from the agreement so long as it can show that a $100,000 change in value is a material event, which it very likely can.

Were I the buyer, I'd also feel pretty comfortable making it known to the bank that, were they to withdraw, I would, under the circumstances and taking into account the practicalities of the situration, be very unlikely to sue. Sure, the seller can try suing the bank himself as a third party beneficiary, but that is likely to be a lot less legally, financially and commercially attractive than suing Mr. John Q. Public.

Furthermore, were I the unfortunate buyer and the seller did sue me, I'd very seriously consider (depending on the timing of the price cut) filing a counter claim against the seller for misrepresentation/fraud on the grounds that he failed to advise me of the material fact that such a cut was impending and/or under consideration. If properly pled, this opens the door for all sorts of interesting, annoying and potentially embarrassing discovery. And, as I vaguely recall from law school, most states hold real estate sellers to a higher duty of disclosure than is the case in most other transactions.

Finally, I doubt any litigation would actually be necessary after my lawyer explained the facts of life to the seller and offered to avoid the time, risk and expense of litigation by quietly renegotiating a revised sales agreement. Selling an empty house for something betweeen $700 and $800 K now is a whole lot more valuable to the seller than an uncertain claim that will take two years and cost thousands of dollars to resolve. Especially if there are other similarly situated buyers whom the seller has to worry about getting ideas.

I'm assuming John is a transactional lawyer and not a litigator. Were I unable to get my client a better deal than forfiting their deposit and signing another contract for $700K, I'd turn in my license to practice. This is not meant as a criticism of John (unless he is a litigator). We just think differently. Were I to try to do transactions, I'd doubtless queer countless deals by being too adversarial and demanding.
1.29.2006 8:50pm
A. Zarkov (mail):
Patrick C

Property taxes are only one of the costs the seller bears when he hangs on to an empty house. While the market did recover circa 1998, the sellers had no way of knowing that. One house I looked at and rejected had already been on the market for 4 years as of 1995. Waiting 7 years to get your price seems a trifle irrational to me, especially when you don't know when the market will recover.
1.29.2006 11:03pm
Ted Frank (www):
1.30.2006 2:36am
Tom Tildrum:
Whatever the seller's motivations may be, it's almost never in the realtor's interest to price high and wait. The realtor only gets a portion of 6% of the price increment, and meanwhile has to devote extra time to the house and carry it on her books. In my experience, a realtor is typically much more inclined to price low and move the property as fast as possible.
1.30.2006 8:29am
peg (mail) (www):
Tom, while I believe your statement is true of some realtors, it assuredly is not of all - and in particular, not this one.

Much of my business is both repeat and referral. To achieve this, my clients must believe that I am always acting in their best interests. Underpricing their homes to "move as fast as possible" is counter to this, and thus, I do not do it.

While my principle that "what is best for my buyers and sellers ultimately is best for me" does not always prove to be the case in real life - overall, I find that it does. Plus, I can sleep at night.
1.30.2006 10:42am
Some Guy (mail):
Please tell this individual to BUY. I can't wait until these fools realize they can't cover their mortgage payments and are faced with either personal bankruptcy or foreclosure and giving up their beloved BMW.

This time next year, I'll be driving a fat ride (bought from one of these shmucks) and living in a sweet crib (picked up after the foreclosure).

People that stupid shouldn't be allowed to breed.
1.30.2006 11:13am
byomtov (mail):
I believe that most people seriously underestimate the cost of holding real estate in the hopes of getting a better price.

It's not only property taxes. There is also: insurance (which goes up a lot if the house is unoccupied), maintenance, some amount for utilities, and very important - capital costs. Note that the capital costs are not your mortgage payments. They are the opportunity costs of not having the cash you could sell for now. If you have a $700K offer, but hold out for $800K, your capital cost is the return you could have gotten on the $700K while you were waiting.

And let's not overlook one more cost: the market risk that you bear while holding on.
1.30.2006 1:14pm
Anon E Moose:

Rest assured that when someone derides common sense as mere schadenfreude, or accuses obvservation of masquerading as advocacy, they themselves have some vested interest in maintaining the status quo. In the real estate discussions, it's typically a Realtor (r) [heh] or some who's "done a bit of real-estate development".

1.30.2006 5:31pm
Not a lawyer but ...:
Whatever the seller's motivations may be, it's almost never in the realtor's interest to price high and wait. The realtor only gets a portion of 6% of the price increment, and meanwhile has to devote extra time to the house and carry it on her books.

Actually, the selling realtor gets only 3%, and typically splits that (roughly evenly) with his/her agency (employer). So the realtor personally gets about 1 1/2% of any price increase.

Realtors do sometimes have an incentive to suggest too high a price, however - when they are competing against other agents to get a listing. In such circumstances, the seller often picks the agent who suggests the highest price. Then the agent hopes that (a) a foolish buyer happens along, or (b) he/she can subsequently talk the seller into reducing the price to something more realistic. (Of course, a lot of agents lose a listing because a house doesn't sell.)
1.31.2006 2:10pm