Real Estate And Lemonade: A Housing Market Analogy
July 29, 2009 - People have been asking me a lot of questions lately about foreclosures, shorts sales, and the elusive shadow inventory in this falling real estate market. From my conversations with both readers and real estate professionals, as well as my reading of articles and blogs on the internet, it is clear to me that most people do not have a grasp for what is coming in this current housing market crisis.
Perhaps the best way to communicate my concerns about the housing market is with a short analogy. An analogy is useful because it is simple and easy to understand. Once we show the parallel between the analogy and the real estate market, you will then understand what I believe is a huge oversight in our nation's real estate reporting and housing speculation markets. So, without further ado...
The Lemonade Stand
One day "Jack" decided that a great way to make a living in Tallahassee would be to set up a lemonade stand in his neighborhood. He figured with temperatures rising over 100 degrees out there every day people were getting really thirsty.
So, Jack went and bought what he thought he needed to set up a profitable business. Here is what he bought:
- a few bushels of lemons
- several pounds of sugar
- some disposable cups
- an ice maker
- a cooler
- some containers to hold the lemonade
- a nice table with chairs for his stand
- and a big poster to make a "Lemonade for Sale" sign
Jack figured out how much he had invested into all the materials and decided if he could sell cups of lemonade for $1.00, he could make a fair profit and could provide lemonade for the thirsty people of Tallahassee. He was so excited about the new business that he started making lemonade right away.
A Housing Market Analogy
Jack's business got underway and he started selling a lot of lemonade. People found his cool, refreshing drink to be perfect for those sticky-hot days of summer in Tallahassee. Jack was working very hard, but he was also very satisfied with his new business venture. Things were good for Jack.
Jack was so successful, he invested even more money into supplies, equipment, and ingredients, expanding his business to cover the entire Tallahassee market. Even though his expenses were running higher, he was able to keep his price at $1.00 per cup due to volume production and volume sales. Things were good for Jack.
One day, as Jack was heading to his top-producing lemonade stand, he found little Jimmy selling lemonade just down the street for 45 cents per cup. Jack swung by and bought a cup from little Jimmy, just to check out the competition. Sure enough, Jimmy made a great cup of lemonade, and he was able to sell it for far less than Jack's actual cost. You see, Jimmy was just a kid, so he used his parents' lemons, sugar, ice, cups, water, coolers, etc. to make his lemonade. The forty-five cents that he charged was "pure profit," because he had no real costs involved. Thankfully Jack thought, Jimmy would run out of his parents' materials and wouldn't pose a long-term threat to his business.
Little Jimmy was making a kid's fortune. He earned so much money that he bought a skateboard and a video game. But he wanted a new bike. So he kept making lemonade. His parents were so proud of his hard work that they kept buying more supplies so he could keep going. Jimmy was working hard and things were good for Jimmy.
Jack was a little frustrated that Jimmy kept at his lemonade business, as Jimmy was under-selling him by over 50%. Jack decided that it was no big deal, as Jimmy could only handle a very little part of the market. Jimmy was no real threat and Jack could keep charging his $1.00 per cup and keep making a profit.
One day, Jimmy was bragging at his Cub Scouts meeting about all the money he was making. His Pack Leader was so proud that she spread the word. Cub Scouts could make lots of money if they would just set up lemonade stands. Soon, neighborhoods all over Tallahassee had lemonade stands with little boys selling lemonade for 45 cents per cup. Things were good for the Cub Scouts.
Jack noticed all the new competition, and initially, he figured they would give up and go away after a while. But instead, he noticed fewer people were willing to pay him $1.00 for his cup of lemonade. They seemed to think that he was over-charging and that they could get it cheaper elsewhere. And they were right.
But Jack held to his price but found he was selling fewer and fewer cups of lemonade. He started noticing that he had too many lemons and that they were starting to rot. So he made them all into lemonade before they could go bad. Now Jack had gallons and gallons of lemonade, but nobody wanted to buy his 1.00 cups. Things were not so good for Jack.
Word got out that the Cub Scouts were raking in the money, soon the girl scouts were selling lemonade too. Then so were many civic organizations, all receiving donations of supplies in order to create lemonade and then sell to the market. It seemed like everybody was now making lemonade.
Everywhere you looked were lemonade stands. Some people were willing to sell it for 35 cents per cub, just to get a quick profit for their fundraising. For the most part, people were selling lemonade for 35 to 45 cents per cup, and Tallahassee was no longer thirsty. Lemonade was plentiful. Things were good for Tallahasseans.
Summer ended and cooler days came to the Tallahassee area. Demand for lemonade dropped, so Jimmy and the other vendors decided to lower their prices when they made too much lemonade. They were now charging 25 to 35 cents per cup, and since they received their raw materials for free, they were still happy. They weren't making as much money, and most of the vendors quit producing the lemonade. But Jimmy was happy because he was still making money, so he continued at his little stand.
Others took more of a "wait and see" approach. They figured they could mass produce the lemonade and freeze it, and then bring it back to the market when some of the others stopped selling it. These people, the shadow lemoneers, knowing that it made no sense having a lemonade stand if nobody was willing to pay for it.
Finally, Jack started lowering his price to get rid of his glut of lemonade. He was losing money and could no longer make a living from his lemonade business. His competition did not have to pay for raw materials and he just couldn't compete on those terms. While he was confident that the fad would end and the kids would go back to being kids, he was nevertheless stuck with hundreds of gallons of lemonade and the buyers had pretty much gone away.
When winter came around, nobody wanted any lemonade. Jimmy quit making his and froze his remaining supply for the Spring. Jack on the other hand, still had hundreds of gallons left and nobody was buying. He too froze his supply of lemonade and also waited for the Spring.
Thankfully, Spring arrived and it was seasonally warm. Lemonade sales started up again, but Jack knew it would take months to sell all of his frozen lemonade. He lowered his prices, trying to get new customers to try it out. He had raffles and promoted his business online, trying to "stimulate" the market.
But Jack did not understand how many other vendors out there had frozen lemonade as well. As soon as the temperatures hit the 80s, lemonade stands were everywhere.
Though most people were not making new lemonade, there had been so many thousands of gallons frozen at the end of last season and they all started to hit the market when the weather got warmer. It seems like Jack got hit by the shadow lemoneers harder than he could possibly imagine.
Jack went around from stand to stand, asking the different vendors how much lemonade they had prepared to sell. It shocked Jack to find out there was already enough lemonade for the entire year and even some left-over for the beginning of the next year. Jack was truly bummed out.
So Jack had a decision to make. Sell all of his lemonade now, or just leave the market until normal market actions had recovered. Because so many people had lemonade to sell, Jack knew he would sell now at a loss, or just store his lemonade until he could make a profit, and that is what he did.
The Housing Market Analogy - Real Estate And Lemonade
Right now our national real estate market is in the consumption stage (as highlighted in the analogy above). Home builders and developers are producing houses at the slowest pace in the past 70 years or so, and we are seeing inventories drop.
In the analogy, we reference the competition getting "free materials" from parents, etc, to make lemonade cheaper than Jack is able to do. This is the comparison of short sales versus normal arms-length sales, in that short sales will occur at prices far below the market. Short sellers are able to undercut the market because they are not fulling paying off the loan(s) that they used to buy the property.
In the analogy, when Jimmy first started, Jack saw that one lemonade stand as a "niche" and no real threat. This is parallel to how we have viewed foreclosures in the housing market. They occur every year, but with such low frequency that we do not really consider them when valuing a home. But that is not the case anymore. These foreclosures and short sales, much like all the lemonade stands, are popping up all over the place with great frequency. This will have a major impact on home values for the short-term.
Unfortunately, I think our housing market has more homes in the shadow inventory than any of the "experts" understand. This shadow inventory consists of
- homes that were on the market, but pulled off and not relisted
- homes hitting foreclosure that have not been on the market
- homes about to see mortgage rates adjust for the first time
- homeowners who want to move but just haven't tried due to market conditions
When you attempt to measure the shadow inventory, you find it is much larger than we had imagined. I am concerned that if these homes all hit the market in the next twelve months, we will see pricing pressures for many years to come.
This shadow industry, much like the lemonade vendors who froze their product until the market recovered, represents more than a full year's worth of inventory. But builders are licking their chops, as was Jack, to start producing again because the "rebound" is just around the corner. I just don't think it is. We still have several more year's worth of housing inventory to consume, our shadow inventory.
So, If you read an article talking about the "recovery is here," and it advises that the housing market is going back to "normal" appreciation, just remember, the author of that article probably doesn't know Jack!
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