I just re-read Barron’s cover story from story from two weekends ago. Barron’s is the only paid subscription newspaper I get, in addition they tend to be conservative or on the bearish side of the coin. While I thought the article was quite lacking in substance, their timing I believe is of value.
So here is my observation regarding their article.
Noting the Damage
At year end 2011, the S&P/Case-Shiller National U.S. Home Price Index fell to a record low, 33.8% below the boom peak level, recorded in 2006’s second quarter. The descent has been all the more hideous in such once-manic markets as Las Vegas, Phoenix and Miami, which, according to the Case-Shiller 20-City Composite Index, have fallen 61%, 55% and 51%, respectively, from their high-water marks.
The Long Beach and surrounding Real Estate Markets are similar. The more stable areas of Long Beach have seen corrections of around 30%, while certain segments, like condo’s or North Long Beach, have seen greater corrections of around 45%. It is the inland empire that has seen the 50%+ type of correction that the Barron’s article is citing.
Affordability
This is probably the single more important feature of an overpriced or underpriced market. Affordability fell through the floor towards the peak of the market in 2005/2006. It was even difficult years prior to the peak to buy a home, but creative financing kept the market moving higher for longer than should have been allowed.
The near-record low in mortgage rates and concomitant slide in home prices has made houses and condos stunningly affordable (although stiff underwriting standards have made getting home loans more difficult). This is captured in the National Association of Realtors Housing Affordability Index, which measures how much purchasing power a median-income family needs in order to buy a median-priced home, using conventional mortgage financing.
This measure stood at 206 in January, which meant that the typical family has more than double the income needed to purchase an average home. That reading is more than twice the 102.7 at the peak of the bubble in July 2006.
This is a huge, so let me just restate what we just read. The average (or median) family has more than double the income required to purchase the average home. This allows for a huge upside potential in home values, once the market does turn. Putting this in prospective with the last market peak and recovery:
When the market is hot, buyers feel the pressure to get into the housing market at all costs. The typical rule of thumb is that banks allow buyers to borrow up to 40% of their income towards a home payment. During market peaks of 1989/90 and 2005/06, lenders found ways to give buyers more rope to drown themselves in debt. Loans called ez qualifiers or stated income loans, buyers could push debt ratio’s to 50% or more. But at market bottoms, buyers tend to be very conservative. During the last bottom of the market in 1995 and it was typical for me to work with a buyer that were only purchasing 1/2 of what the bank would qualify them for. Much like today.
Why are buyers so overly aggressive at just the wrong time and so timid when they should be doubling down? Well, there are two factors.
First, buyers mistakenly do consider their home an investment, when a home is really a use asset. Unless you rent your home out, then it IS an investment, but that is another article.
When home prices are at their peak, there is often a stiff premium to own vs. rent. But prospective buyers feel that they will make that up with appreciation. In 2005, I calculated that it was 40% more expensive to buy than rent. So what if it costs an extra $1,000 per month to buy, even taking into consideration tax breaks. If the home goes up $50,000 in a year. I am still ahead $38,000 was the logic.
Now what happens if homes are going down in value, and generally considered a bad investment? Then buyers figure the cost of owning shouldn’t be any more than the cost of renting (including the tax advantages). And maybe the cost of buying should actually be less. Which is the case today. The simple fact that a home goes up in value actually makes the home more desirable from an ownership standpoint, and if homes are going down in value, they value is less then as well.
The second reason for buyers being overly confident at market peaks and timid at market bottoms, is simple consumer confidence that comes with a vibrant market versus a pessimistic outlook. It was not uncommon for me to speak with potential buyers during the 1995 bottom and when asked why they weren’t going to purchase more home, the response was “I want to be able to afford the home on one income, just in case my spouse looses their job”.
Tale of Two Cities
Absolutely, in the opinion of Karl Case, professor emeritus at Wellesley College and one of the progenitors of the Case-Shiller indexes, launched in 2002. “If you drill down in the numbers by zip code in the Boston area, as I have done, you find that more desirable, affluent neighborhoods like Back Bay and Beacon Hill are doing just fine now—while, say, Fall River is still in the dumps and dragging down the entire Boston Metro area,” he asserts.
This bifurcated market is seen all across the country. While the Nob Hill neighborhood in San Francisco never saw values drop drastically and is now recovering nicely, Stockton, Calif., remains in the dumps. It’s a tale of two cities elsewhere, too. The Santa Monica real-estate market is doing fine, while the desert towns to the east are still suffering. And, in the Miami environs, South Beach is strengthening; Hialeah, Fla., isn’t.
The title of my 4th Quarter 2008 Newsletter was “A Tale of Two Cities”. In this article I simply pointed out that marginal financing with buyers that overextended themselves was a large factor in the market. And it was these buyers that were the first wave of foreclosures. The observation was that these buyers were more likely to buy in marginal neighborhoods. While prime areas saw buyers that were more financially capable and savvy. This trend is still a strong part of the market. The great deals are not always in the neighborhoods where you would want to live.
Shadow inventory
The biggest impediment to a turn in the home market remains the so-called shadow inventory of some 3.671 million homes, according to estimates by Mark Zandi of Moody’s Analytics: those that remain somewhere in the foreclosure pipeline. Payments on some are 90-plus days delinquent; others are already lender-owned properties, known as REOs (real estate owned), that haven’t yet been listed for sale.
This inventory sits atop a market for existing-home sales that this January reached an annual pace of 4.5 million units. Moody’s Zandi, for one, finds particularly worrisome the recent $26 billion settlement of charges, alleging malpractice in home foreclosures, reached by 49 state attorneys general and the five largest lenders and mortgage servicers in the U.S. If nothing else, as a result of this, the shadow inventory will hit the home market far faster than it would have otherwise.
In all honesty we could use more inventory. I wish some of these homes were released. However, these homes will not likely be in the better areas where inventory is lacking, they are likely to be in the already depressed areas where the Real Estate market has already been dominated by distressed sales.
The actual number is of 3.7 homes on annual sales of 4.5 million units is about a 10 month supply. This quantity, if unleashed all at once would certainly cause prices to re-assert a downward trajectory. But they of course will not. Right now, inventory is pretty low, somewhere around 2.75 months supply city wide in Long Beach. The better areas are working with only a 1-2 month supply of homes for sale. The market can handle these at risk properties if they came on the market over 1-2 years. But certainly it seems that this shadow inventory should keep a cap on prices for maybe 2 years.
What Barron’s is Missing
Just as I said that the Affordability is a HUGE factor which will allow the market to go higher, Barron’s missed out on one observation. And that is what I consider to be interest rates that are artificially low. Affordability IS a function of interest rates. If rates start to climb affordability will suffer. There is no way for me to predict where rates will be in two years. Right now 30 years mortgages are in the low 4% range. Would it be unrealistic for rates to be back at 6%? I don’t think so. If rates were at 6% vs. the 4 1/8% published on Wellsfargo.com today. Home payments would be almost 20% more expensive.
Outlook
While I do agree with the Barron’s article, heck my last newsletter was titled “The Coming Bottom in Real Estate”, there are two items that will drag out this recovery and keep it from being a real barn burner. First, I do believe that there is a shadow inventory of homes that will be on the market. But let us consider what these shadow homes really represent. They are workers, employees and business owners that are having a tough time making their mortgage payment. Partly because the debt they choose was too much for their ability. This problem can be cleared out and resolved. But these at risk homeowners are also likely struggling because the economy is just ho hum, and maybe they are in an industry that has been particularly hard hit. So these shadow homes are partly a reflection of dumb home financing moves, but more importantly they represent a weak economy.
The second concern will be rising interest rates. Right now the Government guarantees some 80% of home loans. Why such a large percentage, when this had traditionally be the domain of banks and savings and loans. Because nobody in their right mind would loan money out for 30 years at 4%. That is right! If you had $500,000 sitting in the bank would you loan it out at 4%? I doubt it.
It is a little difficult to answer what would be the “right” market value for interest rates today. It should obviously be something around 2 or 3% above the rate of inflation. But since the Government has so bastardized the CPI figures it is difficult to tell what inflation is today. Is it 2% as reported, or is it more like 5% – 8%, when you only consider the items that people really buy, like food and energy. The who knows what inflation will be like in 2 years with all of the Fed money printing. So while I don’t have an answer as to what real market rates should be. It is fair to say that they are a the absolute low end of the range, and are most likely to only go higher. This will create a head wind to home price recovery.
What if you are a buyer on the fence?
The good news is that in many markets homes are as cheap, or cheaper to own than to rent. So if your time frame is 5+ years and you can afford where you want to live, they there should be nothing holding you back. It is always impossible to time the exact market bottom, but it is fair to say that there is little risk buying today.