Four traits of the new normal in the US housing market
The US housing market stabilized with low interest rates, low MLS inventory, low owner-occupant demand, and high but affordable house prices.
The norm in California housing over the last 40 years has been extreme volatility. We had one stretch in the mid 1990s when prices were closely tethered to rent, but other than that house prices were either in a bubble or over-correcting to the downside. For the most part, the rest of the US did not participate in the wild price swings characteristic of California, but starting in 2003, financial innovation in housing finance brewed up a toxic concoction of unstable mortgage products that inflated a massive housing bubble and a deep over-correcting crash.
Prior to the housing bubble, the normal state of affairs for the housing market was slowly but steadily rising prices that matched the growth in rents and incomes. From the early 1980s through the early 2000s, house prices rose a bit faster than incomes due to steadily falling interest rates, but generally the rate of appreciation was gentle and predictable.
A normal housing market was characterized by a balance between supply and demand. The supply of housing was controlled by millions of individual homeowners with sufficient equity to sell whenever they pleased without obtaining a bank approval, and banks owned almost no REO. Historically, lenders had very little direct impact on the housing market through short sale approvals or REO sales.
The demand for housing also came from millions of individuals, about two-thirds of whom borrowed around 80% of the purchase price to acquire property. New household formation from high-paying jobs prompted builders to provide more rental and for-sale products wherever job growth occurred, and low unemployment kept house prices steady even in areas of temporary economic distress.
1. Low mortgage rates
The first unique characteristic of the new normal is very low mortgage rates. For the last several years, the housing market has been subject to one temporary abnormality after another. First, lenders inflated a massive housing bubble by burdening borrowers with nearly double the debt their incomes could support. The inevitable credit crunch caused a sudden and dramatic reduction in loan sizes, requiring several adjustments to restore an affordable and sustainable equilibrium.
The first of these adjustments was initiated by the federal reserve that lowered the federal funds rate to zero and began buying mortgage backed securities to bring mortgage rates down from 6.5% in mid 2006 to 3.5% in early 2013. This significantly raised the amount borrowers could finance on sustainable loan terms.
The long-term average for mortgage rates dating back to 1971 is about 8%; only looking back 25 years brings this average down to between 6.5% and 7%. The current regime of 4% rates is very low by historic standards, but given the need for lenders to reflate the housing bubble to recover on their bad loans, it’s likely we will sustain below-average mortgage rates for a very long time. This is a feature of the new normal.
2. Low supply of for-sale homes on the MLS
The second unique characteristic of the new normal is unusually low MLS supply. When the housing bubble first burst, lenders followed their standard loss mitigation protocols and initiated foreclosure, mostly on the subprime borrowers whose loan resets blew up first. This flooded the MLS with bank REO and initiated a dramatic house price decline in every market loaded with subprime borrowers.
Lenders finally realized in late 2008 that they had to remove the distressed inventory before they pounded house prices back to Great Depression levels, so they lobbied lawmakers and regulators to suspend mark-to-market accounting in favor of mark-to-model (mark-to-fantasy) accounting so that they could report their bad loans as good assets and alleviate the need to foreclose and liquidate the REO. This wasn’t enough.
From 2009 to 2011, lenders still foreclosed and liquidated too many REO to be absorbed by the seriously depleted buyer pool, so they embarked on a more aggressive policy of loan modification can-kicking to get some income from their bad loans and get the distressed properties off the market. The final piece of the puzzle came together in 2011 when most lenders stopped approving short sales if the borrower had any assets.
The loan modifications and denied short sales kept borrowers in their homes and it kept the homes off the market; inventory plummeted, and by early 2012, there were so few homes available that even the tepid demand was enough to cause bidding wars and force the housing market to bottom.
The problems and solutions that lead to our current state of low MLS inventory is likely to persist for quite some time. Both lenders and underwater borrowers do not want to lose money on the bad deals they made nearly 10 years ago. Lenders can kick-the-can indefinitely, and they can force borrowers to play along. There are still 9.7 homeowners who are underwater, and the government loan modification programs and private-label loan modification programs delayed and deferred several million more distressed sales, so low MLS inventory will be an issue for a very long time. This is a feature of the new normal.
3. Low demand from owner-occupants
The third unique characteristic of the new normal is low demand from owner-occupants. When the housing bubble burst, several million people lost their homes in foreclosures, and several million more ruined their credit scores by defaulting on their loans to obtain loan modifications. This removed several million potential borrowers from the buyer pool, and despite hopes that these boomerang buyers would come back to the market in large numbers, they haven’t, and they won’t.
Further, first-time homebuyers, typically the largest demand cohort with an average 40% share, are not buying homes. Today, the share of first-time homebuyers is only 29%, and with the poor economy and excessive student loan debts, the Millennial generation won’t be major housing market participants until 2019.
The housing market enjoyed a brief boost in demand from institutional investors, but now that prices are pushed up too high for to meet their return thresholds, that component of demand is gone unless prices go down again.
The boomerang buyers and the first-time Millennial buyers either can’t or won’t participate in the housing market for the foreseeable future. They have bad credit, too much debt, and too little savings — which won’t be changed quickly or easily if at all. Owner-occupant demand will be weak. This is a feature of the new normal.
4. Home prices expensive but affordable
I create monthly market reports that carefully document rents and ownership costs for most cities and many zip codes in Southern California; this site displays the cost of ownership and comparable rental rates for every for-sale property on the MLS: between those two sources, it’s easy to determine market trends and gauge relative affordability from the county level all the way down to individual properties. Last week’s housing market update made note of a characteristic of the new normal.
Relative to rents, house prices stabilized across Southern California at prices very similar to the stable equilibrium from the mid 1990s. This didn’t happen by accident. The lack of MLS supply cause prices to get pushed up quickly in 2012 and early 2013, but they hit the ceiling of affordability and stopped dead. We still see sellers coming to market asking 10% over recent comps, but unlike 2012 and early 2013, they aren’t getting what they want. Buyers simply can’t raise their bids any higher with the current incomes.
In the past, toxic mortgage products would have restarted the Ponzi scheme, but since these products are effectively banned, rather than restart the Ponzi scheme, sales volumes declined, and buyers are giving up. Unless mortgage rates tumble again, or unless incomes start rising in the face of high unemployment, house prices aren’t going to move up from here — at least not any faster than wage growth will allow.
After almost of dozen years of volatility, the market has reached a stable equilibrium where prices are high but affordable. Since we aren’t likely to get an influx of supply, and since the weak economy means we aren’t likely to get a surge in demand, we will maintain this equilibrium for the foreseeable future. This is a feature of the new normal.
What’s old is new again
When you consider the market manipulations of mortgage rates by the federal reserve and supply by lender policy, it’s a miracle the market stabilized at all. It’s an open question as to how stable these props are, but it seems very unlikely they will be unwound any time soon because the health of the banking sector depends on it. Despite the overhanging issues, when you look carefully at where we are and how the market is reacting, the new normal looks much like the old. Prices will rise slowly from here always being expensive but attainable, not unlike they were in the 1990s.
Welcome to the new normal.