Real Estate’s Lost Decade
Japan simultaneously inflated massive financial bubbles in real estate and stocks during the late 1980s. The slow deflation of this bubble and the general economic malaise that impacted Japan during the years that followed became known as the “Lost Decade.” The United States is facing a similar set of circumstances in the aftermath of the Great Housing Bubble. So far, we have been following the same policy actions as the Japanese did. Perhaps our officials have come to believe a Lost Decade is preferable to the next Great Depression.
Today, I want to demonstrate how easy it would be to have a similar result in our own housing market. By lowering interest rates to artificially low levels, the Federal Reserve hopes to stabilize the housing market; however, weaning the housing market off these subsidies will need to be a slow process to prevent real estate prices from taking another nosedive. Gradually increasing interest rates back to long-term norms will result in an erosion of buying power that prevents price appreciation. I want to be clear about the implications of this; we are not looking at a decade to get back to peak prices, we are looking at a decade of stagnate prices at the bottom. Real estate will not reach peak prices until 2032.
The Lost Decade
The chart above shows median home prices in Irvine stabilizing at $450,000 in 2010 as interest rates bottom at 4.5%. To calculate a median home price, I needed to make assumptions about incomes, allowable debt-to-income ratios and interest rates.
The example above uses the most recent Irvine Median Household Income Data. At the end of 2007, the median household income in Irvine was $91,101. Due to the recession, I have assumed this will also be the median household income at the end of 2009. It might be higher; it might be lower. The historic rate of income growth between 1980 and 2007 is 3.6%. I assume that median household income will again increase at this rate starting in 2010. By 2019, this figure reaches $129,500.
The recent bailout legislation passed by Congress is a combination of workouts and government buy-downs to get borrowers debt-to-income ratios down to 31%. Previous bailouts failed because they only got the borrowers debt-to-income ratios down to 38%. The FHA has long term records showing 31% is as high as this ratio can go without significant increases in defaults. I have assumed debt-to-income ratios will be limited to 31% going forward. Also, I have assumed 30-year fixed-rate conventional financing; exotic financing will not be coming back any time soon.
The Federal Reserve’s policy of “quantitative easing” (aka printing money), is an attempt to drive down long-term interest rates like those for home mortgages. If the FED is successful–and for the short term they probably will be–mortgage interest rates could drop as low as 4.5%. The average interest rate since the early 1970s when the GSEs started keeping records is 8% (7.99% actually). I further assumed interest rates will rise once this economic crisis is over from an unprecedented 4.5% to the long term average of 8%.
I used Microsoft Excels handy solver tool to calculate the interest rate required to keep prices stable while incomes grew. The interest rate chart above shows interest rates going up about 35 basis points a year for 10 years. This puts interest rates back to historic norms of 8%. If interest rates can be eased upward at this controlled rate, and if incomes rise again at their historic 3.6%, prices will stabilize at $450,000 in 2009, and they will stay there for 10 years. After 2019, incomes have caught up with 8% interest rates, and prices begin to appreciate at 3.6% a year to match income growth.
In my opinion, this is a realistic outcome. Eventually interest rates have to go back up. When this crisis is over, the money the FED is printing will cause inflation to return. The Federal Reserve will need to raise interest rates to control inflation. If they do this too quickly, it would take the floor out from under home prices, and despite a high level of general price inflation in the economy, house prices would resume their descent.
When you look at these charts collectively, it suggests the Federal Reserve may allow inflation at levels higher than what is normally desirable for several years after this crisis is over. This will help the Federal Government inflate away much of the debt it is taking on with its stimulus spending, and it will keep a floor under asset prices, particularly housing. Note that asset prices will not be increasing. The consumer price index may increase significantly, but house prices will not budge. Also when you consider the impact of the long-term foreclosure crisis in real estate due to the resetting of adjustable rate mortgages, the FED has incentive to keep rates as low as possible for as long as possible, and house prices have resistance to upward movement.
It is difficult to be bullish with these market conditions. How exactly would prices go up? Will interest rates stay at 4.5% permanently?
- People can only increase their bids if lenders give them the opportunity. Rising incomes provides the ability to bid prices higher, but only at the rate of rising incomes. The long-term average is 3.6 %, not exactly rampant appreciation.
- Another way people can raise bids is if they increase their debt-to-income ratio, and lenders must allow this in their underwriting. With the history of defaults with DTIs over 31%, it doesn’t seem likely that lenders will be relaxing this parameter any time soon.
- Another way buyers can raise their bids is through using exotic financing; we all know how that turned out last time. I don’t see Option ARMs going to Subprime borrowers without verified income happening again, do you?
- The final way people can raise their bids is to settle for less. Personally, I will not buy a tiny 1/1 condo like today’s featured property when I can rent a nice 3/2 SFD.
If my assumptions are correct, and if events unfold as I have outlined, prices will bottom over the next couple of years, and they will stay there for a decade while both incomes and interest rates slowly increase. The “Lost Decade” that the Japanese experienced is not just realistic, it is perhaps a best-case outcome.