What four factors really determine prices in the housing market?
There are four fundamentals that determine resale value: borrower income, allowable debt-to-income ratios, interest rates, and down payment requirements.
When economists write about the fundamentals of housing, they usually mention job and wage growth, both of which impact sales (of special interest to homebuilders), but job and wage growth don’t establishing the housing market’s equilibrium price level. Job and wage growth are only important in that they impact a borrower’s income, which is a true fundamental.
Fluctuations in supply and demand are not fundamentals either. Restricted inventory caused by loan modifications and denying short sales—the tactic lenders used to reflate the housing bubble—these manipulations temporarily disrupt the natural balance, forcing buyers to substitute down in quality and elevate prices above what they otherwise would be. However, once these props and manipulations are removed, a new equilibrium based on true fundamentals quickly reestablishes itself, as we saw in 2010 when prices went south after the tax credit stimulus was removed.
The purchase price of any property (and thereby the aggregate market) is based on four fundamentals:
- borrower income,
- allowable debt-to-income ratios,
- interest rates, and
- down payment requirements.
These variables are impacted by some other minor cost inputs, but for the most part, the variables above determine market pricing. Notice also that none of these four are often cited by economists or reporters for their true significance in establishing market pricing.
Payment is a direct link to borrower gross income. The allowable debt-to-income ratio applied to the borrower’s monthly income is the maximum monthly housing expense an underwriter will consider. From the maximum allowable payment, a lender will subtract taxes, insurance, and HOAs to calculate the total amount of the available housing expense applicable to debt service (PITI).
A bank calculates loan balances, payments and other important numbers based on borrower income. If the payment is known, lenders apply an interest rate and amortization schedule to calculate a loan amount.
Once the largest loan amount a certain level of borrower income can support is known, adding the down payment requirement to the loan amount equals the maximum amount a borrower can pay for a house. At that point supply and demand becomes important. Are there more buyers at these income levels than properties available? If so, then prices stabilize or go up. If there are fewer buyers than available property, then prices go down. But these minor fluctuations due to supply and demand are all tethered to the total amount borrowers can put toward buying a home.
Borrower gross income is the basis of all lending—or at least it’s supposed to be. With Stated Income (liar loans), income didn’t matter. It isn’t a mystery why liar loans went away first; they undermine the foundation of all lending—accurately measuring borrower capacity.
Wage inflation is the slow increase in aggregate wages over time in a given area. Wage inflation is a driver of price inflation because workers will use wage increases to bid up the cost of goods and services they demand. in a housing market, wage growth pushes up prices as follows: Assume a worker is earning $100,000 and can borrow $500,000 to bid on property in today’s market.
In one year, if this worker gets a 3% raise, he will be making $103,000, and if other terms do not change, he will be able to borrow $515,000. If he has also increased his savings, the amount he can bid on real estate has also increased by 3%. A property that might sell for $500,000 today can sell for $515,000 in one year and it is no more expensive in terms of its financial impact; debt-to-income, savings impact, time of amortization—the key variables remain the same.
This is “normal” home price appreciation.
The substitution effect
In a normal real estate market, people at each income strata compete with each other for available properties in their price range. If there is a shortage of supply, shoppers learn to settle for less. Rather than a 3/2, someone settles for a 2/2 with a den. A shortage of supply results in a lowered standard of living as people take the income they have and compete for what is available.
Assuming supply is sufficient—which in the long term it always is—the most desirable properties will be held by the highest wage earners, and the least desirable properties will be inhabited by the lowest wage earners. That is how markets work. Is there a fairer way to determine who owns what house?
The median income will control the median property over time, and the median home price should represent the median income applied to conventional financing metrics. When it doesn’t—and it doesn’t in many California markets—the lack of parallelism is caused by a chronic shortage of supply causing a downward substitution effect.
Allowable Debt-to-Income Ratios
The Allowable Debt-to-Income (DTI) Ratio is a limit lenders determine is the largest percentage of a borrower’s wage income they can pay before the borrower goes into default on the loan. Lenders allowed DTIs to fluctuate since the 1970s, intent on squeezing every available penny out of borrowers. Lenders permitted these higher DTIs ostensibly to allow customers to bid on more expensive homes, resulting in a higher equilibrium price for all properties in a market and a higher percentage of income that everyone puts toward debt service, hurting the economy.
Lenders sought ways to increase disposable income and service a higher DTI through innovative loan programs. Lenders developed the Option ARM, and together with eager borrowers, they used it to inflate The Great Housing Bubble. The moment lenders allowed customers to pay debt with increasing debt, it became a Ponzi Scheme, and it was doomed to crash. It’s amazing how large it became; hundreds of billions of dollars flowed into these Ponzi Scheme assets. The collapse of the subprime home mortgage Ponzi pyramid was a precipitating factor that lead to the financial meltdown of 2008.
The beauty of the arrangement was the sales pitch; borrowers receive a huge pile of spending money, pay less per month on their mortgage, and whenever they needed more, the California ATM house will magically refill itself with money through home price appreciation. It was self-reinforcing delusion used to hide a Ponzi Scheme beneath.
The idea is popular with bankers and customers alike; lenders underwrite larger loans, putting more money to work, and homeowners borrow and spend like maniacs. As a result, a large number of people who greatly over-borrowed. Many still struggle, and many walked away.
To prevent a recurrence of the housing bubble and the irresponsible lending and borrowing that rendered the banking industry insolvent, legislators passed the Dodd-Frank financial reform and capped back-end DTIs at 43% of borrower income. Will lenders circumvent this cap and inflate another bubble? Right now, it doesn’t seem likely.
Interest rates determine how much someone can borrow: the same payment at different interest rates produces significantly different loan balances. When lenders calculate the size of the mortgage a borrower can sustain, they plug in the interest rate and the maximum payment (calculated by applying maximum debt-to-income ratio to gross income). At low interest rates, this amount is quite large, and at high interest rates, the supportable mortgage balance is much smaller.
What happens when interest rates rise?
If mortgage interest rates rise back to historic norms of 8% or go even higher, it will be a catastophe. There is no question that higher interest rates make for lower loan balances: The math is inescapable.
At today’s sub-4.0% interest rates, borrowers can comfortably leverage over five times their yearly income. The 40-year average for interest rates is 8%; for the last 20 years, it’s still 6%. What happens if those interest rates return? 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. Hopefully, we’ve reached a permanently low floor in mortgage interest rates.
As is evident in 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. Unless rates go negative, those days are gone.
If interest rates go on a sustained rise, financing home purchases will become more expensive. 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 may fall again, or sales volumes may dry up.
Down payment requirements
Down payment requirements have traditionally been very high. During the 1920s, interest-only loans with 50% down payments were the norm, and very few people owned their houses. By the 1950s, conventionally amortized loans with a 30-year term and 20% down payments became the norm, and house prices rose significantly from the bottom of the Great Depression to the 1950s due to the increased use of leverage in real estate.
That is the end of the road for financial innovation. All further attempts to tinker with the stability of conventional financing failed because they were Ponzi Schemes. People require a reasonable expectation of paying off a loan in their lifetime, and multi-generational debt is frowned upon here in the United States, so any term beyond 30 years really doesn’t make sense. If borrowers feel like they will never pay it off, they will not try, and they fall into Ponzi thinking and borrow in terms of maximum debt service.
By 2005, Option ARMs and 100% financing left us with 0% down payments as the cycle reached its ultimate limitation—lenders were giving away free money. Not surprisingly, prices skyrocketed; unfortunately, the terms of the Option ARM were not stable and the Ponzi Scheme imploded. We’re back to the safe and prudent standards 1990s—and that’s a good thing.
The 30-year fixed-rate fully-amortizing loan is the only stable loan product, and a significant down payment is required to keep down speculation, with 10% being a reasonable minimum. As down payments get smaller, the incentives to speculate with lender money get larger. With no-money-down the incentive to speculate hits infinity. One-hundred percent financing with no qualification is a free-for-all no-limit housing market casino.
The four fundamentals of real estate are (1) borrower income, (2) allowable debt-to-income ratios, (3) interest rates, and (4) down payment requirements. Pay careful attention to what policies and market conditions impact these four variables, and you will have a deeper understanding of how prices are established and where the market is going. The rest is just noise.