The move-up market will suffer for another decade

Everyone is cheering the bottom of the housing market, and the false assumption is that all properties will rise in price at a rapid rate as housing “recovers.” Properties priced below the conforming limit will almost certainly continue to rise thanks to restricted inventory and record-low interest rates, but the move-up market is a different story entirely.

As I pointed out last week, Delinquent jumbo loans in Coastal California pollute bank balance sheets. But it’s not just Coastal California that will feel pain in the jumbo market. The jumbo market is not supported by government-backed loans, and as Mike pointed out over the weekend, these loans are subject to new more stringent regulations regarding amortization, appraisal, and debt-to-income requirements. But beyond the supply pressures lingering in shadow inventory, the move-up market will be hurt by a lack of equity among potential buyers.

How the move-up market works

Most first-time homebuyers don’t have 20% down for a house, particularly at today’s high prices, so most opt for a 3.5% down FHA mortgage or a 5% or 10% down conventional mortgage with private mortgage insurance. Over time, assuming they don’t refinance or add more debt with a HELOC, a homeowner will build equity by paying down an amortizing mortgage. With wage growth in the area, house prices will rise 3% or 4% per year, and presumably, the borrower will have a higher income as well. So after 5 to 7 years, a prudent homeowner will have sufficient equity to cover the closing costs of a sale and have 20% to put down for a move-up purchase.

The collective action of all homeowners who purchased at the same time provides the demand for a move-up market. The equity ported from a previous sale is used to bid up prices in the most desirable neighborhoods which is why markets like Newport Beach always trade at a healthy premium to rental parity. However, the current move-up market is broken because potential move-up buyers don’t have the equity to make the move.

The down payment barrier

High prices make the down payment hurdle onerous to cross. Jumbo loans require 20% down because private lenders won’t take the risk on lower down payments. In Coastal California the houses beyond the reach of conforming loans or FHA financing start at $900,000. That requires $180,000 down plus extra financial reserves. Coming out of a deep recession, few have saved that much on their own.

Most move-up market sales get their equity from the profitable sale of a previous home. With the crash of house prices, those who bought over the last 10 years have no more equity than they originally put down, and most are underwater. This potential buyer pool is dead. As we know from the chart on originations, the number of buyers who purchased at the bottom is relatively small.

Plus, many more buyers than usual are either small investors or hedge funds. In a normal market about 35% of purchases are for investment (the inverse of a 65% home ownership rate). Over the last few years, about 50% of home purchases have been investors. Investors don’t sell their properties to complete a move-up trade, so 15% of the market that ordinarily would have been move-ups will not be over the next decade.

As I pointed out in One man’s mortgage debt is an entire neighborhood’s equity, the equity that would otherwise be accruing to homeowners is instead recollateralizing the bad loans on underwater properties. With 25% of properties underwater, a huge portion of the move-up market won’t have equity because that money will instead be going to a bank.

With 15% of the move-up market removed by investors and 25% removed by recovering underwater loanowners, 40% of the demand for future move-ups is gone.

The rebuilding of a move-up market will likely take a decade or more, and that’s assuming interest rates remain super low to keep the market under the conforming limit affordable. And of course, it also assumes the conforming limit is not lowered by political pressure from politicians who are tired of the enormous losses at the GSEs and the FHA.

When the banks finally get around to foreclosing on the legions of squatters in the jumbo market, who are they going to sell those houses to?