Apr042014
Are California house prices fairly valued or overvalued?
Measuring home price value requires a reliable metric and a reasonable benchmark. Most California markets are fairly valued — at least for now.
I recently wrote that Rental parity establishes the value of residential real estate, but others use different metrics to measure value and affordability. If the metric is price-to-income, today’s prices look inflated; if the metric is payment-to-income, today’s prices look undervalued. So which metric is correct? In my opinion, they both are. Over the short term, it’s impossible to ignore the payment-to-income ratio because it will establish the market equilibrium at any point in time; however, over the long term, it’s hard to ignore price-to-income because interest rates will revert to the mean, so the long-term price-to-income ratio will also come back into alignment.
Since the federal reserve drove mortgage rates down to record lows to prop up house prices and bail out the banks, the short-term equilibrium is much higher than the long-term equilibrium will likely support. Therefore, one of two things are going to happen: either prices will stagnate or decline in the future to correct for this short-term distortion, or wages will go up quickly to compensate for increasing ownership costs. If measured against inflation, either scenario produces weak financial returns, but nominal prices — the prices most people understand and focus on — will show gains, perhaps large gains if wages start to climb.
Is U.S. Housing Unaffordable? It Depends on How You Chart It
By Nick Timiraos, February 11, 2014, 1:59 PM
… Bubble fears are being fanned by this chart comparing median home prices to household incomes. Robert Albertson, chief strategist at Sandler O’Neill + Partners LP, produced a report last November titled “Another Housing Bubble” that featured the price-to-income chart prominently.
Before the housing bubble, median prices stood just under three times household incomes. During the housing bubble, they reached nearly four times incomes. After falling during the bust, prices have since rebounded, and they currently stand slightly above their long-run, prebubble average.
“Without a meaningful recovery in jobs and incomes, higher home prices now will, at best, temporarily reduce negative equity in existing mortgages at the expense of new homebuyers,” Mr. Albertson wrote in his report.
In other words, today’s homebuyers are assuming the bad debts of bubble-era homebuyers, hopefully under more stable loan terms. Does that make you feel good about being a homebuyer today?
Looking at the relationship between mortgage rates, prices, and incomes produces a slightly different picture. Because financing costs have been so low thanks to the Federal Reserve’s stimulus campaign, the monthly mortgage payment as a share of median incomes remains unusually low. On a payment-to-income basis, then, home prices still look undervalued.
John Burns, a homebuilding consultant in Irvine, Calif., called into question the price-to-income chart in December in a report titled, “A picture: more misleading than a thousand words?” To conclude that home prices are overvalued, he wrote, “you would have to conclude that mortgage rates don’t matter.” He pointed to the payment-to-income chart as a better barometer of near-term housing affordability.
Both Messrs. Burns and Albertson share the same underlying concern: that low rates could ultimately boost prices to levels that would be unsustainable once mortgage rates rise above 6%.
I wrote about this phenomenon last September in What will a long-term rise in interest rates do to home prices?. The chart at the top showing price-versus-income is similar to the fundamental value line in the chart below, a chart generated by assuming a steady interest rate. The affordability chart above that charts monthly mortgage payments as a percentage of income is similar to the rental parity line in the chart below, which does account for changing interest rates.
So what determines value? Is it the fundamental value of income, or is it the current payment equilibrium jacked up by low interest rates?
Below is the chart of median resale, rental parity, and fundamental value for Orange County, California, from 1988 to present. Note the upward tilt of rental parity as compared to fundamental value. That’s a result of three decades of falling interest rates.
… Interest rates must rise from about 4.5% to 7% to reach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.
Personally, I don’t see the rapidly rising wage scenario happening; we have too many unemployed for rapid wage gains. In my opinion, the more likely scenario is a slow grinding correction as rising interest rates take the air out of the reflation bubble.
I am also of the opinion that we are not currently in a housing bubble in California; however, a spring house price rally may inflate new housing bubble if prices start rising rapidly again. So far it looks like the spring house price rally may be called off due to affordability problems, but it’s only early April, so we have three more months to witness higher demand driving higher prices.
I may not be correct in my assumptions about current valuations. Ted Kolko from Trulia says Southern California is already overpriced.
O.C., L.A. and Inland Empire homes are overpriced, Trulia says
Real estate website Trulia ranks Orange County, Los Angeles and the Inland Empire among the five most overvalued housing markets in the U.S.
By Tim Logan and Andrew Khouri, March 25, 2014, 8:25 p.m.
Southern California is home to some of the most overpriced housing markets in the country. And that’s taking the wind out of the recovery.
Three Southland regions ranked among the five most overvalued markets in the U.S. in a new report by real estate website Trulia. These are places where the housing costs have far outpaced growth in income. …
“Southern California has seen big price increases since the bottom,” said Jed Kolko, Trulia’s chief economist, “without big increases in income.”
House prices have certainly risen sharply. Orange County house prices on a per-square-foot basis are up over 20%.
Rent, which is a proxy for income, was up less than 4%.
Rising prices without rising incomes causes affordability to plummet.
… If a new housing bubble is forming, he wrote, it will form here first.
But Kolko was quick to note that the picture is a lot better today than it was in 2006. “This is not the edge of a cliff,” he said.
Coastal California housing markets will be very interest rate sensitive. It’s very difficult for builders to add more housing stock in Coastal California due to a variety of constraints, so when prices rise rapidly, supply is slow to market to blunt the increases. If any location is likely to show the adverse effects of a reflation bubble, it’s right here.
“The test this year will be whether regular people looking to buy homes for themselves can pick up the slack from investors,” he said. “Ultimately that depends on how well the economy does.”
Institutional home buying abruptly tapered off this year, and so far owner-occupants haven’t stepped up. In fact, purchase applications hit a 19 year low. as the much anticipated boomerang buyers failed to materialize.
The reflation rally of 2012 and early 2013 abruptly ended when mortgage interest rates spiked. Prior to that rally, house prices were undervalued across much of the country, including Southern California. Few analysts who can be taken seriously are claiming house prices are still undervalued (the NAr doesn’t count). The debtate today is whether or not the market is fairly valued or overvalued, and the answer to that depends on the metric you use to determine value. A good case can be made for both.
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What has been/is currently driving the Calif market? Subsidies!
Calif house prices are overvalued.
End of debate.
So you don’t believe the subsidies can be withdrawn to exactly match the increase in organic demand in a seamless transition?
The magicians at the federal reserve believe they can.
I have my doubts.
100% guaranteed they can’t.
Here is my problem, what if interest rates don’t revert to the mean? The banks have bet on the low rates in all the swaps they issue. The companies who get the loans from these bankers are forced to take the high interest fixed side of the bet. They keep buying protection from high interest rates that never come.
So I say reverting to the mean won’t happen. The clearing houses for the swaps need treasury bonds for collateral, which insures demand for bonds from here on out. What say you OC guy?
The reversion to the mean will eventually happen, it’s mostly a matter of what timeframe. If low interest rates persist long enough, they become the mean.
One of our other astute observers noted that the long-term growth prospects of the US are low, not unlike Japan of the last 25 years. In a low growth environment, low interest rates become the norm. If we are to see a low growth future here in the US, the reversion to the mean will get dragged out, and the mean will come down. Instead of seeing 7% rates in 10 years, we might see 5.5% rates in 20.
This is an important question because the measure of value both short and long term depend on it.
>> Instead of seeing 7% rates in 10 years, we might see 5.5% rates in 20.
What happens to pensions in this scenario? They are assuming 7-8% rates of return, which will not happen with those kind of interest rates.
Good question.
It reminds me of the law of unintended consequences. For every brilliant market manipulation the guys at the federal reserve come up with, there is some counter-reaction nobody thinks of until the results appear.
That’s another benefit to the coming economic reset.
Listen, we can’t have true pension, retirement & entitlement reform without a MASSIVE CRISIS. The US has over 100 trillion in future entitlement obligations that have not been addressed, and will not be addressed without a MASSIVE CRISIS. We love to kick the can in this country … no one wants to face AUSTERITY.
For instance, why has the retirement age for Social Security not been raised to 75? After all, life expectancy has increased at least 15 years since S.S. became an entitlement. Why has the retirement age not gone up too?
Regarding these pensions … A BK Judge will do the work when the shit really hits the fan. The States & Municipalities cannot afford to pay these pensions.
Affordability Issues Create Housing Bubble Concerns
Recovery in the housing market is not without its side effects, particularly in major metro markets on the West Coast and in Florida. A look into 35 major markets by Zillow reveals that buyers making the median income in Southern California, the Bay Area, Portland (Oregon), Denver, and Miami face markets where more than half the available homes are beyond their price range—which could mean the beginning of a new housing bubble.
Zillow’s latest report, released Friday, found that buyers who make the median income in Los Angeles, San Francisco, and San Jose are paying a larger share of their income toward mortgages than they did during the pre-bubble years of 1985 to 2000. In addition, median-income buyers in San Diego; Riverside, California; Portland; Sacramento; and Miami typically pay 5 percent mortgage interest rates, meaning these buyers are also paying more of their incomes towards mortgages than they have historically.
Freddie Mac announced this week that the average 30-year fixed mortgage rate nationally is 4.41 percent; Zillow expects 30-year fixed rate mortgages to reach or exceed 5 percent by the first quarter of 2015.
The largest gulf in affordability is in Miami, where 62.4 percent of houses are beyond the reach of the average resident. Los Angeles, San Diego, and San Francisco each have more than 55 percent of their homes above the means of the average resident. Denver, San Jose, and Portland are at just over 50 percent.
Moreover, existing mortgage holders in these markets are typically spending more than 40 percent of their monthly income on their mortgages. Consequently, more buyers are forced to look farther out into peripheral markets surrounding metro hubs for more affordable homes.
Comparatively, about 33 percent of homes in the other 28 markets surveyed by Zillow are out of reach to the average buyer, which is typical. Better news for those making median income in cities such as Dallas, Seattle, and Philadelphia is that in addition to a sizeable number of within-reach homes, average residents spend a far smaller percentage of their income on their homes. In some areas, such as large cities in Ohio, Atlanta, and Dallas, owners are paying less than 12 percent of their monthly income toward mortgages.
If Zillow’s predictions of 5 percent mortgages come true and if rates at that level and another year of forecasted home value growth pan out as expected, buyers in California, Portland, and Miami will also soon be paying a larger share of their incomes to their mortgage than they were during the pre-bubble years.
What this translates into for Stan Humphries, Zillow’s chief economist, is worry of a new bubble. “As affordability worsens, we’re already beginning to see more of the kinds of worrisome trends we saw en masse during the years leading up to the housing crash,” Humphries said. Specifically, he cited a growing reliance on non-traditional home financing, smaller down payments and a greater pressure to move farther away from urban job centers in order to find affordable housing options. “We’re not in a bubble yet, but we’re beginning to see the early signs of one in some areas.”
CoreLogic does not measure the number of non-performing notes sold to private investors, and it does not consider loan modification redefaults in its measure of shadow inventory.
CoreLogic Continues to Understate Delinquencies and Shadow Inventory
CoreLogic released its National Foreclosure Report for February, 2014, reporting 43,000 completed foreclosures for the month, a 13.1 percent decrease from January, 2014. Yearly, foreclosures declined 15 percent from February, 2013.
Comparatively, foreclosures averaged 21,000 per month before the housing crisis from 2000 to 2006. Since September, 2008, 4.9 million foreclosures have been completed.
As of February, 2014, 752,000 homes were in some stage of foreclosure, compared to the previous year’s figure of 1.2 million. The drop in foreclosure inventory represents a year-over-year decrease of 35 percent and a drop of 3.3 percent from January, 2014.
February makes 28 consecutive months where inventory has declined on a year-over-year basis.
“Although there is good news that completed foreclosures are trending lower, the bigger news is the impressive decline in the foreclosure and shadow inventories,” said Dr. Mark Fleming, chief economist for CoreLogic.
Foreclosure inventory represents 1.9 percent of all homes with a mortgage in February, down a full point from the February, 2013 total inventory percentage of 2.9 percent.
Shadow inventory, or unsold foreclosures or homes that owners delay putting on the market until prices improve, has also decreased from 1.724 million in December, 2013 to 1.708 million to January, 2014. Shadow inventory declined 2.9 percent over the fourth quarter of 2013, and is down 22 percent year-over-year in January.
“The stock of seriously delinquent home and the foreclosure rate are back to levels last seen in the final quarter of 2008. The shadow inventory has also declined year over year for the past three years as the housing market continues to heal, including double-digit declines for the past 16 consecutive months,” said Anand Nallathambi, president and CEO of CoreLogic.
Seriously delinquent mortgages fell 23.8 percent year over year in February, and dropped from 1.8 percent to 1.5 percent from January to February, 2014.
States with the highest numbers of completed foreclosures include Florida (118,000), Michigan (50,000), Texas (39,000), California (37,000), and Georgia (34,000).
States with the highest foreclosure inventory as a percentage of mortgaged homes were New Jersey (6.2 percent), Florida (6.0 percent), New York (4.7 percent), Maine (3.4 percent), and Connecticut (3.2 percent).
34 states and the District of Columbia have foreclosure rates lower than the national rate.
States with the lowest foreclosure inventory as a percentage of mortgaged homes were Wyoming (.3 percent), Alaska (.4 percent), North Dakota (.5 percent), Nebraska (.5 percent), and Colorado (.6 percent).
Banks continue peddling their ARM propaganda to pass interest rate risk off to their customers. This one is particularly bad as it attempts to make dupes look smart, informed, and sensible.
3 pathetic and pandering reasons borrowers use ARMs
Rapidly rising interest rates have been driving a growing number of home buyers to adjustable rate mortgages, which have grown from a 3.4% share of all conforming home loans in December 2013 to a recent high of 9.9% in March 2014.
The unpredictability of ARMs has given them a bad name for some people, but ARMs are making a comeback.
ARMs have grown from a 3.4% share of all conforming home loans at the end of 2013 to just shy of 10% in March 2014.
While some have said this is a warning sign of a return to risky pre-recession lending, Cameron Findlay, chief economist at Discover Home Loans says that’s not the case at all.
Today’s ARMs are very different, Findlay says, for three reasons.
1) Safer And Smarter
There is a critical distinction to make between the hybrid ARMs offered in today’s marketplace and the interest-only products that were widely associated with the financial crisis. Hybrid ARMs, which have fixed interest rates for an initial period of time and includes period and lifetime caps, can offer a significant benefit over 30-year fix rate mortgages.
2) Smart, Informed Borrowers
ARMs can be a viable and responsible alternative to fixed rate loans in the current market – but they are not for everyone. ARMs will provide the most benefit to borrowers who make smart, informed choices based on their home-buying plans. Recently most ARM borrowers have chosen a 5/1 Hybrid with a 2/2/5 structure, meaning the rate is fixed for the first five years, both the initial and subsequent adjustments are capped at 2%, and the loan has a lifetime cap of 5% in adjustments. For a borrower who only plans to live in a home for seven years, this type of loan can provide savings over the first five years when compared to a 30-year fixed rate loan in the current rate environment.
3) Sensible Alternative to Rising Rates
While there continue to be widespread misconceptions that ARMs are simply an alternative for those who cannot afford traditional loans, the market dynamics that are driving more borrowers towards ARMs tell a different story – and one that makes a great deal of sense for many consumers. Over the 18 months, and particularly since the Fed announced its decision to “taper” its economic stimulus program, the rate for a 30-year fixed-rate home loan has risen by more than a full percentage point from 3.31 to 4.40%. In that time, the spread between Hybrid ARMs and fixed-rate loans has ballooned, as increases in adjustable loan rates have moved at a much slower pace. Today, a 5/1Hybrid ARM is 0.96% less than a 30-year fixed rate loan.
If 90% of people are using fixed rate loans, it’s because that is what their lenders are pushing them into. Banks prefer fixed rate loans because it ensures that a higher interest rate is paid over the first 7 years, which is the average timeframe before people sell. Getting that higher interest rate locked in allows the loan to be sold for a higher margin in the secondary markets.
The sad part is that loan officers and the financial media have successfully convinced 90% of borrowers that what they are doing is smart.
Agreed, but, when the borrower can’t squeeze into the applicable back-end DTI (43%?), lenders will push an ARM to get that payment down sufficiently.
“Over the short term, it’s impossible to ignore the payment-to-income ratio because it will establish the market equilibrium at any point in time; however, over the long term, it’s hard to ignore price-to-income because interest rates will revert to the mean, so the long-term price-to-income ratio will also come back into alignment.”
What’s the long-term? It seems to me that the most important question is how quickly the rates will mean revert. The second most important question is what is the mean? The third most important question is what will be the extent of governmental rate support going forward? Fourth, how do incomes change in a rising rate environment?
The answer to all these questions will aid in determining current valuations. When we discuss value, we are really just trying to predict the future.
First question: at what rate will rates return to the mean? One of the articles assumes 7 years. Is this a valid assumption? Rates have been falling for the last 32 years since they peaked at 18.45% in October 1981. During that time, how often have we reverted to the historical mean? Once as we passed through it? If 7% is the mean, it wasn’t until October 1993 that rates breached the 7% level — 12 years. Over the last twenty years rates have fallen another 3%, which leads me into my next question.
Second question: What is the historical mean? The mean for the last forty years is 8.62%; 30 years = 7.61%; 20 years = 6.29%; 10 years = 5.23%; 5 years = 4.36% (Freddie Mac). Depending on the number of years you include, you can get any number of different mean rates. The trend has been lower and lower means for the last 40 years.
Why have rates been falling for the last 30 years? What is going to cause them to suddenly revert to the 30 year mean over the next seven, arbitrary, years? I think that without the falling rates over the last 30 years, we have little or no economic growth. Rates can only rise when incomes are also rising. In fact, income growth has to drive rising rates, not the other way around. If it doesn’t, then economic stagnation will result, another round of QE will commence, rates will fall, and we are back where we started again.
Third question: how will the government respond to rising rates? The FED has made it clear that it will adjust rates and QE levels based on economic indicators. If the economy takes it on the chin from rising rates, then the FED will cut its target and discount rates, and may even re-institute QE now that we have a precedent. The US debt is also massive. Higher debt service costs will take money away from other areas. I would think that since the FED would keep rates low until they are forced to raise them by inflation as a result of economic expansion and wage growth. At this point wage growth will justify higher rates.
Fourth question: How do rising rates impact wages? How do rising wages impact rates? Which has to rise first? For a sustained economic expansion, wages have to rise before rates. For a sustained contraction, rates rise first. I think we would all prefer the former. Rates are like a parasite, they can only grow as the host grows. If rates rise too quickly with respect to the incomes which pay for the debt service, then the symbiotic relationship fails, and rate growth reverses.
For the last 30 years we had falling rates supporting economic expansion. The refinance boom is evidence enough of that. At the same time we had home price growth as a result of lower rates, and home equity extraction that further fueled economic expansion. Going down hill with the wind at your back is easy, going uphill into the wind is a bit more difficult.
My personal opinion is that we will be bumping our heads on the affordability ceiling for years if not decades. Rates affect affordability along with housing prices. How can rates rise if prices can’t? Prices won’t fall like many think as rates rise, but volumes sure will. Prices only fall if there is a lot of must-sell inventory. This is typically a massive loss of jobs (see Detroit) or a speculative bubble of massively over-leveraged investors. Unemployment rates are falling, and leverage is being restrained by the new ATR rules. Any must-sell inventory is being modified to the point where only a trickle makes it to market. A trickle is not a flood. A dam will not release a flood of distressed inventory when levels are maintained through planned releases.
So when people talk about affordability or value, what they are really asking is what is the risk that I will pay too much now versus one year or seven years from now? There is always risk, but is there as much risk now as seven years ago?
Great post. We’re not in a position to buy the house we’d like to buy today, but, I figure the $44k we’ll pay each year in rent for the next two-plus years is peanuts relative to the risk. If we bought a $1m house today and rates rose to ~5.5%, that would reduce purchasing power and possible its value ~13%, or $130k. What’s the probability rates rise that much over the next year or two? If rates do rise 100 bps, then we’ll have rented for free for two years when we buy. At least, that’s how I justify renting…
In this game of musical chairs, the original bubble burst showed that we had way too many players and only one chair. With so many losers, the government threw every chair it had out there and restarted the music. Some stayed out. Most got up and started circling again. And the music keeps playing and playing and playing. No one can lose if the music keeps playing. But eventually someone will get tired of non-stop circling and exit the game Eventually the music will stop. There will be winners and losers. Irvine Renter alluded to the truth… if we refinance the bad debt to new people at lower rates, can we convince enough losers that they didn’t really lose when the music stops? If we get investors in, do we care if they lose when the music stops? As with the stock market, manipulative bubbles can only survive so long. The “this is a different market” nonsense always proves to be false. If Japan is our example, their real estate market continues to tank. The music may not stop today, but eventually it will. By then we may be too late and have created an entire generation of people who value educational debt and flexible living over real estate debt and stationary living.
30+ yrs falling interest rates. USA is not and will not be Japan. Looking forward, Japan will not be Japan of the past.
The low growth low interest rates into perpetuity is nonsense. Rates are only low because of suppression. The low interest rate argument is complete bullshit.
It appears Mr Market is reminding ‘Tech’ that when an apparatus is NOT actually even reasonably secure, and wealth is NOT supported by income, wealth can simply be deleted.
Nasdaq: 4,134 -107 -2.46%
Orange County is both overvalued and unaffordable, especially after the easily predictable run-up last year. Like most bubbles in the making, it will continue to get more overvalued and unaffordable before a tipping point is reached. All ties to fundamental valuation (both income and rents) need to be broken before things can come crashing down again. There’s still too much rational thought going on for this to be a full-blown bubble yet.
The bears are going to have a frustrating 2014.
While those observations are correct, the inflow of buyers coming from all over the US and worldwide, not just China, to buy in OC makes the OC market different. Demand is rising.
I would presume all the builders putting up new communities are doing so based on very good predictive models of population growth and inflow to OC… imho
After allowing the “free market” death of Lehman Bros, I was surprised at the notion of TBTF, as it seemed like, “we don’t like this part of the free market, so we’ll just change the rules.” Then I got freaked out when they screwed over the GM bondholders, and then I went into weird mental swirl — written contracts were mutable, and I lost some faith in pretty much all parts of the system. Then we stopped taxing income from forgiven debt, and individual people start rushing to the dooor.
Seriously, I’m still trying to recover my faith in everything, and I’ll only include one little politically-related issue: “Yes, I said that black is white, but that was not intended to be a factual statement.” Well, goody!
But what I’m thinking now is that dramatic changes in any direction, whether they be logical or illogical, instantly give rise to opposing forces that slow the change as people figure out how to game the system “today,” while larger forces try to calm things down by injecting other contrary forces, but at a slower pace, because it takes a lot of thought to make humongous decisions, particularly the decisions that are ill-advised.
This reminds me of Lenz’ Law, which basically states that a collapsing magnetic field generates forces that act in opposition to the collapse, because the corresponding electrical field changes generate little “eddy currents” that generate new magnetic fields that support the magnetic field that was collapsing in the first place. (The same thing happens with collapsing electrical fields, but electrical fields collapse so easily in conductors and end up appearing to be weaker than the attendant magnetic fields). Basically, what I’m imagining is that these out-of-left-field decisions and policy changes seem to dampen the intended changes, and whatever people are instinctively trying to change gets slowed down by everyone else because they’re trying to dip their metaphorical toes in mofa’s roiling fields in a vain attempt to mimic the beauty of electromagnetic fields.
I don’t know where I’m going with this, but it’s incredibly late on a Thursday night (being noon on Friday), and I had one of those hellacious 14 hour days which turn into “fsck it, I’m taking 2 hours of PTO and watching CNN explain sonar via interpretive dance” early weekends. But the thing I think I’m trying to say is that there’s logic, and there’s behavior, and we people are astonishingly creative at rationalizing absurd decisions, but thankfully, other players pop in and make even more absurd decisions that effectively slow everything down, and perhaps there’s something to be learned about how these little dramas slow down at different rates compared to what we might have predicted given models which made sense when we were less insane.
I really better get another cup of coffee!
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