The investment world has no shortage of commentary and media on the state of the economy. CNBC runs 24/7 with analysts prognosticating the next boom or bust. Most larger stocks have analysts that follow with baited breath each new earnings report. Real Estate on the other hand, receives no such treatment or following. I just Googled Real Estate news, and found very little interesting information regarding the residential housing market.
With this said, I am personally in a quandary about the state of the Real Estate Market. Is it good, is it bad? Certainly over the last 10 years we have had a large doses of both, in fact, some of the greatest swings in price ever. The early 2000’s saw a few years with 25%+ price increases, then the credit crunch with 30-50% declines, and now prices are up 15+ off the bottom. These extremes are disorienting, making it difficult for the average homeowner, buyer or investor to decide what the future may hold.
This leads me to this quarter’s newsletter. A brief primer on many of the factors that affect Real Estate values. And how these contributing factors may sway the future direction of prices. Sure, we may all know that certain things influence prices, but it is the synthesis of all of the factors, that may lead us to a realistic prognostication regarding the future.
Interest Rates
This may be the biggest factor affecting home prices. As recently as June 19th, Bernanke said that the Fed would start easing up the stimulus plan. In the weeks that followed rates spiked significantly from around 3.5% to around 4.75%. This certainly brought a heated market back to normalcy. Prior to this spike in rates, prices had risen around 15% in the previous year, and multiple offers where common place.
Interest rates and home prices are inversely proportional. If interest rates drop, home prices can rise and a buyer’s payment stays the same. Conversely this is also true if rates rise, prices must come down if payments are to remain the same. A quick rule of thumb is that 1% difference in rates equals about a 10% change in a home’s price.
Last year saw home prices increase around 15%. Buyers seemed to take this in stride. But then interest rates jumped over 1% higher effectively adding another 10% to a buyer’s mortgage payment. This has given buyers enough to chew on for a while.
Since the initial rate shock from 3.5 to 4.75, rates have come back down to a very favorable mid 4% number which has stabilized the housing market for the near term.
While interest rates are a huge factor in the outlook for housing, it also might be the single biggest factor by which many experts disagree. Fundamentally we have the inflation /deflation debate. The deflationists point to a low CPI (Consumer Price Index – inflation rate) and feel the lower rates are justified by the weak economy and low CPI. The inflationists point to the massive money printing and point out that the CPI is a “Cooked” set of numbers. They say real inflation is higher and if the Fed and the government didn’t buy most of the mortgage debt, interest rates would be much higher.
I personally tend to side more with the inflationists, but some very smart people disagree with me. Only time will tell which side is right. But for now, I think the higher interest rates at 4.375% coming up off a bottom of 3.5% is a good thing. It has slowed the somewhat frenzied market of early 2013. Further it reduces the future interest rate shock, as we have already seen a slight rise. Much like a earthquake fault line is safer yielding small shocks rather than a big one.
Ironically, should interest rates head higher, it will likely be because inflation has picked up. While this will have an immediate negative impact on the Real Estate market, as it did during the summer spike in rates, the long term prospect of higher inflation makes Real Estate a good hedge against the ravishes of inflation.
Inventory
Powering the decent to the market’s bottom was a wave of short sales and foreclosures. These are now a thing of the past. It has been a long 6 years since the bursting of the credit bubble in late 2007. If a homeowner hasn’t made the decision to let a home go back to the bank by now, then they are likely in the market for the long haul. In addition, with prices up 15% from last year, owners now have more skin in the game. Short sales and foreclosures have all but disappeared from the landscape in most cities. This bodes positively for the market and is a huge contributing factor towards last year’s price increases.
Other Investment Alternatives
The standard of risk less investment is Government Bonds. With money in savings earning such a dismal return, investors search for conservative investments that still produce a return. Real Estate certainly qualifies as one of the better alternatives to letting money sit idly in the bank. There has been no shortage of cash buyers or retirees looking at Real Estate as a way to replace the lost income from cash sitting in the bank.
I think it is a reasonable to state that this was exactly Ben Bernanke’s plan, drive interest rates down to very low levels to shore up the housing market.
While higher interest rates in the future may remove some of Real Estate’s luster, as buyers seek higher rates of return, these higher rates will likely be the result of higher inflation. Real Estate has always been a good asset to own during inflationary times. So if the speculative money stops flowing into Real Estate, it is likely that it is a result of higher rates of return, and a corresponding higher inflation will likely offset each other. So this factor, if it reverses, should be neutral.
Current Valuations – Where are we in the cycle
California Real Estate is certainly been more prone to booms and busts. Buying at the right time makes you look like a hero and buying at a market peak can leave lasting scars.
We are early on in a cycle of improving prices. The market bottomed in 2011. Typical cycles may last 5 years. The last boom from 1996 to 2006 was probably an exception, where this boom was prolonged by decreasing rates and a mortgage market that added new buyers with more flexible underwriting guidelines that kept increasing the number of potential buyers, even when these buyers never should have purchased.
Even if this time around the market only has a 5 year upswing, it is reasonable that you will not be buying into an overly frothy market. I consider the timing of this market cycle to be a net positive for prices moving forward.
Current Valuations – Relative to Rent, Relative to other Cities
One quick metric of valuations is a home purchase price compared to fair market rent. Many might argue with the choice of numbers that I use, but this metric has proven to be accurate over the previous booms and busts.
My metric showed that the market was 25% and 40% overvalued in 1990 and 2006 respectively while only around 10% undervalued at the ensuing market bottoms. The metric that I use compares a home mortgage payment with 10% down relative to rents. To neutralize the tax advantages of home ownership, I multiply the total home payment by 75%, as a good portion of a home payment is tax deductible, while rent is not.
How does today’s market compare? Using the following numbers for homes, rents, and rates: $550,000 for a typical 3 bedroom, 2 bath home in the East Long Beach area, $2,400 for rent and 4.375% for interest rates, the preceding yields a total payment of: $2,471 (P&I) + $80 (insurance) + $573 (taxes) = $3,124. Which when multiplied by .75 yields a rental equivalent of $2,343, which compares very favorably to estimated rent of $2,400, just slightly less than rent.
This statistic, has ranged from around 10% undervalued to between 25% to 40% overvalued at market peaks, so it is not unlikely that paying a slight premium to own a home may be the norm. Also note that if rents go up 5% then home values can float up 5% as well, with no loss in relative affordability. However higher interest rates will negatively only affect the home price side of the equation.
This exercise shows that at today’s interest rates and rents, homes are fairly priced, not overpriced and not underpriced. Certainly this was cause for prices to climb recently. Last year home prices were lower and interest rates were lower as well. So last year’s home prices were underpriced.
Since we are in the earlier stages of a the housing recovery cycle and homes are not yet overvalued, this should be a positive factor moving forward.
Nationally and Worldwide
While Long Beach and California in general have higher home prices than many other parts of the country, Los Angeles is quite reasonable compared to other big cities. It is also extremely reasonable relative to other major financial centers in the world, such as London and Hong Kong. This isn’t the time and the place for any kind of exhaustive study of world wide housing prices. But I will state that for a major international city or region, Los Angeles offers a reasonable place to invest in Real Estate. Anecdotally, there have been quite a few instances where foreign capital has been flowing into Los Angeles Real Estate.
Economic Backdrop
This is where I throw up my hands. Is this a recovery, or is the Fed putting its finger in the dyke with cheap money, only to have the dyke spring another leak, or completely implode when the finger of quantitative easing is removed?
This is very difficult to quantify, because while we may not be in a recession, not everyone is benefiting from this recovery. Overall I will give this factor a neutral to slightly positive benefit to the Real Estate market moving forward.
Consumer Confidence
Buying a home is the ultimate leap of faith. It is a 30 year commitment that requires you to have a good feeling about your job and financial situation. The greatest example of how this plays out is in a buyer’s typical debt ratio. A typical rule of thumb is that lenders allow a 40% debt ratio when purchasing a home. This 40% ratio is defined as a buyers total monthly debt payment (including the proposed housing expense) in relation to the gross monthly income.
During dire and depressing times I often see typical debt ratios at 25%. Buyers are unwilling to overextend themselves because they need to have a greater financial cushion. “What if one of us looses our job?” is the typical response. On the other hand, when Real Estate has been the best investment in recent years, and all other business are benefiting from a robust housing market overflowing with excess home equity being spent, buyers (and banks) have been willing to lend to buyers stretching themselves above the conventional limit with 50%+ debt ratios. The irony is that this is the exact wrong time to be pushing the limits.
This statistic is similar to housing affordability and echos the wall street phrase that “a bull market climbs a wall of worry”. It is precisely this worry that keeps buyers purchasing power on the sidelines. For the future this excess of untapped buying power will provide fuel for the future.
Because we are only about 1 year into the housing recovery and because the economic confidence is still questionable, I actually give this a relatively strong positive influence as we move forward into the future. Buyers with documentable and stable income have the ability to purchase quite comfortably today. This will allow for future price expansion.
Local Economy
While the Los Angeles region has always been a mecca of business development, it is fair to say that governmental restrictions and taxation is likely to neutralize all of the positives that LA has typically experienced. I rate this factor neutral moving forward.
Other factors
Possible Future Easing in Lending Underwriting Standards
What helped fuel the previous boom was lax underwriting standards. Yet after the crash when all of the proverbial horses had been let out of the barn, lenders went completely overboard, with very rigid underwriting guidelines. They have been rigid going on 5 years. In the future we might see the re-immergence of some of the traditionally more flexible loans like easy qualifiers (if a buyer had 20+ down AND perfect credit) come back into the lending landscape. I would suspect in the ebb and flow of things that loan programs may open up with more flexible underwriting. This may have a small but noticeable positive effect on future prices should this come to pass, as it would allow more buyers to enter the home buying market.
Pool of previous homeowners looking to get back into the market
In the last 5 years there were obviously quite a few homeowners who lost their homes. There were three sets of buyers. The first could not afford their home purchase no matter what. These buyers will not be re-entering the market. But a bulk of the buyers could afford their homes, and just made the business decision to let the home go, because it was too far underwater.
The third group of buyers may have been stretching themselves a little. Maybe their could afford the home if they were able to benefit from lower rates. Or maybe they lost their home because of a temporary job loss.
The second two sets of buyers, with the ability to qualify, had their credit temporarily damaged. When homeowners have no equity, it is close to impossible to refinance and they are locked into a loan that makes no economic sense. If they make a business decision to walk from their home, their credit is negatively impacted so they can not repurchase until their credit improves. This takes time.
My guess is that the majority of homeowners fell under the last two categories, and when time passes and their credit improves, they will be able to repurchase. This should provide the housing market with a significant pool of buyers. This will create future demand and potentially higher prices in the future.
Keep in mind that as these buyers become homeowners, it will take buyers out of the rental market.
Limited to No New Supply
The simple fact is that there is little buildable land in Los Angeles, and the area is a growing region. This has always been a huge factor. While other areas can bring on new supply at the drop of a hat, Los Angeles can’t, and when demand increases and supply can’t, the result is higher prices.
Summary
If I were to rate each of of the factors for their negative or positive Future Influence on Price, with 5 being neutral, 1 being strongly negative and 10 being strongly positive it might look like this:
Note: Keep in mind that some of these factors are contrarian, such as very low interest rates may be good today, but represent a future threat as rates are more likely to to be higher in the future.
Interest Rates 4
Inventory 7
Other Investment Alternatives 6
Current Valuations – The Cycle 7
Current Valuations – Relative to Rent 8
Economic Backdrop 4
Consumer Confidence – Debt Ratios 7
Local Economy 5
Easing of Lending Underwriting Standards 6
Previous Homeowners buying again 7
Limited Supply 8
Unweighted Average 6.3
If my seat of the pants model is correct Real Estate prices will be higher in the coming years, a conclusion that probably doesn’t require a degree in “Rocket Surgery”. I did bold out and blacken the factors that are most important. This analysis should give a potential buyer comfort in knowing that even though prices are up, it is still a smart time to buy. And if a purchase is made with a fixed rate loan, any future interest rate risk is eliminated.
On the very strong side, Interest rates are a huge factor, and these may provide a mild negative headwind going forward. Current Valuations relative to rent, and the low inventory of homes for sale, and lack of available new homes are strong enough to overcome any negatives in my opinion.
It seems like a lot of analysis to come to the conclusion that “Yes, the future for Real Estate prices is moderately positive”, but that’s how it goes sometimes. Maybe slow and steady growth is just what the doctor ordered, after a 10 year roller coaster ride.
Your assessment of the individual contributing components may be different, and your conclusion about the future outlook may vary. As we move forward it will interesting to see if home prices are higher by a couple of percent next year, or if there is a possible repeat performance of last year’s 15% gain?
What is your opinion? Post any comments below.
Should you have questions about your own property, we welcome your inquiry. Call John at 562 572 2296 or email
John@LBRE.com