Monday, February 6, 2012

2012 Real Estate Outlook: Demand - Ability

2012 Real Estate Outlook: Introduction
2012 Real Estate Outlook: The Rise (1980 - 2006)
2012 Real Estate Outlook: The Fall (2006 - 2011)
2012 Real Estate Outlook: Where We Are Today
2012 Real Estate Outlook: Where We Are Going
2012 Real Estate Outlook: Demand - Willingness
2012 Real Estate Outlook: Demand - Ability
2012 Real Estate Outlook: Supply - Local Market
2012 Real Estate Outlook: Supply - Shadow Inventory
2012 Real Estate Outlook: Conclusion
2012 Real Estate Outlook: Commercial Real Estate

The sentiment toward real estate is extremely important because if no one wants to live in a home, there will be no homes purchased. However, a home provides a basic necessity in life, shelter, something there will always be a built in demand for. As our population grows, at some point new homes will be needed to house these Americans.

Therefore, we must look beyond sentiment and discuss the second factor that determines home buying demand. After someone’s willingness to purchase a home, their ability to make that purchase becomes just as critical.

Imagine you have 100 people living on an island. 70 of them have decided they want to become homeowners. Each one of the 70 ready to purchase makes an appointment with the local bank to apply for a loan. What impact does this simple appointment have on home prices? It is massive.

Let’s say there were 50 homes built on the island and ready for sale at $200,000 each. If all 70 of the willing homeowners are eligible for a loan of $250,000, then you can clearly see what this will do to the price of real estate on the island. There is going to be a bidding war for properties. Homes will almost immediately re-adjust up to the $250,000 threshold.

But what if the lender only approved 35 of the willing buyers and the maximum they were willing to lend was $150,000? If our residents had no savings for a down payment and relied exclusively on this financing to purchase then the price of the real estate would collapse downward. Prices would immediately fall to $150,000 and most likely continue to fall as there would be less buyers (35) than the total stock of inventory (50). 

Can you see how important financing is for real estate? This is why lending standards tightening (simultaneously reducing the supply of buyers) in 2007 created the downdraft in pricing across the country.

So with this understanding, we can now review where financing stands today and where it will be going in the future.

After the collapse of the financial system in 2008, the government stepped in and literally became the mortgage market. Almost 97% of homes financed after the 2008 collapse were insured, guaranteed, or financed directly through some form of government entity – The Federal Housing Administartion (FHA), Fannie Mae, or Freddie Mac.

The government’s decision to step in and provide financing for the housing sector has created an artificial floor under housing prices, causing them to first bump higher to begin 2010 with the home buyer tax credit, and then fall slower due to the available government credit.

The reason this floor is artificial should now be obvious. Should the government’s financing be removed (even if just a portion is removed) then real estate prices will collapse downward to the available financing in the free market (just like on our island). If a homeowner had to put down 20% on a home, have excellent credit, and a proven job income for two years strong enough to support the loan (this is how every loan was financed prior to 2000) then the available supply of homebuyers would essentially disappear. This is combined with the fact that many of the buyers in that category would be financially savvy enough to know that they should not be buying and they would wait.

Enter the FHA, an entity created to fund low income housing over 50 year ago, which up until 2007 made up only a small fraction of the total loans financed. They now insure the lion’s share of new mortgages and they offer financing with only 3.5% down. The FHA insurance is now stamped on a loan and then it is housed and stored on the balance sheet of a financial institution with a government backed guarantee. It is the equivalent of the AAA stamping the ratings agencies doled out during the early 2000’s, only the FHA has gone one step further and agreed to cover the costs should there be a problem with the loan (insuring toxic mortgages was formally AIG’s role, a company you may have heard of).

A recent report on the FHA shows that they will need an estimated $10 to $50 billion bailout just to cover current liabilities (if homes were to stop falling today). The FHA has used accounting tricks to create a rosier picture on their balance sheet, such as booking future insurance premium payments immediately as available capital against defaults.

Monthly Payment Costs:

The total loan amount a potential homeowner can receive is only one portion of the complete picture. You must also factor in their ability to handle the monthly payments. Their ability to finance these payments can be determined by looking at two variables:

1. Interest on the loan
2. Home owner’s monthly income

If an American takes out a $250,000 interest only loan (no principle payments) at a 4% interest rate, then their annual interest payment is $10,000 or $833 a month.

What if interest rates were to rise to 7%? Their monthly mortgage payment would then rise to $1,458. This is not important for Americans who have locked in on low rates because their monthly payment amount will not change.

This is important for new buyers entering the market (demand). On our island of 70 people who want to purchase a home, let’s say all 70 can handle a $833 per month mortgage payment. However, if interest rates were to rise to 7% then only 35 could handle the monthly mortgage. If there were 50 homes available priced at $250,000 what would happen to the price of the homes?

The prices would collapse downward to reflect the threshold where new buyers could afford the monthly payment.

Today, our Federal Reserve has short term interest rates held at 0% and they have promised to hold them there through 2014. In addition, they have entered the mortgage market since the financial collapse of 2008 and purchased mortgages directly to help ease the financial system.

This brought mortgage rates to an all time record low rate this past week under 4%.

These ultra low mortgage rates and ability to finance homes has provided an enormous increase to the number of willing homeowners who also have the ability to purchase. It grows the number of home buyers on our island from 35 up to the maximum 70.

Why does this matter?

Home buyers and analysts today have priced in the ability of our government to provide 97% of the mortgages in this country and the ability of our Federal Reserve to lower interest rates forever into their calculations and models on future home prices.

The general public does not understand that the slow down in home price declines is an artificial trap door. If the Federal Reserve and the federal government were forced to move away from the mortgage market in any form then lending restrictions would tighten considerably reducing the number of willing home buyers.

Prices would collapse downward, and lending restrictions would tighten further.

Purchasing a home is a direct bet on the finances of our United States government and the ability of our Federal Reserve to keep rates at zero forever. This website dedicates a tremendous amount of time and research to showing that the United States cannot do this and is heading toward fiscal disaster. As goes our government bond market, so goes our real estate market.

When our government bond market reaches its “Greece” moment we will have to make decisions on the portion of government spending is the most important. I am betting that the American people will prefer to receive a social security and medicare check every month vs. having the government try and keep home prices artificially high.

Next: 2012 Real Estate Outlook: Supply - Local Market

2 comments:

  1. Very good article

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  2. agreed... even I can understand it!

    Sure glad I paid off all my real estate in 05 & 06 when everybody said I was craZY. the definition of dumb luck... now everybody thinks I'm a brainiac.

    Jeez, I need sites like this to keep up the facade (ha ha ha)

    another excellent view of the market, especially the commercial that is just as ominous, is from Andy Miller @ Casey Research.

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