May072007

Your Buyer’s Loan Terms

bring_back_ the_bubbleOver the last several years, buyers have not concerned themselves with the day they were going to become sellers. Why would they? There was an endless demand for properties, and buyers were going to pay whatever was asked. Those days are gone. They are not coming back any time soon.

In one of my first posts, I talked about Financially Conservative Home Financing. There has been much discussion on these boards about the high debt-to-income ratios and adjustable rate mortgage terms now required if you chose to buy in today’s market. For anyone considering buying a home right now, I would like you to think about the buyer who is going to buy your home from you at some point in the future, and more specifically, what debt-to-income ratio and loan terms will this buyer utilize. This is important, because the amount of money this take-out buyer will pay you for your home is completely dependent upon these variables. Your house is only worth what your buyer can pay for it. For you to get out at breakeven or better, your take-out buyer must be leveraged more aggressively than you are, or you must wait for fundamental valuations to catch up to today’s pricing. In this post, I will examine both scenarios, and I will present a range of valuations for homes based today’s income and prospects for the future.

Fundamental Valuations

As a primer, please read How Inflated are House Prices? In that post I discuss a simple method to calculate a house’s fundamental valuation. In short, 160 times the monthly rental rate is a useful number. The monthly rental rate can be calculated as follows: Median Income / 12 (months) x debt-to-income ratio = monthly payment = monthly rental rate. For example, in Irvine in 2006, the Median Income was $83,891 / 12 = $6,990 monthly median income. Financial planners (and your banker) will tell you not to put more than 28% of your gross income toward housing (Realtors will tell you to put 55% or more if that is what it takes.) Assuming a more rational 28% debt-to-income ratio, the median monthly payment (and thereby the median rent) is $1,957. Based in a 160 multiplier, the median house price should be $313,120 or 3.7 times earnings. Since the borrower should have a 20% down payment, it can be argued that the median home price should be $375,744.

So how does all the above compare to reality? The median rent in Irvine is $1,660. This is going to include many 1 and 2 bedroom apartments and very little at 4 bedrooms and above. The housing stock in Irvine is generally larger and nicer than the rental units, so a median house rental of $1,957 is probably not too far off. This means that most Irvine renters are probably spending more like 35% of their gross income on housing instead of the suggested 28%. So if you recalculate the theoretical median based on $2,500 a month, the median home price should be $400,000; add a 20% down payment, and the median could be as high as $480,000. The last statistics I saw for the Irvine median home price was $687,000: No reasonable metric can be constructed to justify that price.

fvt

As you can see from the discussion above, there is a range of values which can be used as a “reasonable” fundamental valuation. For the sake of simplicity, I am going to use $360,000 which is the number I used in the post Predictions for the Irvine Housing Market.

Debt-to-Income Ratios

The table below shows the impact of debt-to-income ratio on house price.

dtit

As you can see, the current debt-to-income ratio in Irvine is 60.8%. Even if you assumed ever buyer is puttting 20% down (which is laughable), the DTI ratio is 50.1%. Remember this is gross income; as a percentage of take-home pay, the number is much higher. Will your buyer be willing to spend that much of their income on housing?

Amortization

The above table shows the DTI assuming a 30-year conventional mortgage. Only 20% of loan originations in Orange County were conventional mortgages in 2006. People have bid prices up using interest-only and negative amortization loans. The table below shows the impact of these loan terms.

avt

This is where the action is. There are many factors which contributed to this bubble, but it is the combination of these loans with Southern California’s Cultural Pathology that really made this bubble happen. The biggest gamble current buyers are taking is the availability of future financing options. If defaults continue to increase at the current rate, these products will likely be eliminated: the banks are losing to much money. Will these loan terms be available for your future buyer?

Interest Rates

Mortage interest rates on 30-year fixed rate mortgages with no points are running about 6.4%. This is about 20% less than the historical average of 8% for home mortgages.

irt

As you can see from the above table. The higher interest rates go, the less a borrower can finance utilizing the same payment. If interest rates go up from the current 6.4% to the normal 8%, buyers will be able to bid 15% less than previously; therefore, house values will decline 15% as a result. If interest rates spike to 10%, house values decline 30%. What will interest rates be when your buyer wants to buy your house?

Appreciation over Time

I will use an appreciation rate of 3% to reflect the normal growth of wages and rental rates. It can be argued that appreciation will be higher, but it can also be argued that Appreciation is Dead.

at

Fundamental valuations are directly tied to wage growth. How much money will the buyer of your house be making in the future?

Future Value Table

Pulling together all of the above variables is a challenge. Below is a table which attempts to do so. Please click on the table to enlarge.

fvt2

To make it easier to read and follow, I have broken down the above table into three sections based on the DTI ratio of your future buyer.

fvt28

The most likely scenario is that your future buyer will pay from the second column in the above table. A 28% DTI is not just advisable, it may become a limit imposed by lenders — liar loans and high DTI ratios cause defaults and may be eliminated. Interest rates will likely climb back to their 50-year historical average of 8%. Notice that today’s median home price is not reached in the 29 years shown on this chart if interest rates rise.

fvt32

If you believe the “sun tax” is alive and well in Southern California, and you believe lenders will allow DTI’s in excess of 28% in the future, future values may be found in the above chart. This DTI is what house renters are currently paying in Irvine.

fvt60

Of course, there are those who believe we have reached a permanently high plateau, and buyers will continue to either utilize exotic financing or put 60% or more of their income toward housing (You have to believe those things to think prices can appreciate from current levels.) If you believe these conditions will persist, or occur again in a future bubble, then the above chart is for you. Who knows, maybe those of us who buy at the bottom can sell at these prices at the top of the next bubble…

Don’t get greedy.

Think about what terms and conditions your buyer will face, and you may save yourself a lot of problems today. Right now the market has been pushed up to unsustainable heights, and it will fall. Don’t buy when the conditions are not favorable. If interest rates are low, debt-to-income ratios are high, and exotic financing is the norm, it is a bad time to buy. You want to purchase when credit is tight and values are depressed — this is coming soon. Be patient and wait for the conditions to be right because you want your buyer to buy from you when credit is loose and prices are inflated. Remember, your house is only worth what your buyer will pay for it.