Coastal California housing markets will hit affordability ceiling first
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.
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.
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.
My monthly housing market reports still show most markets even in Orange County as being undervalued. That’s the impact of super low interest rates on the affordability ceiling. Many sub-markets in Orange County are very near the affordability ceiling, and as that ceiling falls, some of these markets may be exposed as burgeoning housing bubbles.
As mortgage interest rates climb, the local bubbles that have quietly been inflating in a number of markets will reveal themselves.
Imagine global warming raises sea levels so high that all the land is underwater (remember the movie Waterworld?). This is analogous to lenders who created so much housing debt they put all homeowners underwater. Now imagine rising interest rates are like falling sea levels. Beneath the surface, volcanic islands may still be growing and plate tectonics is still raising mountains just like our efforts to reflate the housing bubble is raising values in some markets more than others.
Interest rates are a blunt instrument. Lenders can’t charge one rate in Coastal California that doesn’t need stimulus and another in Las Vegas that does. Interest rates will raise or lower the affordability ceiling everywhere, just like global warming raises sea levels everywhere. As the sea levels recede (interest rates rise), the areas nearest the surface will poke above the water and become islands. These islands will represent exposed housing bubbles.
Perhaps wave action and erosion will knock these islands down and prevent them from reaching the sky, but as long as the interest rate stimulus is being applied, and as long as inventory is overly restricted, there is always the danger of inflating an echo bubble.
Between 1985 and 2000, the monthly mortgage payment on a typical American home (after 20 percent down) represented about 20 percent of monthly median household incomes. By the end of 2012, that had fallen to roughly 12.6 percent. Thanks largely to a combination of a big dip in home prices during the recession and historically low mortgage rates, Americans were spending 37 percent less of their monthly salaries on mortgages at the end of last year.
That is the basis for a durable economic recovery.
But recently, mortgage rates briefly crossed the 4 percent threshold, and are expected to continue to rise, slowly but steadily. So we set out to discover those areas in which affordability will be most affected once mortgage rates hit 5 percent, 6 percent and 7.1 percent. The 7.1 percent threshold is the point at which homebuyers nationwide will be back to spending 20 percent of their monthly incomes on a mortgage payment.
At current mortgage rates, on a monthly payment basis, the U.S. as a whole and all of the top 30 largest metro markets covered by Zillow are more affordable today relative to their historic norms.
But at 5 percent mortgage interest rates and assuming homes in these metros appreciate in line with Zillow’s Q1 2013 home value forecasts, homes in half a dozen markets will look more expensive than their historic norms on a monthly payment basis: San Jose, Calif. (22 percent more expensive); Los Angeles (19 percent more expensive); San Diego (14 percent more expensive); San Francisco (11 percent more expensive); Portland, Ore. (7 percent more expensive); and Denver (1 percent more expensive).
That covers over 90% of the readers of this blog.
At 6 percent, five more major markets become more expensive: Riverside, Calif. (11 percent more expensive); Miami (7 percent more expensive); Seattle (5 percent more expensive); Sacramento (4 percent more expensive); and Washington, D.C. (2 percent more expensive). And, logically, the six markets that were more expensive at 5 percent only look even pricier at 6 percent. In San Jose, for example, at 6 percent mortgage interest rates, homeowners can expect to pay 36 percent more of their monthly salaries on mortgage payments than they were paying between 1985 and 2000.
As interest rates rise, if wages don’t rise with them, the affordability ceiling will put pressure on house prices. Buyers today expect this rally to continue until prices double again. It’s entirely possible that rising interest rates will cause the best markets to pull back while the weaker ones catch up. That’s what the analysis at Fitch Ratings believes, and I concur with their analysis.
At 7.1 percent mortgage rates, the point at which homeowners in the U.S. as a whole are back to spending their monthly historic average on mortgages, homes in another 7 large metros fall into the more expensive bin: Phoenix (13 percent more expensive); Boston (10 percent more expensive); Philadelphia (9 percent more expensive); New York (7 percent more expensive); Baltimore (6 percent more expensive); Pittsburgh (5 percent more expensive); and Charlotte (2 percent more expensive).
Yes, rates will remain very low for at least the time being. But it won’t be long before they climb back to 5 percent. Consider some historical context: The average 30-year fixed rate mortgage rate over the past 42 years is roughly 8.5 percent, according to Freddie Mac. In other words, rates of 5 percent or 6 percent should still be considered bargains, historically speaking.
And when (not if) they reach that point again, we’re likely to see price volatility, as consumers are forced to either spend more of their incomes to buy ever more expensive homes; or home value appreciation will stagnate or fall while waiting for incomes to catch up.
Since the new qualified mortgage rules ban debt-to-income ratios over a certain threshold, consumers won’t be given the option to spend more of their incomes on houses; therefore, home price appreciation will stagnate or fall for a while while incomes catch up.
The folly of Coastal California cashflow investing
I pointed out last week that Orange County real estate has rarely been cashflow positive. In 2006, it certainly wasn’t. Today’s featured REO was purchased as a cashflow property; however, since the loan was so large, the property was not cashflow positive, and the combination of declining values and negative cashflow wiped the former owner out.
He paid $5,150,000 using a $3,347,500 first mortgage, a $400,000 second mortgage, and a $1,402,500 down payment — all lost… or was it?
The first NOD was filed in September of 2009, so the borrower wasn’t making payments at least three months prior to that. The property was finally sold at auction on 5/21/2013 about four years after. Did the owner make any payments during that time, or did he skim rents from this property to recoup is down payment?
[idx-listing mlsnumber=”OC13141648″ showpricehistory=”true”]
227 CARNATION Ave Corona Del Mar, CA 92625
$3,700,000 …….. Asking Price
$5,150,000 ………. Purchase Price
3/23/2006 ………. Purchase Date
($1,450,000) ………. Gross Gain (Loss)
($296,000) ………… Commissions and Costs at 8%
($1,746,000) ………. Net Gain (Loss)
-28.2% ………. Gross Percent Change
-33.9% ………. Net Percent Change
-4.4% ………… Annual Appreciation
Cost of Home Ownership
$3,700,000 …….. Asking Price
$740,000 ………… 20% Down Conventional
4.87% …………. Mortgage Interest Rate
30 ……………… Number of Years
$2,960,000 …….. Mortgage
$759,990 ………. Income Requirement
$15,656 ………… Monthly Mortgage Payment
$3,207 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$771 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$19,633 ………. Monthly Cash Outlays
($2,803) ………. Tax Savings
($3,643) ………. Principal Amortization
$1,385 ………….. Opportunity Cost of Down Payment
$945 ………….. Maintenance and Replacement Reserves
$15,518 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$38,500 ………… Furnishing and Move-In Costs at 1% + $1,500
$38,500 ………… Closing Costs at 1% + $1,500
$29,600 ………… Interest Points at 1%
$740,000 ………… Down Payment
$846,600 ………. Total Cash Costs
$237,800 ………. Emergency Cash Reserves
$1,084,400 ………. Total Savings Needed