California’s housing market slows due to affordability ceiling
California home sales weaken because prices are higher than most potential buyers can qualify to borrow, a problem that will worsen if mortgage rates rise.
Borrowers face real limits on mortgage debts thanks to Dodd-Frank. Prior to Dodd-Frank lenders would extend credit without regard to a borrower’s ability to repay because lenders could sell these loans to eager investors willing to accept the repayment risk. The ability-to-repay rules mandate that lenders must document a borrower’s income and demonstrate the borrower has the ability to repay on a fully-amortized repayment schedule; thus Dodd-Frank eliminated liar loans and Option ARMs, two toxic loan products that destabilized the housing market.
Without toxic affordability products, the four fundamentals of housing market pricing, borrower income, allowable debt-to-income ratios, interest rates, and down payment requirements, exert stronger influence on aggregate home prices. Borrowers endure affordability limits, so they can’t push up home prices nearly as high. Future housing markets will be much more interest-rate sensitive as a result.
How high can buyers push home prices? It depends on the four fundamentals of housing market pricing. The federal reserve engineered record low mortgage rates in order to imbue the market with affordability so borrowers could finance bubble-era prices with current incomes and allowable allowable debt-to-income ratios.
Since Dodd-Frank capped debt-to-income ratios at 43% and effectively banned loans that don’t amortize, borrower income and mortgage interest rates largely determine how high the ceiling can go. As borrowers incomes increase and as mortgage rates go down, the affordability ceiling rises; unfortunately, as mortgage rates increase, the affordability ceiling lowers, reducing sales volumes at bubble-era prices.
Rental parity analysis
Theoretically, borrowers could push prices higher than aggregate wages suggest by substituting downward in quality to own housing. Buyers routinely shoehorned themselves into small condos prior to the housing bust for fear of being priced out forever. However, because that fallacy was laid bare by the housing bust, buyer behavior changed over the last decade, and people no longer accept lower quality housing than what they can rent. Thus aggregate rental rates become an ideal proxy for borrower income when evaluating the affordability ceiling in any housing market.
Rental parity analysis is powerful because it makes specific predictions about aggregate home prices, sales volumes, rates of home price appreciation:
- Aggregate house prices can’t exceed a limit established by the four fundamentals. This limit is quantifiable.
- If home prices exceed the affordability limit, sales volumes will suffer, and if the gap is large and persistent, house prices will fall.
- If house prices fall below affordability limits, sales volumes will increase, and home price appreciation will quicken.
- Once prices reach the ceiling, home price appreciation is determined by the rate of increase in aggregate income and rent and by mortgage interest rates.
In the short term other economic factors may influence aggregate home prices, sales volumes, and rates of appreciation, but these four predictions of rental parity analysis have been repeatedly affirmed since Dodd-Frank was passed.
Most housing market economists subscribe to the doctrine of “escape velocity,” the belief that rising prices stokes demand. In the pre-Dodd-Frank era, when house prices went up, buyers became more motivated out of greed and fear, and those buyers were enabled by lenders with affordability products. Escape velocity is really a euphemism for foolish optimism and widespread participation in a financial mania.
According to the doctrine of escape velocity, the house price rally since 2012 when coupled with an improving economy and robust job growth should result in higher sales volumes and higher prices irrespective of how prices already are — and in the past, this would have happened.
The slow sales we see today defies economists notions of escape velocity; however, it is precisely what is predicted by rental parity analysis.
No Bounce yet this Spring, March off to Slow Start
March Sales Down 4.7 Percent Year-over-Year, Second Lowest March Since ’08
By Madeline Schnapp, April 20, 2016
On a year ago basis, sales were down 4.7 percent from 35,023 in March 2015, the second lowest March since 2008. On a quarterly basis, Q1 2016 sales were down 1.2 percent from Q1 2015, also the second lowest Q1 sales since Q1 2008.
“March marks the start of the selling season and sales this past month were the second lowest March since 2008,” said Madeline Schnapp, Director of Economic Research for PropertyRadar. “The lack of inventory and terrible affordability are a drag on sales. Without new inventory, sales will likely remain flat for the foreseeable future. ” …
The lack of inventory is a realtor red herring. The real problem is affordability as housing inventory abundant at prices buyers can’t afford. Expect realtors to renew their shrill pleas for looser lending standards.
The March 2016 median price of a California home was $415,000 …. On a year-ago basis, median home prices were up 5.6 percent from $393,000 in March 2015. …
“The increase in the median price from February 2016 to March 2016 is a great example of the influence of the shift in mix of homes sold rather than the price of a house actually increasing,” said Schnapp. “In February, there were more lower priced homes sold than higher priced homes. Conversely, the mix shifted in March when more higher priced homes sold pushing the median price higher.”
Cloud inventory restrictions prevent many sellers from lowering their price to meet the market; thus only higher-prices houses are available despite the stronger demand at lower price points.
“Affordability and lack of inventory is a challenge in every part of the state with a decent job market. The closer you are to the coast, the worse it gets,” said Schnapp. “As prices march steadily higher, they eventually hit a level where you run out of buyers willing to pay those prices. …”
The evidence demonstrates we are already at that point.
New U.S. single-family home sales unexpectedly fell in March, but the decline was concentrated in the West region….
Economists had forecast new home sales, which account for about 8.7 percent of the housing market, rising to a 520,000 unit-rate in March. …
But sales plunged 23.6 percent in the West, reversing February’s 21.7 percent jump….
California pending home sales decreased for the third straight month, despite a group of buyers anxious to secure one of the few available homes on the market, according to the February California pending home sales and Market Pulse Survey by the California Association of Realtors.
Pending home sales decreased in March by 1.7% from 138 sales in March 2015 to 135.6 sales this March, based on signed contracts, according to the report. …
Lack of inventory is expected to continue to hinder sales in the housing market throughout the year, CAR states. …
March pending home sales in Southern California have been flat, decreasing by only 0.3% from last year…. Los Angeles had an annual increase of 1%, whereas Orange County fell by 4.3%.
Ordinarily, home prices and home sales both increase for the first six or seven months of the year. To have three consecutive months of declining pending home sales is highly unusual for this time of year. One month doesn’t make a trend, but three months certainly does. Despite super low mortgage rates and a strong job market, homebuyers shun housing today — mostly because house prices are getting too high.