Jan052015

Affordability will be the major housing market issue of 2015

Home price affordability will be the biggest issue in housing in 2015, particularly if mortgage interest rates rise.

Over the last 40 years, California inflated three different housing bubbles. Starting in the 1970s with regulations like CEQA, California began to restrict growth. This inhibited builders and developers from bringing new product to market to meet demand in many areas. As a result, demand pressures caused prices to rise. Rather than react to rising prices as a deterrent to buying, the sudden upward price movements served as a catalyst for even more buying as homeowners became speculators hoping to cash in on rapid appreciation.house_I_cant_afford

As with all financial manias where asset values become detached from fundamentals, the first three housing bubbles all resulted in housing busts with each one being more severe than the last. As a result of the most recent horrendous crash in housing values, government regulators stepped in and put new rules in place designed to prevent future housing bubbles from inflating. (See: New mortgage regulations will prevent future housing bubbles) For as cynical as I am about the ability of regulators to get anything right, the rules put in place, if enforced, will do much to prevent future housing bubbles.

The housing bubble of the 1970s was inflated because lenders abandoned long-held standards for debt-to-income ratios. Prior to the housing bubble of the 1970s, lenders would only allow a front-end ratio (the percentage of income directly attributable to housing costs) of 28%. Further, lenders would only permit a back-end ratio (total debt service as a percentage of income) of 36%. These standards were completely abandoned during the 1970s because lenders reasoned that with 10% yearly wage inflation, a borrower’s onerous front-end ratio in the early years would become affordable after a few years of steadily rising wages. Of course, they were wrong.

The housing bubble of the late 80s and early 90s was inflated by lenders who again allowed debt-to-income ratios get out of control, and they experimented with “innovative” loan programs such as interest-only and negative amortization. And the latest housing bubble was inflated by the proliferation of those same toxic loan programs.

The common denominator behind the previous housing bubbles was an abandonment of affordable debt-to-income ratios and the use of loan products that don’t amortize. Shockingly enough, regulators figured this out, and the new qualified mortgage rules specifically ban interest-only and negatively-amortizing loans. Further, these rules but a cap on debt-to-income ratios of 43%. This effectively eliminates the primary tools lenders have to inflate housing bubbles.

Affordability Ceiling

Lenders don’t set out to inflate housing bubbles. The pressures on lenders to obtain business prompts them to expand loan programs and develop “innovative” loan products in order to keep sales volumes up when prices reach the limit of affordability. Sellers could always rely on lenders to arm borrowers with dangerous loans to finance ever-higher asking prices. That will not be the case in the future.

The result of the new regulations will be a much more rigid ceiling on affordability. Borrowers will be required to document their income, and that income will be applied to amortizing loans with a reasonable debt-to-income ratio. They can either afford the property or they can’t; their bids will be limited.

If borrowers don’t have the ability to raise their bids due to limits on financing, then future housing markets will be very interest rate sensitive. Rising interest rates will lower the affordability ceiling if salaries don’t rise to compensate.

It’s harder to smooth out interest rate fluctuations

With the normal mechanisms for smoothing out interest rate fluctuations banned, house prices and sales volumes will be dictated by the course of interest rates. It’s widely believed mortgage interest rates will rise in the future. I once asked What will a long-term rise in interest rates do to home prices? Based on what we’ve seen over the last 18 months, we can expect sales volumes to plummet when interest rates rise, and if they rise high enough, price pressure will mount. We won’t see a crash without must-sell inventory, but we may see air pockets where prices drift lower as discretionary sellers decide they want to get out.

Why 2014’s low sales volume matters

The first sign of a troubled real estate market is a dramatic reduction in volume known as buyer exhaustion. There are simply not enough buyers able or willing to push prices any higher even at the lower transaction volumes. In a residential real estate market, this phenomenon is particularly pronounced at the entry level, and since first-time homebuyer participation is near record lows, the market has some painful adjustments ahead.affordability_ceiling

The imbalance between supply and demand first becomes apparent at the bottom of the affordability scale with entry-level buyers because these buyers are not bringing the profits from a previous sale with them to the next property. Affordability is less of a problem for existing homeowners in the move-up market due to this equity transfer, which is why the move-up market continues to do relatively well even while the entry level market languishes.

The foundation of a residential real estate market is the entry-level buyer. Entry-level buyers are generally young people starting to form new households. When a homeowner wants to sell their house and move up to a nicer one, someone needs to buy their house. If you follow this chain of move-ups backward, eventually you come to an entry level buyer. If there are no entry level buyers pushing the sequence of move ups, the entire real estate market ceases to function.

move_up_market

If prices were to remain at the upper limit of affordability for a long period of time — and they have been held there for 18 months now — the rate of price increase would slow dramatically until it only matched the rate of wage growth and inflation, assuming interest rates remain steady. If prices are not rising in excess of inflation, there is little financial incentive to buy because when affordability is very low, it is much less expensive to rent, and the extra money going toward a housing payment is not generating a financial return. If there is no financial incentive to pay more than the cost of rent, people stop buying, and prices fall back to levels where they are affordable again.

OCHN_OC_Housing_Market_Report_2014-12

Affordability will be the major housing issue of 2015; of course, this will get perverted into a loan qualification standard issue by the real estate community chafing against the ban on affordability products, but the core issue will be affordability because interest rates are likely to rise in 2015, and when they do, affordability will crumble.

Will affordability problems in 2015 cause a bust? That depends on what you characterize as a bust. If affordability becomes a problem, prices may not go down due to cloud inventory, but sales volumes could see a significant drop, which would be completely against the consensus opinion of economists. If we get a housing “bust,” and it’s a real possibility, it will be a bust in volume, not in price.


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