May132013

House prices nearing affordability limits in many markets

Thanks to record low mortgage interest rates, monthly payment affordability is very high. In fact, it costs the same on a monthly payment basis to own a house in Orange County as it did in 1989 (see chart below). This allows buyers to raise their bids on the limited inventory available. This is highly desirable for the banks who want to recover as much as they can on their bubble-era legacy loans. Existing homeowners are not complaining.

There is a limit to how much buyers can raise their bids. Gone are the days of liar loans, so now borrowers much qualify based on their verifiable income. Also gone are the affordability products including interest-only and negative amortization loans with teaser rates that allowed borrowers to leverage many times more than what their incomes can support. That leaves us with a market with a true barrier to affordability based on borrower incomes and prevailing interest rates applied to conventionally amortizing loans.

The monthly reports I publish each month delineates where these limits are. Below is the most recent readings on Irvine, California. The chart contains three lines all buyers should pay attention to: median resale, rental parity, and historic value. The purple line is the median sales price. As you can see, Irvine prices are rising rapidly and quickly approaching peak valuations.

The green line above is rental parity. It represents the price point where the cost of ownership equals the cost of a comparable rental. Not every neighborhood trades at rental parity. Some neighborhoods are more desirable, and people will bring equity from previous sales and bid prices up. Also, many are motivated to pay more to own than the cost of a rental. Many justify this additional expense as an “investment” that will be recouped based on appreciation. It’s a foolish belief. In reality, the additional cost is a consumptive use, and for those willing to pay the extra price for consumption, at least they are not deluding themselves with fantasies of great investment returns based on appreciation.

Since some neighborhoods trade at a premium and some trade at a discount, to really determine if a property in a given neighborhood is a bargain or overpriced, the current premium or discount must be compared to a stable historic value. I use the period from 1994 to 1999 as it represents the stable bottoming period between the two most recent housing bubbles. If you look at the chart above, you can see Irvine homes traded within a very tight range around this price level for many years (purple line matches orange line).

During that stable period, Irvine traded at a 15% premium to rental parity. If past is prologue, then Irvine should again trade at this premium once market values stabilize at the affordability limit. The affordability limit is represented by the orange dashed line in the chart. It plots the price point where prices are at their historically stable values relative to rental parity. As you can see, Irvine is no longer trading at a discount to rental parity (green line) and is quickly approaching the limit of affordability (orange dashed line).

When prices hit the limit of affordability, appreciation will wane. Buyers simply won’t be able to raise their bids any higher. Perhaps with the limited inventory and increased activity of all-cash buyers, prices might get pushed higher for a while, but that would represent the inflation of a new housing bubble, and those all-cash buyers, mostly investors, will get burned. Even now, many of those investors are expecting the steep slope of the purple line to continue to infinity. That simply isn’t going to happen.

Home Prices Jump but Affordability Remains in Buyers’ Favor

By Robbie Whelan — May 9, 2013, 1:03 PM

Home prices in 150 U.S. cities saw their biggest year-over-year gains in over seven years in the first quarter of 2013, but affordability still remains high in most markets. …

The biggest gains in home prices were in boom-bust markets that were hard-hit by the housing crisis, depressed Midwestern towns and markets in California benefitting from robust job growth.

Job growth and new household formation has nothing to do with this market rally. The bulls wish it were because that would reflect stronger underlying fundamentals; however, the price rally is entirely predicated on interest rate stimulus and changes in lender foreclosure policy favoring can-kicking over foreclosure.

Akron, Ohio, saw prices rise 32.7% to $108,300, the widest median price increase in the country. It was followed by the San Francisco Bay area, where prices rose 32.6%; Reno-Sparks, Nev. (32.1%); the Silicon Valley area surrounding San Jose (31.7%); Atlanta (31.1%); and Phoenix (30.1%).

Prices are still falling in Kankakee-Bradley, Ill. (-18.8%); Edison, N.J. (-8.6%); Allentown-Bethlehem-Easton, Pa. (-8.3%); Champaign-Urbana, Ill (-5.5%); and Erie, Pa. (-5.0%).

The judicial foreclosure states which avoided early bubble deflation are finally getting their comeuppance.

“The supply/demand balance is clearly tilted toward sellers in a good portion of the country,” said Lawrence Yun, NAR’s chief economist, in a statement. “Some of the previously hard-hit markets like Phoenix, Sacramento and Miami continue to experience a dramatic turnaround, while a new set of areas like Atlanta, Minneapolis and Seattle have begun to show strong signs of upward momentum.”

The NAR’s quarterly reports on median pricing are a good measure of where prices in certain markets are headed generally, but their results can sometimes overstate the magnitude of price gains because they don’t control for shifts in the number of low-priced homes versus high-priced homes that are sold each quarter.

Those price changes mentioned above sound remarkable, but the prices of individual homes did not rise nearly that much. Prices are certainly up, but the change in mix distorts the value upward just as it distorted the value downward in 2009.

A companion study showed that despite the economic downturn of recent years, low mortgage interest rates and consistent wages have given home buyers in the U.S. “ample buying power” in the current market…

Still, credit remains tight for some buyers, especially those with damaged credit scores and those who are not able to save enough for a large down payment.

That describes a much larger percentage of the potential buyer pool than ever before. Millions lost their homes to foreclosure, so they are broke and have bad credit. Millions more are Ponzis or recent college graduates who also don’t have savings, but more importantly, they don’t have the back-end qualifying ratio to take on more debt. Millions more were wiped out during the recession and don’t have the huge down payments necessary to buy at inflated prices. None of those people will contribute to a push higher.

Prices have also risen in large part because inventories of homes for sale have plummeted. The number of homes for sale in March totaled 1.93 million, the lowest level of inventory for the month of March—typically the first full month of the spring selling season—since 2000. Low inventories in some markets have sparked bidding wars among buyers and bolstered sales of newly built homes, which rose in March to their second-highest monthly sales pace in three years.

Low inventories are the key. Low interest rates give buyers the ability to raise their bids, but if large numbers of competing sellers are on the market, buyers don’t have to raise their bids. Inventory is being withheld from the market by banks who are can-kicking and underwater borrowers who are waiting until they reach the surface. This won’t change any time soon. As we get nearer the affordability limit, we also approach where borrowers can sell without a short sale. That will bring more sellers to the market — at WTF prices — who want to get out from under the debts they can’t really afford.