Nov152016

Will the current real estate cycle end before the remote suburbs recover?

The housing cycle probably hasn’t reached a turning point because the far-flung suburbs haven’t recovered yet.

The old real estate adage says “you drive until you qualify.” Potential homebuyers substitute to far-flung suburbs (exurbs) because high house prices push them away from more desirable markets closer to employment centers. Basically, if people drive far enough, they will find a house they can afford. This phenomenon causes many California homeowners to endure brutal commutes.1391004432503283

The cost-push substitution effect explains why recoveries start in the most desirable neighborhoods closest to employment centers and radiate outward to the exurbs. In past recoveries, the most distant commuter markets fully recovered and even participated in the subsequent bull run (bubble cycle). One notable difference between this recovery and previous recoveries has been the slow rate of home price appreciation in far-flung exurbs.

Experts posit two competing explanations for this change. Each explanation says something about consumer behavior and where we are in the current real estate cycle.

One school of thought says that the Millennials simply balk at participating in the housing recovery. After all, they witnessed the housing bubble and bust, and the prospect of losing hundreds of thousands of dollars like the previous generation frightens them. They don’t believe that real estate always goes up, so they refuse to sacrifice their lifestyle and happiness to assume an enormous debt and a soul-crushing commute for the benefit of homeownership. The emotional cost exceeds the emotional benefit.

caddyshack_turd_ihbEvidence exists to support this theory. Millennials react to real estate price changes far differently than previous generations. Rising house prices excited the Boomers and Generation X who thought they would make a fortune on appreciation; however, Millennials recoil at high home prices, mostly because they witnessed how poorly chasing home price appreciation turned out for their forefathers.

Further, first-time homebuyer participation is near record lows, demonstrating that Millennials turned their backs on home ownership during this recovery. Debates still rage as to whether this demur is a permanent shift in consumer preference for ownership or a temporary delay in homebuying caused by high student loan debt, underemployment, low wages, and delayed marriage. It could be either alternative, and it might be a blend of both.

The Millennial generation currently enters the peak homebuying years of their lifecycle. If they permanently shun homeownership, the current recovery will weaken and sputter. If they embrace homeownership and move to the suburbs like previous generations, then the recovery is in its infancy.i_want_to_believe

I believe we are still early in the recovery, and evidence supports this conclusion.

First, the cost-push substitution effect hasn’t forced potential homebuyers out to the exurb markets, and the cycle will not mature until those markets recover. I favor this explanation because it’s simple, it comports with past experience, and it doesn’t posit a drastic change in buyer behavior. Most parents resist raising children in apartments, and those with the means to buy a house rarely choose to remain in an apartment. Some may opt to rent single-family homes, but the urge to own is primal, and the bust didn’t change human nature.

Also, since Dodd-Frank effectively banned affordability products, the nature of the real estate cycle changed. Back in mid-2013 many markets bounced off the ceiling of affordability. In the past, buyers utilized affordability products to push prices higher and sustain sales volume. Instead, without these unstable loans, home price appreciation leveled off, and sales volumes plateaued, slowing to a rate commensurate with job and wage growth.

For all the criticism of Dodd-Frank, the intended effect was to stabilize the housing market, and it succeeded. By sacrificing short-term price increases and sales volume that accompany the proliferation of affordability products, Dodd-Frank changed the housing cycle. Real estate will still have ups and downs along with the business cycle, but prices won’t rise and fall nearly as much, though sales volumes will be much more variable.

Dodd-Frank lengthens the real estate cycle by eliminating the instability. For those skittish about where we are in the current cycle, take comfort. Dodd-Frank made it harder to close deals, but it also ensures those buyers are stable and that the market keeps chugging along.

Inland Empire Valuations

These markets trade at steep discounts to their historic norms.

inland-empire-rental-parity-2016-11

The above map clearly demonstrates that the high desert communities of Adalanto, Apple Valley, and Victorville are deeply undervalued as are the east desert communities of Palm Desert, Rancho Mirage, and surrounding areas.

The substitution effect hasn’t pushed homebuyers out to these communities yet, so homebuilding activity is muted; however, investors and developers should investigate these areas because the cycle probably won’t end without a recovery in these areas. Home prices should bounce back to their historic norms.