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 risingover 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 his new business that he started making lemonade right away.

A Housing Market Analogy

Status Quo

real estate and lemonade Real Estate And Lemonade: A Housing Market Analogy, Tallahassee Real EstateJack’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.

Niche Market

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.

Market Shift

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.

Over Saturation

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 fund raising. 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.

External Pressures

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 loosing 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 quite 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.

Consumption

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.

Rebound

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 any more. 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 contditions

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, represent 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!

 

[youtube width="400" height="324"]http://www.youtube.com/watch?v=d6uzXBIOKaw[/youtube]

 

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Joe Manausa is a real estate blogger, a real estate investor and the Broker and Co-Owner of Joe Manausa Real Estate. He can be reached via e-mail through the Tallahassee Real Estate Website or catch his latest writings on the Tallahassee Florida Real Estate Blog , or by calling (850) 386-2001.

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 Real Estate And Lemonade: A Housing Market Analogy, Tallahassee Real Estate

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Comments

  1. Joe, today’s blog about Real Estate and Lemonade was a great analogy. It made today’s real estate market status very easy to understand – even by people like me who don’t know “Jack” about realty. Keep up the good work.

    • I’m glad it helped Marlie. I’m wondering why so many articles are saying the worst is behind us and that builders are getting ready to get busy again. There is so much left to fix.

  2. I do enjoy your blog. I want to work with people who wan to sell their home. I’m in the business of selling homes not listing them. Listing is worthless unless you are willing to do what it takes to sell it.

    Keep writing, it gives people real information.

  3. Thanks Jim. I was trying a little different technique here to communicate a tough point about our market. I hope it helps.

  4. Very nicely told. Another proof of what you are saying is I am a builder and have some lots that I was planning to build rentals on for my own account . I can purchase rentals in my market cheaper than I can build them so it makes no sense to build. I don’t see construction jumping in the near future.

  5. I agree Martin. In the Tallahassee market, the rental properties still have a long-way to go.

  6. Thanks for trying to explain the situation, but my problem with your analogy is that you compare people short selling to somehow cheating. ie, not paying off the loan in its entirety is somehow unfair… So what you’re saying is that the banks themselves aren’t somehow cheating in the first place. A better analogy would be that Jack had inherited the lemonade business from his family who had been selling lemonade for the past few centuries (Jack is the bank). The other kids in the neighborhood weren’t born with any potential to make lemonade since their families hadn’t chosen to concentrate on passing money down the line of genetics, and instead had concentrated on followed their own personal dreams (and arguably less abstract dreams than increasing an imaginary worth like Jack’s family had done).
    The real problem here is that all the other kids in the neighborhood figured out a way to make lemonade without becoming indebted to the banks. This caused the root of capitalism to wither,ie, the banks were no longer making money off of money, and thus, the leaves turned brown and the banks lost money. Instead of letting Jack feel the hurt of what amounts to a legalized theivery, Bush chose to bail him out, ie.. he bought all of his lemonade supplies and now they’re rotting away at the other kids in the neighborhood’s expense.
    Bush’s capitalism only functions with inequality. If the bankers had to go out and get a real job, ie, actually design or build a house, or farm a crop, or cook some food, or anything besides sit in an office and play with pencils and imaginary numbers contributing nothing real to society, then the dreamers and workers would be equal.
    So instead of taking capitalism to it’s logical extreme (in this case, a failure of the upper classes stranglehold and a more equal playing ground caused thru short-selling) which would have benefited more people, Bush chose to benefit the few who have a vested interest in making sure that things are never equal.
    The end! sleep tight kids

  7. Sr. Lopez, thank you for the long comment. You can read my reply in the blog written 9/16/2009.

  8. Very well-written.

    I’ve been trying to get a hand on the national association of realtors’ supply of unsold homes report. Would you be able to e-mail me that, Joe? Wrkoutguy08@yahoo.com is my e-mail address.

    I have already checked the national association of realtors’ website.

  9. Mike, I do not have that report, but I suspect leaving a comment on the NAR site is the best way to find it.

  10. Joe, I was thinking that those putting up lemonade stands, and receiving free goods, were the recipients of government bailouts including lowered rates saving the borrowers from foreclosure. The government intervention in the marketplace is preventing prices from reaching their true equilibrium, or is forestalling the market correcting pricing. Natural market forces always clean up excess demand, causing new construction to line up with the actual market demand.

  11. Hey Warren, thanks for the comment. I agree that the government intervention (the bandaid) is slowing down pricing pressures and that natural forces would clean up excess supply. Time will tell if this bandaid was a waste of money, or if it “gave some time” for the market to correct with new buyers brought to the table.

    Look for my full reply to “Sr. Lopez” in the blog on 9/16/2009.

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