A 2008 Update to: What Happens When The Buying Stops?
That the was headline of a published article I wrote in June of 2005 when the real estate market was surging with sales activity enabled by loan programs with ridiculous terms enhanced with the most liberal of underwriting consideration and little thought to the future consequences. At the time I was ridiculed by many in the industry who said that I didn’t understand the real estate market, it was not like the stock market, and housing would always appreciate. Have you ever seen a real estate agent who preached a conservative approach to future values? Everything was always going to go up. But as I wrote in my article “What happens if interest rates rise 2%… or if the secondary markets start taking losses and have to change their underwriting guidelines”?
Ah hah!….it would probably lead to a mortgage market meltdown. I must admit however, I did not foresee the extent of the damage to the financial industry that has actually taken place.
So what now? What is in store for the real estate market? The best answer for that will start with the necessary and inevitable corrections that must take place, starting with the credit markets and working backwards to the valuation of real estate.
Underwriting has now turned 180 degrees. In order to sell a 30 year fixed rate mortgage into the secondary markets, which are saturated with non performing loans, the lenders that have survived are taking a most cautious approach. They can not risk adding a loan to their portfolio which hinders their ability to fund additional loans. As we all have learned recently, mortgage loans are securitized and sold to investors enabling a lender to fund more loans. As an industry we are going back to the basics of underwriting, more commonly known as the three C’s; Credit, Capacity and Collateral.
Credit is relatively easy to evaluate. Do you have established credit? Do you pay your bills on time? Do you have too much debt? Do you have unsatisfied liens or judgments? Your FICO score will give a snapshot evaluation which takes all of the above into consideration. History has a chance of repeating itself, so the way someone has approached their financial responsibilities in the past is probably the same way they will approach their future responsibilities. An important underwriting consideration.
Collateral is the security for the pledged debt, or in the case of a mortgage, the value of the property. This is an issue and will continue to be an issue for the next 3-5 years until property values, like water, finds its own sustainable level. Location will always be the key, with amenities and condition adjustments. Cost has nothing to do with value. Remember, the key to value is what a willing and knowledgeable buyer is willing to pay a willing and knowledgeable seller. This is also an important underwriting consideration.
So now we come down to what I consider the most important factor - Capacity or Affordability. When all is said and done, if it is a fixed rate loan, adjustable rate loan (potential issue), or an interest only loan it comes down to can the borrower realistically afford to make the payments. Consider:
1. The Average US household annual income in 2006 was $48,000 or $4,000 a month.
2. The Average California household annual income in 2006 was $74,500 or $6,208 a month.
Let’s make an assumption that the average family income is 33% higher or $100,000 annually or $8,333 a month. What can this family afford for a monthly mortgage payment? Let’s further assume this better-than-average family has sold a home, or saved, had a gift or somehow has available $100,000 to use for down payment, closing costs, and still have a couple of months in reserves.
• If they negotiate a purchase price of $480,000 and have a down payment of $80,000, they will need a mortgage of $400,000.
• If we use an interest rate range of 6-7% for a 30 year fixed rate loan, they would have a payment of $2,998 - $3,261 including taxes and insurance.
• That would be housing debt ratio’s of between 36-39% the absolute maximum they can afford to sustain assuming they want to have an auto or two, put gas in the tanks, provide some amenities like clothing, food, electricity, water, repairs and health insurance.
• Expensive vacations and extravagant expenditures will be put on hold for a few years.
• Note this above-average income family with $100,000 cash will be hard pressed to purchase a home of $480,000.
For those buyers of million dollar tract homes, simple math tells you that you have to have a family income around $250,000 (+/-), as jumbo loans are priced higher (yes, even the new FNMA conforming jumbo loans), and while we have many families with those income levels I am here to tell you there are far more “million dollar tract homes” than there are people who can afford to buy them.
Note the History of Home Values compiled by Yale economist Robert Shiller. This chart shows the inflation adjusted values since 1890 to present. It does not take a PhD to quickly determine that property prices escalated beyond income growth or affordability during the past 8 years and property values will need to adjust accordingly. The highest sustainable run up in history was the post world war II boom which was a sustainable index increase of 30. From 1997 to 2007 the index increase was 83. There is a tremendous adjustment we are facing if we are going to be realistic.
Congressman Chris Dodd has recently stated that every foreclosure costs each homeowner in that neighborhood about a 1% decrease in their property value. The point is that property value was illusionary in the first place. Cheap money given to unqualified buyers competing against each other drove up those values, and like a cheap house of cards, those inflated values will have to come tumbling down.
The various proposals being offered in Congress to put a temporary stay on foreclosures is going to do nothing but forestall the inevitable. Other than the lenders working out individual forbearance solutions, which may include reducing the loan amount and taking some future percentage of appreciation, are all unrealistic. If the income is not there, they cannot afford to keep the home…. it is that simple.
I have an associate who is raising funds in a private placement with a minimum investment of $350,000. The purpose is to purchasing estate property in Beverly Hills for cash and after a holding period of 5 years sell. They feel that the ultra rich (actors, professional athletes, etc.) can always afford and want the most extravagant. That is probably a true assumption.
Our approach is completely the opposite. Our focus is investing in the lower rung of the housing market which is the manufactured housing and mobile housing market. The default rate of approximately 1%, comparable to the 5-6% rate of conventional housing today, makes this an extremely attractive investment. Our approach is affordability with responsible underwriting will be what provides an investor secure, consistent and attractive yield for their investment.
Time will tell, but to me, as in 2005, the problem and the solutions are obvious. The corrections will take time as values seek their own sustainable levels.
Keith Webb
CEO