Was 2012 housing affordability an illusion?
Payment affordability is very high by historical standards. That means people who borrow most of the money to buy a home — which is about 70% of buyers — the cost of monthly payments is low relative to a borrowers income. But is this a good measure of affordability? A recent paper argues it is not. Further, they argue that affordability is still a major problem hindering demand.
I recently wrote about this issue in Record low interest rates fail to spur demand.
Interest rates are at record lows, and prices are at or below rental parity in most markets, yet demand is low and sales volumes are weak. Most real estate shills blame intransigent buyers. Many realtors believe legions of buyers are fence-sitting due to falling prices. In their world, if buyers could just be cajoled into buying, everything would be okay.
The main reason buyers aren’t buying is because they can’t. The buyer pool has been depleted by the recession. Fewer buyers qualify for loans because they have bad credit from excessive debt loads or a recent foreclosure or short sale. Plus, few people have the requisite down payments to buy a house at California prices. Prices are now affordable on a monthly payment basis, but until people go back to work, repair their credit, and form new households, demand will remain weak. Further, since the collapse of prices has wiped out so much equity, there is no viable move-up market. This will be a drag on high-end pricing for many more years. Expect to see high-end prices languish even after the bottom tier of the market finds stability.
The authors of the paper above have a different view.
Home prices and mortgage rates have made monthly mortgage payments lower than at any time in the past decade. But housing isn’t any more affordable than it was five years ago, during the go-go lending days, after factoring in down payment requirements and other financing terms, according to a new paper.
The National Association of Realtors and other housing economists typically measure housing affordability by looking at home prices and mortgage rates. Prices of course have fallen to nearly 10-year lows nationally, while rates have never been lower. Freddie Mac on Thursday said rates stood at 3.71% this past week for the average 30-year fixed-rate mortgage.
I have made the same argument and same observation in our market. The record low interest rates have made the cost of ownership lower than the cost of a comparable rental and in many areas lower than historic norms.
But the total cost of homeownership, as a share of a borrower’s income, is the same today as it was during the height of the housing mania, according to the study by Andrew Davidson and Alexander Levin of mortgage consulting firm Andrew Davidson & Co.
The reason: borrowers have to put more money down to get a loan, and the exotic lending products that allowed borrowers to make low initial payments have gone away. That means while the absolute monthly payments are lower, the all-in costs of homeownership haven’t become more favorable. …
“Home affordability needs to be considered in light of the full financing package,” said Mr. Davidson. “During the bubble the low all-in cost of mortgage financing allowed borrowers to purchase homes, even at inflated prices.”
The erosion of down-payment requirements from 2000 to 2006 reduced borrower costs by around 15%, according to Messrs. Davidson and Levin, while tighter down-payment standards since 2006 have raised borrower costs by 22%. That more than offsets the benefit of a drop in interest rates from around 6% to less than 4%.
Their conclusions are erroneous. They have assigned an unrealistically high cost to the equity component of home ownership. Their basic argument is that the increased cost of equity when applied to the increased equity requirement drives up the cost of ownership to match the bubble-era. This is wrong.
First, this is an issue I explored at length in the post on Ownership cost: taxes and opportunity costs:
Calculating Opportunity Cost
Projecting future costs is more an art than a science. Trying to estimate the opportunity costs of an average investor over the life of a 30-year mortgage is a guess at best. However, since this opportunity cost is real, there are useful theoretical models for providing an estimate to use in decision making.
Interest rates on savings are tethered to mortgage interest rates as all debt and deposit instruments are tied together in the web of risk and return in the debt market. The loosely correlated relationship between mortgage debt and reliable savings returns like medium-term Certificates of Deposit is the basis for estimating opportunity cost.
When mortgage interest rates are very high, the demand for money is high, and lenders will be paying high CD rates to try to supply the demand for money through loans. The inverse is also true. When lenders do not need money to loan, interest rates fall, and lenders do not need to pay borrowers much for money. Plus, in a deflationary environment the lender has no reliable customers to loan the money to anyway.
This direct relationship between mortgage interest rates and CD rates — irrespective of how loosely correlated they may be — is the basis of my calculation. I make the following assumptions:
- CD Rates will never fall below 1%.
- As mortgage rates go up, CD rates will go up 66% as fast.
When I put in different test numbers, the stretching spreads this formula creates does re-create the same phenomenon that happens in the real world when inflation expectation is added into the market’s thinking.
We have the ability to override our default settings and put in whatever inputs you believe most accurately reflects your financial situation in our reports.
The paper argues that equity has gotten significantly more expensive as interest rates have dropped, but this is not accurate. Opportunity costs on equity have fallen along with interest rates. Do any of you know where you can find safe investments with higher yields than 2006? I rather doubt it.
Further, this paper uses this falty reasoning and analysis to make its main point that sales are weak despite low interest rates because consumers have a high cost of equity capital. This conclusion is also wrong.
Back to the article:
At the peak of the housing bubble, loan payments were the only cost that borrowers had to consider given the ability to take out no-money-down loans. But today, loan payments constitute roughly 50% of the total cost of ownership “and are rather modest by historical standards,” the paper says. “This explains why the record-low interest rates do not impress borrowers and do not propel home prices up.”
The reason low interest rates have not prompted more buying is not the cost of equity capital, it’s the availability of equity capital. People don’t have the money! They’re broke! It doesn’t matter what value is assigned to capital you don’t have.
This paper attempts to explain the slow pace of sales due as a function of the cost of equity capital. It’s not. The real reason sales are slow despite record low interest rates are as follows:
- With so many people going through foreclosure, the buyer pool is seriously depleted which reduces overall demand.
- With falling prices, few existing homeowners have equity, so the move-up market is effectively paralyzed which also reduces demand.
- The protracted recession has left few first-time buyers with sufficient savings to make a down payment — even a paltry 3.5%.
With fewer total buyers and with the two main sources of buyer equity being depleted, demand is low despite low interest rates. Lenders could reduce interest rates to zero, and it still wouldn’t increase demand much from where it is today. The availability of down payments is what’s keeping demand in check — and that’s a good thing. We tried eliminating down payments during the bubble, and we saw what became of that experiment.
As a further example of this paper’s lack of basic understanding of the issues it explores, I offer the following section on Options ARMs, the Ponzi loans responsible for inflating prices.
The negative amortization volume also has a remarkable coincidence with HPI (home price index) booms and busts, although it remains a chicken-and-egg dilemma.
Option ARMs could only be offered with confidence that home prices would grow. The low-cost financing they offer propels HPI further. Once the HPI reached its peak, Option ARMs stopped being offered. Their death caused HPI to decline deeper as new homebuyers could not afford the prices paid by previous owners who used Option ARMs.
This is not a chicken-and-egg dilemma. This is a PONZI SCHEME! Option ARMs are Ponzi scheme loans. Any loan which does not amortize is a Ponzi scheme loan because it requires rising prices for it’s success. When prices don’t rise, these loans blow up, borrowers stop paying, lenders stop lending, and the resulting credit crunch sends prices spiraling downward. These authors fail to recognize the mechanism by which the housing bubble was inflated and exactly what caused it to pop.
The paper did have a bright spot. The opening paragraphs showed they do understand the dilemma posed by interest rates:
One of the most complex and controversial subjects of home-price modeling is the role of interest rates. … When rates grow, affordability, and therefore, home prices decline. However, over a long period of time, higher interest rates paired with higher income inflation will ultimately push housing values up.
I explored this issue in Will rising interest rates cause house prices to crash?
At today’s 4% interest rates, borrowers can comfortably leverage over five times their yearly income. The 40-year average for interest rates is 9%. At that interest rate, a borrower can only leverage three times their yearly income. The old rules-of-thumb about borrowing three-times income are relics of a bygone era. But what happens if those interest rates come back? Four percent interest rates are not a birthright. In fact, interest rates have only been this low one other time in the last two hundred and twenty-two years.
As is evident in the very long term chart of interest rates above, the interest rate cycle is very long. Alan Greenspan presided over a twenty-five year period of declining interest rates. Much of the increase in value of real estate is attributable to decreasing borrowing costs over that time. Inflation was relatively tame, so Greenspan always had the luxury of lowering interest rates to increase economic activity. Those days are gone.
When the interest rate cycle reaches bottom, the value of the currency declines, and cost-push inflation becomes an issue. As Americans want to buy products from overseas, it takes more and more dollars to do it because the currency is declining in value. Unless we get a commensurate increase in our exports (or cheap money from China), our standard of living will decline. During the cycle of rising interest rates, central bankers raise interest rates to combat inflation and protect the value of the currency, but they are always one step behind. When Bernanke finally does start raising interest rates, we will be embarking on the next multi-decade rising cycle where inflation is a constant problem.
If interest rates go on a sustained rise, financing home purchases will become more expensive. That is the math. The real question then is whether or not these rising interest rates are compensated for by rising wages. If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices will fall again. Given the choice between inflation and falling house prices, which do you think Bernanke or a future central banker will chose? After the all-out effort they have made to prop up house prices over the last several years, I suspect they will chose inflation, a devalued currency, and steady house prices over a strong currency and falling house prices.
So is current housing affordability an illusion?
I don’t think so. Any buyer (who can find a property) can lock in a low fixed-rate mortgage with a cost of ownership less than a comparable rental. That is real, tangible affordability. Sure it would be nice to pay less in total, but that isn’t the world we live in, nor is it likely to be in the foreseeable future.