Spring house price rally may inflate new housing bubble
Today’s house prices align with rents. Any significant increase in prices, if not matched by a commensurate increase in rents and incomes, will push the market into new bubble territory.
The house price rally from February 2012 to June of 2013 reflated the old housing bubble to the degree possible without beginning a new one. Record low interest rates made house prices relatively affordable, and buyers used these low rates to leverage themselves fully to bid up prices on scarce inventory. In May 2013 when interest rates rose from 3.5% to 4.5%, the reflation rally abruptly stopped as the ceiling of affordability crashed down upon market participants. Since that time, house prices have stabilized at the the limit of affordability based on incomes and interest rates. For prices to push higher, and they can be pushed higher by all-cash buyers, the market will enter a new bubble phase leading inevitably to a future price decline.
Did the reflation rally run its course, or did it merely pause on its way to price infinity? What evidence do we have that prices are bouncing off a more rigid price affordability barrier?
First, prices stopped going up abruptly when interest rates went up, and not coincidentally, the price levels where prices abruptly stopped correspond to the threshold of affordability. Consider the following charts:
I reported last October that OC housing market ricochets off affordability ceiling. Once Orange County hit the same level of affordability it experienced during the mid 90s, prices immediately leveled off. Given the raucous frenzy that preceded it, the rapid market change was clearly not an instantaneous change in buyer psychology, but a more profound limit caused by their inability to raise their bids any higher. That’s the affordability ceiling.
Since cloud inventory stops sellers from lowering their prices, prices didn’t decline, but since buyers hit the limit of affordability, sales volumes plummeted, and people began resorting to adjustable-rate mortgage financing to close deals.
OC was not the only market to see this abrupt change at the affordability ceiling; Los Angeles county, after a 40%+ price increase, stopped dead in its tracks.
The market rally stopped a bit later in LA because it was still undervalued when rates went up in May, but it stopped when it hit the same affordability barrier.
What can we deduce from this analysis?
The affordability ceiling is a real barrier. The ability to repay rules coupled with the new mortgage regulations make the housing market very interest rate sensitive and much less prone to bubble behavior; however, this barrier is not an absolute: all-cash buyers could still push through it, but for now, the market is not pausing to catch its breath: the reflation rally is over.
If prices do move into new bubble territory, it will do so on low sales volume. This is the main reason I predicted 2014 will have lower sales volumes despite the consensus stating otherwise. Financed buyers won’t be the ones pushing prices higher; all-cash buyers will, and since there are far fewer all-cash buyers than financed ones (at least normally there are), then sales volumes will necessarily suffer. Further, since professional all-cash buyers — hedge funds — are not willing to pay today’s higher prices, there should be fewer all-cash buyers active in the market. Unfortunately, these will be the least sophisticated and most kool-aid intoxicated buyers willing to push the market to new bubble territory.
Lenders who want to offload their inventory at yet-to-be-reached peak prices will be happy to keep inventory restricted and let the new bubble form; after all, the next downturn will hurt equity players, not the banks. If we do inflate another housing bubble, it won’t collapse in dramatic fashion like 2008; instead, we would likely see another early 90s type decline with slowly deflating prices until affordability caught up again. Lenders will modify loans and sit on inventory just like last time around rather than cause another dramatic decline.
Since we are pushing against the affordability ceiling, the market should become boring with appreciation matching income growth; however, since that doesn’t serve lender’s interests, since inventory is still restricted, and since all-cash buyers are still active, I think it more likely we will inflate a new housing bubble.
The reflation bubble concept is not new. Stimulating housing to save the banks is the national pastime of the British. They first inflated a housing bubble in the 1970s, just like we did in California (see chart below). Then, when house prices crashed and the banks got in trouble, the government introduced stimulatory policies to reflate the bubble and allow the banks to clear off their balance sheets on a new batch of unsuspecting buyers (see the early 80s bubble below). The reflation bubble in Great Britain of the early 80s did not reach the peak of the bubble from the early 70s, but it got high enough to allow the banks to pump-and-dump properties. Since the reflation rally was stimulus induced, it collapsed just like the first one. I believe we will see the same price action here.
Our reflation rally will be a very similar to the one in Great Britain. House prices are still below peak pricing in most markets, including OC, but further price increases are held in check by the affordability ceiling. We may push through this ceiling, then as the ceiling continues to drop due to rising interest rates, eventually, prices will drift down to match.
Take a careful look at what happened in Great Britain, and consider the conditions we face today.
Do you think we are in the early stages of a new sustained rally, or are we merely reflating a bubble to help bail out banks with a huge pump-and-dump scheme?
If prices rise quicker than rents or wages, the rate of inflation, then we are inflating a bubble to bail out the banks.
$1,869 / SF in Manhattan Beach
Coastal California house prices never make much sense, but today’s featured property takes the insanity to new heights. A 2 bedroom 1 bath 789 SF run down cottage is asking 50% over it’s peak purchase price in 2007. If this house sells for anywhere near its asking price, people have truly lost their minds.
[hat tip to Jimmy for pointing out this property]
1514 CURTIS Ave Manhattan Beach, CA 90266
$1,475,000 …….. Asking Price
$995,000 ………. Purchase Price
12/3/2007 ………. Purchase Date
$480,000 ………. Gross Gain (Loss)
($118,000) ………… Commissions and Costs at 8%
$362,000 ………. Net Gain (Loss)
48.2% ………. Gross Percent Change
36.4% ………. Net Percent Change
6.3% ………… Annual Appreciation
Cost of Home Ownership
$1,475,000 …….. Asking Price
$295,000 ………… 20% Down Conventional
4.81% …………. Mortgage Interest Rate
30 ……………… Number of Years
$1,180,000 …….. Mortgage
$301,309 ………. Income Requirement
$6,198 ………… Monthly Mortgage Payment
$1,278 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$307 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$7,784 ………. Monthly Cash Outlays
($1,841) ………. Tax Savings
($1,468) ………. Principal Amortization
$542 ………….. Opportunity Cost of Down Payment
$389 ………….. Maintenance and Replacement Reserves
$5,405 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$16,250 ………… Furnishing and Move-In Costs at 1% + $1,500
$16,250 ………… Closing Costs at 1% + $1,500
$11,800 ………… Interest Points at 1%
$295,000 ………… Down Payment
$339,300 ………. Total Cash Costs
$82,800 ………. Emergency Cash Reserves
$422,100 ………. Total Savings Needed