Will the high cost of FHA financing derail the housing recovery?
First-time homebuyers are the foundation of the housing market. Move-up buyers need first-time homebuyers to purchase their property to provide the equity to make the move up possible. With the collapse of toxic loan products from the bubble, first-time homebuyers suddenly needed to have qualifying income, and that income would only be applied to conventionally amortizing mortgages. As a result, loan balances cratered, and house prices went down with them.
To prevent further declines in mortgage balances, the federal reserve lowered interest rates to near zero and embarked on “operation twist” to bring down mortgage rates. In the process they have caused the cost of ownership to decline precipitously, at least for buyers putting twenty percent down. My reports show this conclusively. However, when I calculate the cost of ownership, I assume a 20% down mortgage with no private mortgage insurance. That’s not how first-time homebuyers generally enter the market. With high prices, 20% down is a huge barrier to home ownership, and first-time homebuyers flock to FHA loans because it’s the only way they can stretch their meager savings enough to get a home.
Unfortunately, FHA financing carries a big cost. In Friday’s post FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium, I measured the cost of this insurance, and it is having the opposite effect of lower interest rates. In fact, the cost of FHA insurance makes the effective interest rate a whopping 50% higher. Houses are more affordable than ever for someone putting 20% down, but for the first-time buyers who aren’t, affordability is average at best. And since the market must look to first-time buyers for stability, rising FHA insurance costs are pushing prices out of reach for first-time homebuyers.
Home prices have been rising steadily for the past several months, but some fear the rapid increase could actually start hurting the housing recovery.
The reason is that the rise in prices is mainly due to investors, mostly large hedge funds, that have been swooping into the most distressed markets and inhaling properties as fast as their plentiful cash will allow. They are turning those properties into rentals, and getting anywhere from 8 to 12 percent returns on their investments, thanks to still hot demand. The trouble is, as home prices rise, those returns shrink.
“The worry with investment demand is that the very recovery in prices that it is driving will eventually reduce rental yields and undermine the investment case,” warns Paul Diggle of Capital Economics.
Hedge funds will stop buying once prices rise high enough that cashflow returns aren’t enticing. Hedge funds don’t purchase as a speculative play on appreciation. They all project appreciation into their returns, but since that money is years into the future, what really drives their activity is current cashflow. In fact, the biggest worry among these investors is that their appreciation projections won’t turn out as planned. They plan to sell these houses to first-time homebuyers and those who’ve repaired their credit. But since these borrowers will almost universally use FHA financing, they may not be able to leverage enough to buy out the hedge funds at prices they hope to see years from now.
Today’s housing recovery, much like the recent crash, is like no other. While home prices fell nationally for the first time in history, they are recovering locally at drastically different paces. Some markets are still in the red, while others are surging forward with double-digit gains. Those that are seeing the biggest jumps are largely the markets that saw the deepest losses. Witness Phoenix home prices up over 20 percent from a year ago on the S&P/Case-Shiller home price index. The huge influx of investors there shrunk inventories and created bidding wars, hence the price gains.
But even outside those hot markets, this national housing recovery is dependent on investors, who are largely all-cash buyers. The mortgage market is still too restrictive to support the kind of bulk-buying that needs to occur, and many potential buyers either lack the credit scores or the confidence to jump in. Another 14 million borrowers still owe more on their mortgages than their homes are worth, according to Zillow, and are therefore unable to move.
Five million properties are either in the foreclosure process or their owners are delinquent on their mortgages. That means foreclosures will remain elevated for the foreseeable future, and investors will be necessary to absorb them.
And investors will remain as long as cashflow values make sense. Many of the markets that did well this year may flatten in 2013 as investor activity wanes. Without sufficient product and without prices that produce returns, these investors simply won’t buy.
Another concern is that home prices are rising faster than income, which could push potential owner-occupants away just as they were starting to dip their toes in again.
The risk of sales dropping as investors leave is obviously higher in the markets that saw the biggest drop in home prices during the crash, again, like Phoenix. Other markets, such as Chicago, Atlanta, and even parts of Florida, where prices are still weak and distress is still a large share of the market, are still seeing improved sales, as investors shift their sights and cash to more yield-worthy ground.
Investors are not the final answer. They are a stopgap measure that will prevent the low end of deeply discounted markets from falling further. They are primed to be the source of capital recovery for the banks when they finally get around to processing their upcoming foreclosures. Ultimately, these homes need to be sold to owner occupants, and the high cost of FHA insurance will serve to keep them from bidding prices much higher in these markets, despite how undervalued they may look to those with 20% down.
Current homeowners are finally moving up, and distressed sales are making up less of the overall market—all signs of much-needed improvement in housing.
Homeowners accounted for 54 percent of October’s non-distressed market, up from 50 percent in June, according to a new survey by Campbell/Inside Mortgage Finance.
This as the share of non-distressed sales surged to 64.7 percent, up from 55.7 percent as recently as February.
Unfortunately, first-time home buyers are seeing just the opposite, largely left out of this surge in sales and prices. Their share of the market, usually up in the 40 percent range historically, fell to 34.7 percent in October, the lowest in the Campbell/IMF survey’s three-year history.
The National Association of Realtors put their share even lower, at 31 percent.
Without first-time homebuyers, the recovery will not be sustained. Prices will flatline just above levels the hedge funds are willing to pay, and prices will stay there until first-time homebuyers return to the market with sufficient income to borrow more and push prices higher.