Housing market update: prices up slightly, cost to own flat, rent flat
During the spring selling season, house prices are up slightly while the cost of ownership and rents are unchanged.
Over the last few months of the prime selling season, many market pundits lamented the lack of sales, but most continued to point to year-over-year gains as a positive sign for the housing market. The recent drop in mortgage interest rates has allowed borrowers to increase their leverage on flat incomes, so buyers have been able to raise their bids slightly during this spring selling season; however, since job creation is weak and wages are stagnant, sales volumes are low, and the cost of ownership is practically unchanged; rents are also unchanged.
Over the last nine months, the median resale prices has increased from $531,a00 to $547,700, a change of about 3%; however, this increase is almost entirely due to declining interest rates since the spike last June.
The cost of ownership is only up 1% over the last nine months, and rents haven’t moved at all. The year-over-year numbers still show gains, but over the next three months, those gains will vanish; housing market analysts will sing a loud chorus about returning to a normal market with reasonable appreciation rates.
From 1992 to 2002, the median resale price rarely deviated from rental parity. For the last nine months, this correlation returned. Of course, the federal reserve manipulated mortgage interest rates to raise this equilibrium point to help bail out the banks. Also, this balance is maintained by bank policies of restricted inventory by delaying foreclosures with loan modifications and denying short sale approvals. The reality is that this is our new normal.
The connection between the cost of ownership and the cost of rent has been restored.
Without affordability products, lenders simply can’t push prices any higher than incomes will support with fixed-rate financing. This ceiling is proving much more rigid than in years past, largely due to the removal of affordability products from the market. Personally, I think that’s a great thing as it makes it much less likely lenders will inflate another housing bubble.
House prices are high because near 4% interest rates allow borrowers to leverage their incomes to make ridiculous bubble-era prices affordable on a monthly payment basis. And although prices seem crazy high, the cost of ownership relative to rent is not high by historic standards.
The number of undervalued neighborhoods keeps getting smaller as the substitution effect brings up the laggards. The number of overpriced neighborhoods is unchanged.
The OCHN Rating System
If neighborhood values are at or near historic norms, why does the analysis system on this site show so many highly rated properties selling at or near rental parity?
This has been a question I’ve been contemplating over the last several months. My goal is to make a system of property analysis that people can rely on to find properties that are inexpensive relative to historic norms. The system doesn’t look at current comps to make a statement about whether or not a property is overpriced or underpriced today; rather it looks at the long-term historic norms and tries to rate the property in it’s long-term market standing. Current comps might be in a bubble and look great, so only by looking at pricing relative to historic norms can people avoid more serious problems.
Several cities in Southern California have traded at premiums to rental parity since the 1970s. For example, Irvine typically sells at a 14% premium to rental parity as many move-up buyers take equity from a previous sale and bid up prices, yet when I look at individual properties for sale in Irvine, I see many trading at or below rental parity — a phenomenon I see across Southern California. So is this a problem with the system? Perhaps the aggregate numbers exaggerate the premium?
Here’s what I believe is going on.
Today’s featured property is in Placentia, and it rates a 10. I want to focus your attention on two key adjustments to the monthly cash outlays required to accurately measure the cost of ownership: principal amortization and opportunity cost. The amortization of principal on a home loan is not a true cost because these payments build equity even if prices don’t change; it’s basically a forced savings account. Opportunity cost is the loss of income from competing investments. A down payment had to come from somewhere, and the buyer could have left the money in some competing investment vehicle rather than tying it up in real estate.
What’s interesting about these two variables is what happens when mortgage interest rates get very low. Principal amortization increases significantly in the early years of a mortgage at low rates, so the money coming back to the owner is much larger than it would be at higher, more normal mortgage rates. Further, in order for mortgage rates to be very low, competing investment alternatives must also be yielding very low returns, so the opportunity cost of taking money out of one investment and putting it into real estate is very low. So at very low mortgage rates, two of the adjustments to the cost of ownership get heavily skewed in favor of buying — which is what the federal reserve intended when they made rates go so low. So even though prices are very high, and even though the monthly cash outlays are also very high, the actual monthly cost of ownership is not.
There is no good way to capture this distorting effect of mortgage rates when looking at aggregate numbers, so properties like this one look like a great bargain even though the price is high and the monthly outlays are also high. Typically, Placentia trades at a 1% discount to rental parity, yet this property is trading at a significant discount to rental parity; thus it earns a high rating.
What I take away from this is that despite the high prices and large monthly cash outlays, houses are still a good bargain for those who can afford them.
So what happens when the distortions end? Will rising mortgage rates quickly change the equation away from favoring ownership? Yes, they will. Rising mortgage rates will put serious pressure on prices as the deals will become much less compelling on a monthly cost of ownership basis.
For years I extolled the idea that buying at very high mortgage rates and lower prices is better because you can refinance as rates drop. And although that advice is still sound. I now have a better understanding and better feeling about buying at very low interest rates. Low opportunity costs and high principal amortization are positive qualities, assuming interest rates don’t rise too quickly and negate the positive effect — and of course, assuming buyers use fixed-rate financing to lock in these good qualities.