California housing recovery or bubble?
Are we witnessing a new sustained housing recovery in California, or are we witnessing a new housing bubble? Some housing bulls postulate the dramatic increase in prices springs from sound fundamentals. Rents and incomes increased, unemployment dropped, and distressed property sales returned to pre-crisis levels. Some housing bears posit the dramatic increase in prices feigns the signs of market health while the patient is still very sick. Prices moved up far faster than rents and incomes (nearly 10 times faster), unemployment lingers, distressed properties lurk in the shadows temporarily removed by lender can-kicking, and the demand depends on fickle investors and artificial government programs and federal reserve stimulus, both temporary measures.
Debates concerning fundamentals aside, whether or not you consider current market action indicative of a recovery or a bubble depends largely on what yardstick you use to measure value. The reports I generate use current owner cashflow and a comparison to current rents to establish value. This number incorporates real estate prices, rents, and most importantly, interest rates to establish value. It’s susceptible to swings in financing costs, and it can be distorted by manipulative federal reserve interest rate policies. Another method of valuation considers historic relationships of price-to-income and price-to-rent. Those measures fail to consider the impact of interest rates on affordability, so when interest rates are low, these measures claim prices are overvalued when in reality, the market may be at an equilibrium with current costs.
The longer term view of value depends on what you believe will happen with interest rates in the future. My methodology says today’s values correspond to the stable relationship between interest and rents. The competing methodology says prices are overvalued because current interest rates are so low. If interest rates revert to their long-term mean over the next few years, house prices will decline, and current valuations will appear bubbly in retrospect. However, if interest rates revert slowly over the course of another decade or more, this slow reversion in rates will not cause a price decline, and today’s valuations will not look so bubbly in retrospect.
So is the market fairly valued or overvalued? It depends on the yardstick of value you believe most appropriate.
In either case, whether interest rates move up slowly or quickly, at some point, interest rates will rise to their historic norms. Whether reversion to the mean happens quickly or slowly, house prices will not appreciate as quickly over the next decade or more unless something dramatic happens with wages, and given the high rate of unemployment, wage inflation doesn’t seem a likely prospect.
Home prices appear to be overvalued in parts of coastal California and could soon eclipse their bubble-era peaks given recent rates of price inflation, according to a report released Wednesday by Fitch Ratings.
The report estimates that home prices nationally have increased 13% over the last year, leaving prices 17% above a so-called “sustainable home price,” according to the ratings agency, though there’s considerable variation geographically.
The Fitch model looks at traditional drivers of home values, including incomes and rents, to impute a “sustainable” price for a given metro area. Cities where price indexes rise above those levels are considered overvalued, and cities where the indexes fall below are undervalued.
Their methodology excludes the impact of interest rates on financing. Their estimate of value mirrors the yellow line in the chart above. My method that includes the impact of interest rates forms the green line above. Since interest rates are so low, my estimation of value exceeds than theirs.
Home prices in the San Francisco Bay Area are around 30% overvalued by this metric, having risen 20% over the past 12 months, the largest increase for the area in the last 10 years, writes Stefan Hilts, a director at Fitch. At the current pace of growth, San Francisco prices will be at their peak by early next year. In nearby San Jose, Calif., prices are just 11% below peak and are on pace to hit a new record in around six months. …
“When an expectation of rising rates is coupled with rising prices, there could be increased pressure on the housing market that could reverse recent [price] gains,” said the report.
Coastal California hit the affordability ceiling already. This makes Coastal California very susceptible to the impact of rising interest rates, more so than other markets.
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.
Fitch has the most realistic view of the future of housing. The stimulus being applied by the federal reserve to bring the laggards up will inflate bubbles in the strongest markets. Coastal California is likely to look like the pink line in the graphic below whereas Riverside County will look like the teal line. As the weakest markets recover, the fed should taper the housing stimulus. This will lower prices in those markets like Coastal California bumping up against the affordability ceiling while beaten down markets like Riverside County continue to appreciate.
Trulia uses a method of evaluating prices similar to Fitch.
Despite rapidly rising over the past year, home prices are 4% undervalued in the fourth quarter of 2013. Although prices look more than 10% overvalued in Orange County and Los Angeles, prices look undervalued in 83 of the 100 largest metros.
Trulia’s Bubble Watch reveals whether home prices are overvalued or undervalued relative to their fundamental value by comparing prices today with historical prices, incomes, and rents. The more prices are overvalued relative to fundamentals, the closer we are to a housing bubble – and the bigger the risk of a future price crash. …
Prices Far From Bubble Territory
We estimate that home prices nationally are 4% undervalued in the fourth quarter of 2013 (2013 Q4), which means we’re nowhere near another housing bubble. To put this in perspective, prices were as much as 39% overvalued in 2006 Q1, at the height of last decade’s bubble, then dropped to being 15% undervalued in 2011 Q4. One quarter ago (2013 Q3) prices looked 6% undervalued; one year ago (2012 Q4) prices looked 13% undervalued (see note at end of post). This chart shows how far current prices are from a bubble:
Does Trulia’s bubble chart look familiar to you? I produce a similar one.
Bubbling Local Markets: Orange County and Los Angeles
At the metro level, home prices are above their fundamental value in 17 of the 100 largest metros. Most of these overvalued metros are only slightly so: of the 17 overvalued metros, just two – Orange County and Los Angeles – look at least 10% overvalued. (Austin rounds up to 10% but is actually slightly below.) Several California metros also stand out for having both overvalued prices AND sharp price increases, including Orange County, Los Angeles, Oakland, and Riverside-San Bernardino.
I think they are wrong about Riverside and San Bernardino (See: Inland Empire housing markets are still extremely undervalued)
Top 10 Metros Where Home Prices are Most Overvalued
# U.S. Metro
Home prices relative to fundamentals, 2013 Q4
Year-over-year change in asking prices, October 2013
1 Orange County, CA
2 Los Angeles, CA
3 Austin, TX
4 Oakland, CA
5 Riverside–San Bernardino, CA
6 Houston, TX
7 San Jose, CA
8 San Francisco, CA
9 Honolulu, HI
10 San Antonio, TX
Note: positive numbers indicate overvalued prices; negative numbers indicate undervalued, among the 100 largest metros. Click here to see the price valuation for all 100 metros: Excel or PDF.
If house prices are overvalued, then buyers won’t be able to afford them. If that’s the case, then sales volumes should begin to “unexpectedly” drop.
Published: Wednesday, 20 Nov 2013 | 2:24 PM ET
By: Diana Olick | CNBC Real Estate Reporter
They say all real estate is local, but the West has more recently been an indicator of what is to come for the rest of the nation. It was the first region to crash in the mid-2000’s and the first to show signs of recovery toward the end of the last decade. Now the tides have turned again.
Sales of existing home sales nationally fell 3.2 percent in October from the previous month, but in the West they were down 7 percent. The West was also the only region to see a year-over-year decline in home sales.
Our sales volumes dropped off because we were the first market to hit the affordability ceiling. (See: Mounting evidence of housing market’s extreme sensitivity to mortgage interest rates)
“In the West region there is a significant shortage of inventory, so you have buyers who are looking for the right home unable to find it and unwilling to commit,” said Lawrence Yun, chief economist for the National Association of Realtors.
That’s spin. Buyers are not unwilling to commit. That implies a significant number of fence-sitters who merely need to be manipulated into action. Buyers are unable to commit because they don’t have the resources to afford the higher prices.
“But because of the inventory shortage, one is still seeing strong price increases in the West.” …
That’s truth. The manipulation of MLS inventory is exactly what’s causing prices to rise.
While home prices in California, and across the nation, are still well below their peaks of the housing boom, there is a major difference for home buyers today: credit. Mortgage rates may be lower on the 30 year fixed, but that wasn’t the product used during the boom. Adjustable rate loans with no down payment requirement and 1 percent “teaser” rates were popular. Those are gone today. Now, most loans are fixed rate products that require larger down payments and higher credit scores.
“Bottom line, on a monthly payment basis and relative to income needed to qualify for a loan, a house in California is far more ‘expensive’ than from 2004 to 2008, even though house prices are not back to peak levels,” said Mark Hanson, a California-based housing analyst. “Put another way, it costs a lot more today to pay for a house using a mortgage than it did from 2004 to 2008. Thus, if 2004 to 2008 was a “bubble,” then this must be, too.”
My math doesn’t show this to be the case.
It is clearly much less expensive on a monthly payment basis to own a house today than it was from 2004 to 2008.
Investors may be putting some properties back on the market again in Phoenix, eager to take advantage of higher prices, but those same higher prices are crimping demand. If this is an indicator of what is to come in California, that is a clear red flag.
When I was negotiating a deal with a large private equity fund, as one of the principals, my compensation was based partly on the ROI of the venture. Return on investment is maximized by either making more money or by making money faster. If the principals of the ventures holding these properties no longer believe the cashflow returns or future appreciation are going to increase their return on investment — and ROIs are probably maxed out right now — then speedy liquidations maximize the ROI of the venture and their own compensation.
If enough fund managers decide to liquidate, they may stampede for the exit while ROI is still good. This won’t push prices back to where they started because managers will quit liquidations when they hit certain ROI thresholds, but it could push prices down from where they are today. Further, the reduced demand and increased supply could completely change current market dynamics.
The rest of the nation did not see the same dramatic swings as most Western markets, but the supply, demand and pricing dynamics are similar. Prices are up over 12 percent nationally and inventories are down across the nation. For those predicting the national housing market over the next six months, watching the West is a good idea.
In all likelihood, our prices will flatten over the winter on low sales volumes, and both prices and volumes will pick up during the spring. How much depends on investor activity and mortgage interest rates at the time. If investors aren’t excited about the high prices — and they likely won’t be — then mortgage interest rates better be low, or the spring rally simply won’t materialize.
8112 HOLT St Buena Park, CA 90621
$350,000 …….. Asking Price
$163,000 ………. Purchase Price
3/4/1992 ………. Purchase Date
$187,000 ………. Gross Gain (Loss)
($28,000) ………… Commissions and Costs at 8%
$159,000 ………. Net Gain (Loss)
114.7% ………. Gross Percent Change
97.5% ………. Net Percent Change
3.5% ………… Annual Appreciation
Cost of Home Ownership
$350,000 …….. Asking Price
$12,250 ………… 3.5% Down FHA Financing
4.39% …………. Mortgage Interest Rate
30 ……………… Number of Years
$337,750 …….. Mortgage
$94,666 ………. Income Requirement
$1,689 ………… Monthly Mortgage Payment
$303 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$73 ………… Homeowners Insurance at 0.25%
$380 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$2,446 ………. Monthly Cash Outlays
($344) ………. Tax Savings
($454) ………. Principal Amortization
$20 ………….. Opportunity Cost of Down Payment
$108 ………….. Maintenance and Replacement Reserves
$1,775 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$5,000 ………… Furnishing and Move-In Costs at 1% + $1,500
$5,000 ………… Closing Costs at 1% + $1,500
$3,378 ………… Interest Points at 1%
$12,250 ………… Down Payment
$25,628 ………. Total Cash Costs
$27,200 ………. Emergency Cash Reserves
$52,828 ………. Total Savings Needed