Familiarity with these ten factors will enable you to address questions about the real estate market, especially about real estate values and where they may be headed.
By David Girling
REAL ESTATE ECONOMIST,
GIRLING REAL ESTATE INVESTMENT GROUP
Today’s real estate market is characterized by rising home values, low housing affordability, increasing interest rates, and limited housing inventories. All these factors are interrelated, and each will be examined separately in this article.The goal of Dave’s Top 10 is to give you some information that will help you address important issues or answer questions that may arise because of economic and other factors mentioned in the news.
10. Interest Rates
Since the Federal Reserve started its quantitative easing program in 2012, the Fed’s monetary policy has kept mortgage interest rates at historic lows. Today, the economy is healthier, and inflation is now at 2 percent, the Fed’s target inflation rate. As a result, rates have increased since the beginning of the year, and the ten-year Treasury, a benchmark for mortgage rates, is hovering at 3 percent, having reached a high of 3.11 percent in May. The interest rate for a 30-year fixed-rate mortgage is now approximately 4.6 percent, and the fully amortized mortgage payment on a $500,000 loan is $2,563 per month (see Figure 1).
Figure 1. FNMA’s Historic Yields show a steady increase in interest rates since the beginning of 2018.
Takeaway: Expect interest rates to continue to climb and to be higher by the end of the year.
9. Purchasing Power
One effect of increasing mortgage interest rates is a loss of purchasing power. The rule of thumb is that a one percent change in rate equals a 10 percent change in purchasing power (assuming wages remain constant). As an example, to purchase a median-priced home in Orange County ($818,000 in April) with traditional financing (80 percent loan-to-value, 30-year fixed-rate at 4.5 percent), the monthly payment is $3,316. If rates go to 5 percent, the buyer has lost $46,000 in purchasing power, or must now look at homes that cost $46,000 less if the payment is to remain constant at $3,316. If the buyer can afford to make a higher payment, the increase in rates would have increased the payment by almost $200. If rates go to 5.5 percent, the loss in purchasing power will be $88,000.
Takeaway: With an increase in interest rates, purchasing power will decrease and homebuyers will need to look at less expensive homes or make higher monthly payments. Alternatively, home prices may correct as a result.
8. Alternative Asset Classes
When the Fed started to lower interest rates and commenced its quantitative easing program in 2012, the main beneficiaries were real estate and stocks, with both asset classes experiencing significant appreciation. These alternative asset classes are now performing in an increased-rate environment, with the following results:
· The stock market is correcting and experiencing much greater volatility.
· Real estate values continue to increase.
Takeaway: As interest rates increase, investors will take money from stocks and invest in fixed-income assets and the stock market will experience greater volatility as a result. Thus far, real estate has been resilient; however, if housing inventories start to increase, the support that low inventories have been providing for real estate values may go away and housing prices may start to correct as well.
7. Home Prices
Almost every recent measure of year-over-year home price appreciation has shown significant improvement:
· S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index was up 6.5 percent in March for the nine census bureaus.
· California’s median home price was up 8.65 percent (see Figure 2).
· Orange County’s median home price was up 5.6 percent.
· Newport Beach prices for single-family detached homes were up 10.5 percent.
These recent results have been the trend since 2015, where year-over-year price changes have ranged from 3 to 9 percent. In addition, values in some areas of California are approaching, or have surpassed, 2006 peak price levels.
Figure 2. California Median Home Prices versus the Annual Appreciation Rate. Source: C.A.R.
Takeaway: As prices rise, affordability will be further impacted, especially if home price appreciation continues to exceed wage growth.
6. Mortgage Originations
With rising interest rates, loan refinances as a percentage of total mortgage originations have decreased as shown in Figure 3. Currently, purchases constitute 62 percent of mortgage originations, and refinances constitute 38 percent. In 2012, these percentages were reversed.
Figure 3. Mortgage originations. Source: MBA
Takeaway: Lenders will need to become more creative with their loan programs to promote more purchase loans and maintain the overall level of originations. And we may see a loosening of credit standards to improve purchase volume. Mortgage refinances will be originated primarily by homeowners who want to consolidate their debt or who want to move from adjustable-rate to fixed-rate loans. Higher home prices will make cash-out refinances more prevalent because of the additional equity in the home.
5. Housing Inventories
With low housing inventory and strong demand, home prices keep improving to levels that feel unsustainable to some. Listed below are some of the reasons that inventory levels are low and that homeowners are deciding to “stay put.”
· Potential for capital gains taxes and higher property taxes.
· Grandfathered mortgage interest deduction ($750,000 versus $1,000,000).
· Some homeowners were affected by the 2007 crisis and are unwilling to sell. This has helped to push the homeownership tenure from more than four years in 2008 to more than eight years in 2017 (Source: Attom Data Solutions).
· Some homeowners still have negative equity.
· Reluctance to give up low mortgage rates.
· Fear of not finding an adequate replacement.
· Homebuilders are underperforming and not keeping pace with demand although housing starts and building permit data have suggested the inventory may improve.
Takeaway: Housing inventory levels will remain low and, combined with continued strong demand, will continue to support home prices for the foreseeable future. Some legislative efforts, such as the Property Tax Fairness Initiative and Senate Bill 1116 (Moorlach), may have a positive impact on inventories.
4. U.S. and California Homeownership Rates
Across the United States, the homeownership rate now stands at 64.2 percent, having peaked at 69.2 percent in 2004 and reached its lowest level of 62.9 percent in the second quarter of 2016 (see Figure 4). California ranks forty-ninth in the United States with a homeownership rate of 55.1 percent, and the rate in Los Angeles and Orange Counties stands at 48.3 percent.
Figure 4. Across the United States, the homeownership rate peaked at 69.2 percent in 2004 and currently stands at 64.2 percent. For comparison, the homeownership rate in California is 55.1 percent.
Takeaway: With rising interest rates and low inventories, the homeownership rate may not improve much in the foreseeable future. Millennials are the largest segment of potential new homebuyers, and many look to them to eventually push the homeownership rate higher.
3. Price Indices
The Orange County Home Price Index (OCHPI) shows the average price since January 1, 2006, for a standard home (single-family dwelling, between 1,800 and 2,200 square feet, with three bedrooms and two baths) for ten select cities in Orange County. The index value for the first quarter of 2018 is $740,000. Figure 5 shows the values for homes in all ten cities relative to this OCHPI value.
Figure 5. The median prices of homes in ten select cities in Orange County are such that prices in three of these cities are below the Orange County Home Price Index median of $740,000 and prices in seven of these cities are above this median.
Takeaway: The OCHPI is an example of a price index that provides a graphical representation of values showing where they were in the past, where they are today, and where they may be headed.
2. Bubble or Correction?
Is a bubble looming or a price correction on the horizon? The question is often asked in today’s market, one where prices have appreciated at rates that many believe are unsustainable and that have surpassed the 2006 price levels in many areas. Certainly, the conditions that led to the 2006 crash (easy credit, speculation, etc.) do not exist today; however, if you believe in the existence of housing cycles, an argument can be made that a correction may be coming. Historically, housing cycles have lasted seven to ten years; and according to the graph in Figure 6, we are in year nine of the recovery.
Figure 6. A look a median home prices in California and Orange County suggests that we are in year nine of the recovery. If you believe in the existence of housing cycles, an argument can be made that a correction may be coming because, historically, housing cycles have lasted seven to ten years.
Takeaway: Nearing the end of a housing cycle, higher interest rates, and lack of affordable housing will push prices to correct. Continued low housing inventory levels and continued foreign investment will offset some of these price corrections.
And the Number One Economic Factor is—
1. Housing Affordability
The percentage of California homebuyers who can afford to purchase a median-priced, existing, single-family home is currently 31 percent. At 21 percent, that number is even lower for Orange County. Assuming a conventional, thirty-year fixed-rate mortgage with a 20 percent down payment, typical homebuyers would need to earn $111,500 and $167,670, respectively, per year to afford a median-priced home in California and Orange County.
Figure 7. The median price in Orange County has risen more than 80 percent since February 2009.
Takeaway: Affordability is a big concern; and the situation does not appear to be improving, especially with rates expected to go higher and inventory levels expected to remain low.
Summary and Conclusions
· Interest Rates: Rates will increase and be at or above 5 percent by year end.
· Purchasing Power: With higher interest rates, purchasing power will decline.
· Alternative Asset Classes: Expect continued volatility in stocks with higher rates. Home prices may correct.
· Home Prices: Home prices are improving 5 to10 percent in most markets. This trend will continue but start to level off as interest rates push higher and as inventory levels increase.
· Mortgage Originations: The ratio of purchases to refinances will continue to increase, with some downsizing by originators.
· Housing Inventories: Continued low levels of inventory are expected. Additional homebuilder activity might increase supply, but price appreciation and cost of materials affecting this sector will offset some of the relief.
· U.S. and California Homeownership Rates: Expect continued leveling off with higher rates and low inventories. Look for millennials to drive the homeownership rate.
· Price Indices: Price indices are an effective way to see where prices have been, where they are now, and where they may be headed in the future.
· Bubble or Correction: No crash; however, expect prices to correct as we near the end of the housing cycle and as rates continue to climb.
· Affordability: Increasing interest rates and rising home prices will keep affordability low.
David Girling completed his undergraduate work at the University of Southern California and earned the degree of Master of Business Administration from the Anderson Graduate School of Management at the University of California, Los Angeles. In 2008, he formed Girling Real Estate Investment Group (Girling REIG) with his father, Bing. They are affiliated with Villa Real Estate.
Dave was president of the Newport Beach Association of REALTORS® (NBAOR) in 2015, following in the footsteps of his father, who was president of that Association in 2001. Dave served as a NBAOR Director until December 2016 and completed three terms as chairman of the Government and Political Affairs Committee. In 2010, he was named REALTOR® of the Year.
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