The inner workings of house prices and housing markets (redux)

Californian’s believe house prices go up by magic. Real estate appreciation is religion in California as people blindly accept the Truth of never-ending price increases. Few question current prices or wonder why current pricesgo up as most fool themselves with wishful thinking, cockeyed optimism, and kool aid intoxication. Most people do not understand real estate prices — they think they do — every Californian is an expert on real estate, after all, we have about half a million realtors, but few people really understand markets. Motivated by greed, blinded by ignorance and enabled by lenders, borrowers inflated The Great Housing Bubble.

A foundational understanding of house prices and housing markets is critical. From 2003 onward, with exception of those who purchased houses with conservative financing, which was rare, most buyers bought in ignorance. Some were undeniably stupid and irresponsible, but most were simply ignorant going with the herd believing everyone couldn’t be wrong. Well, they were wrong, and the errors they made are easily identifiable and correctable with a better conceptual understanding of house prices and housing markets.

My understanding of housing markets permeates my posts, but the foundational work upon which I base my posts comes from my education and experience — something unique to me and heretofore undocumented; consequently, this post lays down foundational concepts of house prices and housing markets for future reference.

Three primary variables determine house prices

House prices are set by supply and demand in the market, but demand is arguably more important because house prices cannot rise higher than buyers’ abilities to pay. Therefore, this discussion will focus first on demand, then on how supply impacts prices set by market demand.

The three variables directly responsible for determining house prices are (1) savings, (2) interest rates and (3) allowable debt-to-income ratios. A buyer’s ability to bid for real estate is limited by their savings (and their willingness to put savings toward housing) and their borrowing. Amounts borrowed depend on interest rates and underwriting standards. Of the various loan underwriting standards, the most important is the allowable debt-to-income ratio because it is the direct link between income and the loan amount.

Notice that borrower income did not make the list, at least not directly, because borrower income is only important to the degree it is applied toward making debt service payments. The allowable monthly payment when amortized over 30 years at current interest rates yields the borrower loan balance. The current price-to-income ratio distortion is caused by the combination of very low interest rates and very high allowable DTIs. As I noted in, House Prices Will Decline in 2010, prices can fall even when interest rates are low if lenders simultaneously reduce allowable DTIs. In fact, the credit crunch which began in August of 2007 is crushing the housing market due primarily to declining allowable DTIs. The credit crunch is not over, and IMO, aggregate DTIs have not bottomed for this cycle.


Borrower income is important because it serves as a measurable base for market demand. Aggregate incomes rise with economic growth and inflation, and since income plugs in to the house price equation through the allowable debt-to-income ratio, house prices rise in concert with local incomes. Over the long term house price appreciation and income growth must move together; trees cannot grow to the sky.

A Buyer’s budget

Each prospective buyer investigates current financing terms as part of their process. Lenders apply current underwriting standards and determine the loan balance they will approve and downpayment required before they will fund. Since loan plus downpayment equals maximum bid amount, prospective buyers house-shop with the budget established for them by their lender. As is human nature, most people spend their full budget.

Every buyer goes through this basic process, and since financed purchases dominate the resale market, price levels of individual properties become tethered to the incomes of individuals who desire that property. If high wage earners suddenly became enamored with living in condos, prices would rise substantially. The substitution effect to similar resale and rental properties keeps income, price and quality in balance.

Link to Census data table for Irvine

Irvine has a large number of high wage earners, and its income distribution is not as “downward tilting” as other cities. As a result, wage earners at the mid to high end tend to settle for less in Irvine than they could obtain in other markets because the product in Irvine is not McMansion dominated. The opposite exists in cities like Palmdale where a sea of McMansions trickles down to the maids and field hands at the bottom of the income distribution.

High wage earners can both borrow more and save more of their disposable income. Also, high wage earners are generally long-time wage earners who probably already own a home, so in addition to their formidable saving power, many high wage earners also transfer stored equity from one property to the next, assuming they did not spend it.

A distribution of prices based on income

If you take the income distribution for Irvine, apply conservative underwriting standards of four-times income, a reasonable downpayment and an allowance for stored equity, the resulting distribution of housing prices looks like the chart below.


So why doesn’t our market look like that? Well, to a large degree, it does, although low interest rates and residual bubble inflation has increased the above numbers to an unsustainable level. In addition, the current market is mismatched between the number of people capable of supporting house prices and the number of houses for sale at various price points.

For instance, according to the data, about 22,000 of our 69,000 households can support prices over $750,000. That is 32% of the market. When more than half of Irvine properties have comparable values sustainable by less than a third of the population, something has to give. If you look at what is for sale, over 40% of listings are over $750,000, and as we know, much of this market is tied up in Shadow Inventory.

As inventory is released at the mid- to high- end, prices of individual properties will decline, but the median will not. People will still spend the same amount on housing, but they will get more for their money. That plus the changing mix from low to high will make the median less reliable. Just as the median has overstated the decline to date in most markets, it will show strength later where only weakness exists. If mortgage interest rates do not rise, the story of 2010 may be a rising median with continually falling prices on individual houses.

Demand, supply and football

Demand is measured by a borrower’s ability to put money toward real estate, and contrary to popular belief, desire is not demand. Excess supply lowers base market prices established by demand. To better illustrate this concept, consider the following football analogy:

Sellers (supply) are blitzing linebackers and buyers are offensive linemen. If more linebackers blitz than offensive linemen block, then the offense gets thrown for a loss. If more sellers want to sell than buyers want buy, then prices decline; buyers have to be enticed from the sidelines. However, if enough offensive linemen pick up the blitzing linebackers and push the scrum forward, the offense advances the ball. If buyer demand exceeds seller offerings, prices go up as sellers have to be enticed from the sidelines.

In football, the offense generally advances the ball just as buyers generally advance prices with their rising incomes. However, in football, each team is limited in the number of players. In housing markets, no limit exists which can create enormous supply and demand imbalances. When subprime lending took off, we sent hundreds of offensive linemen on the field, and they pushed prices across the goal line. Now, we have a much smaller and leaner offensive unit facing a defense composed of the zombie debt holders who previously were celebrating in the end zone.

Lenders are ordering linebackers not to blitz to prevent further losses, but the number of linebackers building on the defensive side of the ball ensures the offense will not be advancing the appreciation ball very far (imagine being the running back buried in the picture). Such is the nature of overhead supply — banks may hold on to properties to prevent a loss, but they will sell swiftly if they can get out at breakeven, and realistically, being an unruly group of zombies — cartels are inherently unstable — a few linebackers are going to blitz anyway.

It starts at the bottom

The entry level buyer utilizing only their savings plus a loan is the foundation of the housing market. If you follow the chain of move ups backward, it eventually leads to the entry level buyer, and as a result, nobody in the real estate market gains move-up equity until the entry level buyer does. If owners of entry level properties do not gain equity over time due to price declines or stagnation, they do not have the equity necessary to move up, and neither will any other seller in the move-up equity chain.

I want to be careful here because the equity move-up market does not function like most people think it does; buying a home is not the first stop on the equity train leading straight to a Laguna Beach mansion. Each step up also requires an increase in income to support a larger mortgage. With each step homeowners transport their equity — at least those who did not spend it through HELOC abuse — and bid up prices on the next property rung. Over time this produces significant stored equity in neighborhoods most desired.

During the rally of the Great Housing Bubble, subprime financing doubled or tripled the borrowing power of the entry level buyers. Rich Toscano pointed out (sorry, I can’t find the link) housing prices in San Diego rose $250,000 across all property classes in 2004. If you add $250,000 to the average loan balance of your move up buyer, the owner selling that entry level property just received a $250,000 windfall they can use to bid up prices at the next level. This reverberates through the entire system and inflates housing bubbles.

Move-ups must come down

If you examine the three main sources of buyer funding; loan, savings and equity; all three have been under pressure since 2007, and this trend will continue.

Loan balances have been getting smaller because lenders had to go back to rational underwriting standards. Incomes only supported about 50% of the average loan balance in 2006, and the greatest single cause of lower house prices, by far, has been smaller borrower loan balances. The Federal Reserve temporarily helped by lowering interest rates, but mortgage interest rates will almost certainly rise making future loan balances even smaller.

Personal savings rates went negative during the bubble, and much of the reason for our current economic contraction is that people stopped spending and started saving again. With the long term erosion in savings rates experienced during the bubble, fewer borrowers have sufficient savings to buy a home, and those that do have savings have less of it. The result is smaller downpayments — at least outside of Irvine.

Equity has been declining because during the bubble, everyone spent it, and after the bubble, everyone lost it. I have documented on numerous occasions the perils of mortgage equity withdrawal and HELOC abuse. Equity has been crushed by falling prices since 2006 with exception the delusional high end where move ups terminate. The foundation of the housing market is crumbling from below, and only the lack of transaction volume sustains high-end bubble equity. With equity disappearing at the bottom of the market, the high end has nobody to sell to but each other. There is a limit to how many properties even Nicolas Cage can own.

What is required for a healthy real estate market?

The low end of the market is resetting. Based on payment affordability, it is inexpensive to own a low-end Irvine condo like today’s featured property. Prices may go down further as interest rates rise, but payment affordability on these low-end condos is at a bottom. That is a good thing because until these condos find a pricing bottom, the housing market is doomed. There is no chain of moves ups when there is no equity.

Before there will be a sustainable market recovery, we need (1) entry-level units like these to find a pricing bottom, (2) unemployment to go down, (3) wages to go up, and (4) people to start saving. We may be finding a bottom at the low end (I still have doubts), and savings rates are improving, but the savings baseline is zero, unemployment is still rising, and wages are still stagnant. We do not have the building blocks of a sustained housing market price recovery. When the stars and the moon align, loan balances expand, downpayments enlarge, and move-up equity accumulates; those are the three essential elements of an appreciating market.

Once we return to sanity after a few more years of decline and clean up, lenders will be responsible (which worries me) to ensure the growth of loan balances never again exceeds our collective ability to pay. Everyone enjoys the ride up, but once we cross the threshold of insolvency, the market collapse is truly devastating. Let’s not do it again.