Monday, May 17, 2010

Irrational Growth or just Free Market at Work?

I read an article in the New York Times online yesterday and it spurred a lot of thought and a lively discussion with some friends on Facebook. The gist of the story is that despite a 60% decline in home prices, nearly 10,000 new homes sitting vacant, almost 6,000 repossessed just this year, Las Vegas is experiencing a bit of a building boom. New homes are being built and sold despite the oversupply of existing homes. On the surface, it seems completely irrational to continue building despite an oversupply; however, if the homes are selling then who are we to stop it? Also, for those in construction, real estate, etc. this is a very good thing because it means jobs.

That being said there are tremendous public costs created by this overdevelopment. The roads, water and sewer lines, and other utilities that were built to serve those now vacant and dying neighborhoods are going to be maintained by local governments (read TAXPAYERS). The public safety issues of ensuring these vacant homes don't become meth labs, etc. need to be considered as well. Detroit is the extreme example of a community grappling with the very issue of how to manage abandoned neighborhoods. It seems to me Las Vegas is creating this exact scenario for itself by continuing to build in spite of the existing oversupply.

So, some questions that I'd love somebody to answer: First, do the buyers of these homes really believe they are going to see appreciation in their home investment? (see Dutch Tulip Craze as example of irrational buying and oversupply)
Second, how is this financially feasible? How does it pencil out to loan money for this kind of project? I would love for a banker to let me know on this one.
Third, how will local governments respond to increasing costs of service on the infrastructure and public safety serving these dying neighborhoods?
Fourth, what about the families who invested in a home in those now dying neighborhoods? Not everyone is willing to walk away from their home and they are now stuck in virtual ghost towns.
Finally, why does the Federal government subsidize this irrationality with FHA loans, tax credits, etc? Homeownership is not a right, but has been treated as such for generations. This is part of what got us into the mess in the first place by making everyone think they 'deserved' a new home whether they really could afford it or not.

So that's the conflict. This is the free market, suppliers (developers) are responding to demand (homebuyers). This is a good thing in many ways and is creating jobs, etc. However, is the market in this case being way too short sighted? What is the proper government response given that the government (meaning TAXPAYERS) are ultimately going to be responsible for many costs associated with this growth? How do we balance the free market with the inevitable public costs the free market creates? Would 'clawback' provisions, like those used in economic development be appropriate? Developers have to post bonds and if their neighborhood doesn't pan out they have to pay to demolish it or mothball it until demand is there?

If I had the answers to questions like these I'd be sitting on a beach not sitting in a cube writing a blog...


  1. Here is my understanding of the problem. I have read there is a shadow inventory of unsold homes held from the market, including REOs from banks and homes held off the market by private sellers waiting for demand to pick up. Both parties are reluctant to drop the selling price to what the market would likely withstand. Banks do not want to dump their REOs in the foreclosure market because they would have to realize the loss, so they are dragging feet in the foreclosure process and trying to unload as slow as possible in the hopes that inflation fears and an economic recovery will come to save the day.

    Because the "shadow inventory" is being held from the market, prices have stabilized well above where they would likely sit if the inventory flooded the market. If you are a builder/developer, your costs to build are about 25% lower than during the boom and your can sell under what the market is offering. So short term profits can be made right now building: cheaper material, cheaper labor, cheaper land, and your homes are cheaper than what is being offered by banks who are overlevered and can not write down the losses without going into recievership. Of course if the banks start unloading, the economics will change and it will be more expensive to build than buy an existing home.

    As an aside, in Austin i heard the large builders shut down completely leaving a void to be filled by small builders.

    Bobby D

  2. Damn, that's scary to think that it can make more financial sense to build new than to move existing inventory, but there is a logic to it. And, if you're a developer, this is what you do, its your business, so you'll make a go of it if you can because you're not going to make any money sitting at home...