The most ignored homeownership costs: property taxes, insurance, and HOAs
Other necessary costs of ownership consume a quarter to half the amount borrowers could potentially put toward loan payments.
When lenders calculate how much they are willing to loan to any particular borrower, they measure the borrowers income from wages and other sources and calculate how much of that monthly income is available to pay the debt.
One limitation on borrowing is the front-end ratio, generally 31% of verifiable gross income. Lenders assume that a borrower can afford to spend 31% of their gross income on all housing related expenses and still have enough money left over to pay all other obligations and have a life. This 31% is called PITI, or principal, interest, taxes, and insurance.
The lender is primarily concerned with principal and interest because this is the money coming back to them after they make the loan; however, they need to make allowances within the 31% maximum for property taxes (including special taxes like Mello Roos) and insurance. These expenses (1) reduce borrower payments to the lender, (2) reduce the amount they can borrow and bid, and thereby (3) reduce the value of real estate.
Property taxes have long been a source of local government tax revenues. Real property cannot be moved out of a government’s jurisdiction, and values can be estimated by an appraisal, so it is a convenient item to tax. In most states, local governments add up the cost of running the government and divide by the total property value in the jurisdiction to establish a millage tax rate. California is forced to do things differently by Proposition 13 which effectively limits the appraised value and total tax revenue from real property. Local governments are forced to find revenue from other sources.
Proposition 13 limits the tax rate to 1% of purchase price with a small inflation multiplier allowing yearly increases. In California, the first half of regular secured property tax bills are due November 1st, and delinquent after December 10th; the second half are due February 1st, and delinquent after April 10th each year. If the delinquent date falls on a Saturday, Sunday, or government holiday, then the due date is the following business day.
One of the problems with Proposition 13 is that two nearly identical houses with similar real estate values can pay taxes at very different rates. For example, if a homeowner bought in 1978 and locked in that tax basis, their taxes would be a small fraction of the tax bill from a neighboring house purchased today. What justifies one neighbor enjoying a drastically lower tax bill than another?
This becomes particularly problematic when the long-time homeowner with a low tax basis has refinanced their mortgage multiple times. At each refinance, the borrower had an appraisal — an appraisal they agreed with — that established the house was worth much more than the value on which they are taxed. Since the homeowner has expressed a tacit agreement with a higher value, why shouldn’t they be taxed at that value?
Automatic re-assessment for cash-out refinancing
An idea emerged from the aftermath of the housing bubble; limit HELOC abuse by making cash-out refinancing in excess of the original purchase price an event that triggers property tax re-assessment. The effect is to drive up the cost of borrower money and discourage the behavior. It would probably be very effective.
The lenders would cry foul, and in particular there may need to be an exception for reverse mortgages to accommodate seniors (I think reverse mortgages are a bad idea, but forcing retired people to leave their homes is probably worse). Despite the resistance, the legislation if passed would curtail HELOC abuse, but in an economy dependent upon Ponzi Scheme financing, such legislation is unlikely.
Municipalities would love the idea because their revenues would grow as long as there are Ponzis.
Proposition 8: hurting peak buyers
Despite widespread delusions to the contrary, real estate prices do go down, and when they do, property taxes go down with them. But there’s a catch: those that buy when prices are low get the locked-in lower basis, but those who bought at higher prices will see their tax bills go up once again.
What Proposition 8 giveth, Proposition 8 taketh away. California tax code section 51(e), enacted at the same time as Proposition 13, requires the tax assessor to annually adjust tax levies based on current full-market value. This was great when property values were falling and property tax bills fell dramatically. Now, property taxes are set to jump back up for homes bought during the bubble years.
Mello Roos Taxes
In the calculations on this site, I classify Mello Roos as “other taxes and assessments” because Mello Roos fees are paid through your tax bill. To understand how this became a tax you pay, a brief overview of the Community Facilities District Act is in order (What is Mello Roos?.pdf). From Wikipedia:
A Mello-Roos District is an area where a special property tax on real estate, in addition to the normal property tax, is imposed on those real property owners within a Community Facilities District. These districts seek public financing through the sale of bonds for the purpose of financing public improvements and services. These services may include streets, water, sewage and drainage, electricity, infrastructure, schools, parks and police protection to newly developing areas. The tax paid is used to make the payments of principal and interest on the bonds.
Mello-Roos is deductible in some cases but not in others.
That is the textbook version, now I will give you mine. Imagine you are a real estate developer, and you have a parcel of land that would be worth $10,000,000 if it had infrastructure installed; unfortunately, you do not have the money to install this infrastructure and wait for the investment to come back to you in land or home sales.
What if you could take out a 30-year mortgage on your infrastructure improvements and borrow the money? Now you can finance the deal and develop the land, but there is still a problem. How do you get the homeowner to pay off the infrastructure mortgage after they buy the house?
The solution elected officials came up with was to create a special tax district so the repayment of the bonds to fund the infrastructure is bumped up the payment priority list. In short, you can’t avoid paying Mello Roos, or the tax man will be after you, and he has the power of foreclosure, though it is seldom used.
For those of you that are homeowners, the next time you write that check for Mello Roos, realize that you are paying down the loan for the infrastructure around you. You didn’t think the developer absorbed those costs, did you? That would cut into profits.
Realistically, Community Facilities Districts do encourage private development by making marginal projects feasible. It keeps development in the hands of private individuals rather than municipalities developing their own roads, streets and utility systems. To the degree you believe these results are desirable, you should support Mello Roos.
Without the ability to develop marginal projects, supply is always lagging behind. The Community Facilities District Act does encourage development to lead into growing markets and blunt the impact of supply shortages. Despite the additional supply this law puts on the market, it has failed to prevent housing bubbles.
Determining Mello Roos
Property taxes and Mello Roos fees are deducted from a borrower’s available income to service cashflow, and thereby it reduces the amount they can finance. In essence, there is already a 30-year mortgage on the property you must pay off — your portion of the Mello Roos — so the purchaser money mortgage must be paid with left-over funds.
Builders and developers both know the impact of Mello Roos, so builders will pay less for lots with high Mello Roos fees because they know they will have to discount the purchase price of the final product in order to qualify any buyers. Developers want the Mello Roos fees to be as high as possible because the higher the fees, the greater the bond revenue developers receive. Builders want the Mello Roos to be as low as possible to give them competitive advantage. The resulting compromise usually puts Mello Roos at between 0.5% and 0.8% of total value.
The good news with Mello Roos is that the fees are fixed. As house prices go up, the Mello Roos fees become less burdensome to later buyers. If the Mello Roos are set at 0.8% of an initial $200,000 sales price, the same figure represents only 0.4% of a $400,000 resale price. Of course, the reverse is also true.
When the Irvine Company first opened Woodbury and Portola Springs, they were priced to the peak and they had maximum Mello Roos. Now that houses are selling for lower price points, the Mello Roos start to become onerous. If the original sale price of a condo was $400,000, and the Mello Roos were 0.8% of value, if the condo resells for $200,000, the Mello Roos now represent 1.6% of the purchase price. That is a stiff property tax bill by California standards.
Homeowners insurance protects the property owner against loss. It’s nearly always required by lenders because they want to protect the value of their collateral if they should need to foreclose on the property. Even if a lender doesn’t require it, the risk of catastrophic loss makes such insurance a necessity even for those who pay cash. Who would want to lose half a million dollars or more in a fire?
A standard policy insures the structure and documented personal property within. In addition, the package policy covers liability and legal responsibility for property damage caused outside the home itself by the owners, the members of the owner’s family, and even the family pets. Disaster damage is included, but this carries some exceptions, most notable here in California is earthquake damage, but damage due to floods and poor maintenance are also excluded. Separate policies can be purchased to cover earthquake and flood damage, but these policies can be quite costly.
Homeowner Association Dues and Fees
Many modern planned communities have homeowners associations formed to maintain privately owned facilities held for the exclusive use of community residents. These HOAs bill the owners monthly to provide these services. They have foreclosure powers if the bills are not paid.
HOAs are given the authority to enforce the covenants, conditions, and restrictions (CC&Rs) and to manage the common amenities of the development. It allows the developer to legally exit responsibility of the community typically by transferring ownership of the association to the homeowners after selling off a predetermined number of lots. Most homeowners’ associations are non-profit corporations, and are subject to state statutes that govern non-profit corporations and homeowners’ associations.
California has many problems with condo associations that are poorly managed. These associations often underfund their reserves creating potential for costly assessments. This information can be difficult to find and analyze prior to a purchase. HOAs only provide their financials to potential buyers who are already in escrow, and these documents often appear at the last minute preventing any meaningful analysis. Even in circumstances when the documents are provided in a timely manner, most novices lack the time or sophistication to decipher the reports. Further, since these documents come so late in the process, many buyers who do discover problems end up going through with the transaction anyway because they are emotionally invested in the property.
These costs add up
The impact of these costs can be significant, and since they subtract from the amount available to pay the mortgage, these costs have dramatic effect on loan balances and thereby market prices. Just how big is this effect? Take a look at any of the properties on this site, and you can see the calculations for yourself. By and large, about a quarter to a third of PITI goes toward these costs, and on properties with high HOAs, this number can exceed 50%. Have you ever wondered by properties with high HOAs seem like relative bargains compared to similar properties with low HOAs? This is why.