House hunters must sacrifice quality to buy a house in 2015

Cloud inventory restrictions, rising house prices, and stagnant wages is forcing homebuyers to substitute downward in quality if they want to buy a house.


For the last three years, house prices have gone up in price, but the incomes of most buyers has not. This simple fact forces buyers to make a choice: either get a lesser quality house, or keep renting. The decision to get a lesser quality house is the downward substitution effect.

Not everyone will make the choice to substitute downward in quality, particularly if they can rent a nicer house for the same money. Since not everyone is willing to accept less just to own, as prices keep rising faster than wages, sales volumes weaken, which explains much of why 2014 disappointed optimistic housing bulls.

Two facets of demand

Most people who discuss real estate demand don’t understand the nuances of what comprises it. Demand for housing comes in two forms: the quantity of demand (how many people are ready, willing, and able to buy), and the quality of demand (how much can those that want to buy put toward the purchase).

The confusion between these two is apparent in the competing political narratives used to explain the housing bubble. The political right contends that increasing the quantity of demand by lowering lending standards created the housing bubble. This meme is politically convenient, but it’s also completely wrong.

Let’s assume for a moment all qualification standards were eliminated and anyone who wanted to borrow money could get a loan, similar to what happened in 2004 through 2006. Would this cause a housing bubble? In my opinion, it would not. It would inflate prices, and it would cause a great deal of downward substitution of quality to get a property, but it wouldn’t necessarily create a housing bubble as long as loans were based on verifiable income and reasonable debt-to-income ratios on conventionally amortizing mortgages. In today’s housing market, there is no loan program available that can inflate house prices in an unstable way.

The loose lending standards of 2004-2006 allowed many people to buy homes, but it was the combination of liar loans, unlimited debt-to-income ratios, and negatively amortizing loans that allowed the army of borrowers to finance loan balances double what they should have been. Increasing the number of borrowers can inflate prices through the substitution effect, but increasing the total amount buyers can put toward housing is what sends prices orbital.

Option_ARM_Plague_victimsToxic loan programs like the option ARM were not invented during the housing bubble; they were long-standing niche products with a hefty price tag to properly price the risk of default. It was the gross mispricing of risk on Wall Street that created an insatiable demand for these products that drove the price down and put these weapons of financial destruction in the hands of unqualified borrowers. Prices wouldn’t have inflated nearly so much during the housing bubble if the risk hadn’t been mispriced through ruinous credit default swaps and collateralized debt obligations given AAA ratings by a corrupted rating system.

It’s right to be concerned about the return of some dangerous loan products. I expressed my belief that the new mortgage regulations will prevent future housing bubbles because the “Ability to Repay” rules will prevent reckless lending, but I could be wrong. These toxic loan products don’t conform to the new mortgage regulations, so right now they are very expensive and uncommon. We must hope it stays that way.

Downward substitution rules the day

Conditions are not ripe on Wall Street for facilitating another housing bubble, and with the secondary mortgage market still in turmoil, a dramatic increase in the amount borrowers can finance — the least stable and most dangerous inflater of house prices — isn’t going to happen. Therefore, the housing market can only inflate prices based on the willingness of homebuyers to substitute down in quality. Since house prices are near rental parity, since kool-aid intoxication is tempered by fear of a price crash, and since housing faces the headwind of rising mortgage rates, many potential homebuyers will not chose to overpay for a house just to become a homeowner: that form of kool-aid intoxication died with the deflation of the housing bubble.

Call the cops! This house is for sale…huh?

Diana Olick, March 13, 2015homebuying_frenzy

The competition in today’s housing market is suddenly fierce, so fierce that some are calling the cops.

“We got shut down!!” laughed Catherine Luther, an agent with Channing Real Estate in the Boston area. “I’ve been in this business for 30 years, and it’s never happened before.”

At a Saturday open house at her listing in suburban Belmont, she had over 100 people in 45 minutes, which blocked the street. Neighbors called police, who shut down the open house. Then Luther smartly hired an off-duty officer to direct traffic the next day for the Sunday open house. The officer counted more than 150 cars. The three-bedroom colonial house went under contract three days later with more than a dozen bids.

“It’s just that we’re lacking inventory. We really need more inventory. Prices are going up, and we just don’t have enough property to sell,” said Luther. …

The reason inventory is so low is because potential sellers are underwater and unable to sell. With the expiration of the tax break for short sales, almost no underwater owners list their homes for sale. (See: Must-sell shadow inventory has morphed into can’t-sell cloud inventory)

“The surprising part to me is how little the inventory there is. There’s just not that much up here,” said Farag. “A lot of houses you almost exclude because you kind of feel people are putting houses out at ridiculous numbers—you have to eliminate that. They are just throwing it out there, but for realistic houses, realistic numbers, there’s just not that much at all.” …

In the post Did the OC housing market come alive in February 2015?, Shevy noted that the same is true in OC. If a property is priced at levels buyers can actually finance, it draws competing bids; however, if a property is priced beyond what buyers can finance without significant downward substitution in quality, it just sits there, often for a very long time.

“As home affordability continues to look great and rental affordability looks abysmal, many current renters clearly seem to be rethinking their attitudes toward home ownership, and are expressing more confidence in the overall housing market as a result,” said Zillow Chief Economist Stan Humphries. “But while this confidence is heartening, it’s important to inject a note of reality here: Not all renters who want to buy this year will be successful. Saving a down payment, qualifying for a mortgage and finding an affordable home to buy all remain formidable challenges for many.”

hid_the_housesIn the post How restricted for-sale housing inventory saps demand, I outlined the connection between the forced price increases in for-sale houses and rents is caused by cloud inventory. The biggest problem this creates is a long-term drag on housing demand because renters are unable to save for a down payment.

With increased competition for precious few homes, prices have no where to go but higher, faster. Home price gains, which had been shrinking last year, have just taken a U-turn and are now seeing bigger gains. …

When any commodity is in short supply, prices tend to rise; houses are no exception. Beginning in the 1970s, California produced more high paying jobs than it did houses. As a result, there were not enough houses to go around, so people began substituting down in quality to obtain a place to live. This downward substitution effect lifts house prices at every level of the housing ladder and prices out the lowest tier of the housing market.

This phenomenon has been going on for so long, that most Californians resign themselves to the idea of living in lesser quality housing than they could obtain elsewhere based on their income. Since cloud inventory, the artificial restriction of supply engineered by lenders, is a nationwide phenomenon, the rest of the US is experiencing what Californians have endured for the last 40 years.

“We’re afraid that interest rates are going to creep up, and inventory is down, so there’s more of a fear of loss right now in the market and people are coming out, Maria Rini, a real estate agent with Re/Max in Bergen County, New Jersey.

Kool aid served up by realtors will always victimize the ignorant.


Rini, who has been selling homes for 21 years, says inventory in her market is just 60 percent of what it was five years ago. She does add that buyers are picky and won’t pay the higher prices if they don’t see the value.”There are a lot that are over priced,” said Farag, “but they have been sitting on the market for over a year, and they are sitting are the market for a year for a reason, but the ones that do hit the market priced right are moving quickly.”

For now, Farag and his wife will move in with his mother while they continue to search.

The bottom line is that house hunters for the next several years will face the difficult decision of whether or not too keep renting or substitute downward in quality to own a house. Without kool aid intoxication to motivate foolish buying, it will likely cause resale volumes to remain low with bidding wars on well-priced properties and an MLS flooded with cloud inventory that won’t sell because it’s priced too high.

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