May252016

Los Angeles County housing gets less and less affordable

Both rental rates and the cost of ownership rise faster than incomes in Los Angeles County due to an improving economy and a lack of housing supply.

housing_black_holeCalifornia inflated three housing bubbles over the last 40 years, and perhaps a fourth one inflates now. The collapse of each of the previous housing bubbles coincided with economic recessions, so many analysts incorrectly point to these recessions as the cause of the price collapse. The truth is that each of the previous bubbles inflated because lenders abandoned debt-to-income standards (1970s), experimented with toxic financing and relaxed DTI standards (1990), or completely lost their minds with “innovative” loan products (2000s). The coincidental recessions may have contributed to the problem, but they weren’t the cause, and in the last instance, the recession was an effect.

These bubbles inflate in California because the state endures a chronic lack of available housing supply. When the economy is good, businesses create jobs, which creates housing demand, but local jurisdictions reject proposals for new housing, so no few new houses get built to accommodate the worker with a new job. This causes people to substitute down in quality to obtain housing, and it forces the lowest rungs of the property ladder to put 50% or more of their income toward housing or leave the state.

The economy improves slowly but steadily in California, and although developers are providing more apartments, neither the apartment developers or homebuilders provide enough supply to match the demand; thus the cost of housing rises significantly.

L.A. families fall behind rising cost of living

Carrie B. Reyes

4.6 million of the Los Angeles metro area’s population of 8 million lives below an adequate standard of living, according to a recent report by the Economic Policy Center. In other words, over 57% of Angelinos do not make enough money to get by without outside assistance.

This study is more nuanced than other measures like poverty or affordability since it is extremely localized. An “adequate standard of living” is determined by family size and for the unique costs of everyday living expenses particular to an area. …

California is raising the minimum wage to combat this problem, but without more housing, raising the minimum wage will not be enough.

(See: Raising minimum wage enriches landlords in low-supply housing markets)Home_Not_So_Sweet_Home

What does this mean for Los Angeles’ housing market?

First, the housing expenses calculated by the Economic Policy Center are based on the Department of Housing and Urban Development’s (HUD’s) fair market rents. These are calculated based on real rents for dwellings at the region’s 40th percentile (so, 10% below average).

These calculations assume a single person is living in a studio apartment, a two adult household is in a one-bedroom apartment, and a two adult household with one or two children — like in our example — is in a two-bedroom apartment.

This is to say, if you’re an average four-person household looking to rent your shelter, $1,421 on rent in Los Angeles is a steal. Most families with multiple children are looking for three-bedroom apartments or single family homes. Further, if you’re hoping to get into a neighborhood with good schools, you’re going to encounter much higher rents to pay for this privilege. Thus, what the Economic Policy Center determines as adequate housing is truly nothing more — the housing is generically adequate. …

What happens when the gulf widens between rich and poor? More people are sifted from a previous middle class existence to a sub-adequate standard of living, joining the majority of Angelinos already struggling to make ends meet. …

There is a solution, but it requires change. It requires zoning to accommodate demand, allowing rents to drift down to a reasonable level in the most desirable areas where quality jobs and good schools are located. It also requires curbing speculator activity by instituting regulations to reduce short-term flippers and hit-and-run investors. This will bring more stability to the housing market, specifically fewer bubbles and corresponding bursts. These volatile market aberrations discourage potential homebuyers from entering the market, and further punish homeowners by plunging them into negative equity when the bubble invariably pops.

Of the three solutions above, only the first one, requiring zoning to accommodate demand, will help.

Rents will never drift down in the desirable areas. The best we can hope for is to bring enough supply to market to reduce the rate of rent increases to less than the rate of income growth. Over time if incomes grow faster than rent, housing becomes more and more affordable instead of the other way around.

Going after flippers is always an appealing target, but renovating low-quality housing is a vital function that shouldn’t be discouraged. If there were some way to prevent ordinary people from simply buying properties, sitting on them, and reselling them later for more money, that might help, but there is no good way to separate the wheat from the chaff.

Los Angeles County Housing Market Report: May 2016

Whenever either rental rates or resale home price appreciation exceeds 7%, my monthly reports show a downward sloping yellow arrow to signify that such rates of change are not sustainable. For the last several months, both rents and resales rose faster than 7% on a year-over-year basis.

OCHN_West_LA_Housing_Market_Report_2016-05

Rent and resale prices were relatively flat for eight to ten years during the 1990s, but since 2000, both rent and ownership costs rose faster than inflation, mostly due to the lack of supply. As such rates of appreciation are not sustainable, I anticipate another extended period of flat rent and resale price growth in the future.

OCHN_West_LA_Housing_Market_Report_2016-05

Los Angeles County home price appreciation during the reflation rally from 2012 to 2015 exceeded the rate of increase during the housing mania.

OCHN_West_LA_Housing_Market_Report_2016-05

Both rental rate increases and resale home price appreciation exceed income growth and are ripening for a correction.

The next California housing bust

Over the last eight years, credit quality has been pristine. Only the most qualified borrowers obtain mortgages, and lenders actually verify these borrowers’ ability to repay, something they failed to do during the last mania. The next housing bust, should we endure one, will not be caused by poor lending practices. This doesn’t mean California won’t suffer another housing bust, but if it does occur, it won’t be caused by poor lending practices like the last three busts were.

So what will cause the next bust? Assuming toxic mortgages don’t return and lenders continue sane lending practices, only three causes may precipitate another bust:Chinese_freedom_support_California_real_estate1

(1) repatriation of foreign investment,

(2) rising mortgage rates or

(3) an economic recession.

Exodus of foreign cash

The people who deny a real estate bubble in China are wrong, and the deflating Chinese property bubble could destabilize the world economy, but of greater interest to owners of Coastal California real estate, the deflating Chinese housing bubble could turn local real estate buyers into desperate sellers. The Chinese government could easily stop the flow of electronic capital by decree, and if they exercise this power to shut off the flow of capital leaving China for US real estate, it could cause a sudden and dramatic decrease in house prices.

(See: Chinese government policy change could kill Coastal California housing market)

Rising mortgage rates

enticedI suggested that the market reached a permanently low floor in mortgage interest rates. If mortgage rates were to rise, it would cause a dramatic decline in home sales because cloud inventory restrictions prevents owners from lowering their prices, causing so many problems with housing that the federal reserve would need to increase it’s bond purchase program (printing money) to lower rates to keep the housing market functioning.

If the federal reserve failed to act, and if mortgage rates were allowed to drift up to 5% or 6% or higher, we would endure a complete collapse in sales volumes and massive unemployment among homebuilders, realtors, and mortgage loan officers, causing house prices to fall again, exposing banks to tremendous losses. Given those problems almost certain to accompany higher rates, it simply won’t be allowed to happen — even if that means the federal reserve buys every mortgage in America.

Economic recession

The next correction in California house prices (call it a bust if you like) will be caused by an economic downturn. Previously, such a downturn would lead to foreclosures, and the must-sell inventory would push prices down. That won’t happen next time because lenders mastered the art of loan modification can-kicking, so they would amend-extend-pretend their way through any recession. Therefore, any future downturn will be a long, slow grind similar to the bust of the early 90s.rising-rates-sales-prices

The downturn will be caused not by foreclosures, but by the lessening of the downward substitution effect. Both rental rates and resale home prices are high and rising faster than incomes because the shortage of supply is forcing people to settle for less. Take away the demand pressure, which a recession does, and both rents and resale home prices stop rising, and if the recession is deep enough, prices go down.

In fact this phenomenon is most acute where the supply is most limited. The most volatile rents occur in the Bay Area because highly-paid tech engineers bid up rents while times are good, and they leave town when the venture capital flow stops. The same is true in Los Angeles too as evidenced by the wild swings in both rent and resale prices in the charts above.

I don’t believe the next housing bust will show dramatic declines in resale prices like the last bust because borrowers are more secure and lenders are more adept at handling troubled borrowers. Plus, resale prices haven’t departed long-term fundamental measures yet either. Depending on the depth of the recession, rents and resale prices may both go down, and that’s what the next housing bust will look like.

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