Let me preface this note by saying “I am a raging bull over houses”. I love real estate. On any given Sunday you can find me and my family touring open resale houses or new builder communities. My grammar school-aged kids love it too; especially the free cookies and peering into the beautifully staged rooms and really believing that some lucky kid has every gadget or musical instrument ever made and with utter amazement on how clean he keeps his room. Of course, my wife and I fully propagate the lie by saying “did you two see how clean the Lennar boy and Pulte girl keep their rooms? Why can’t you do the same?”
I think it’s safe to say that America — especially the American media and Wall Street firms — has fallen in love with real estate again. But, this time around it’s not ‘all of America’ like the last time; when the most exotic mortgage loans known to mankind turned every ma and pa end-user homeowner into a raging speculator. One has to look no further than the generationally low level of purchase loan applications — with rates at generational lows — to realize something isn’t ‘normal’ about this housing market. Rather, controlling this housing market over the past three years has been a small, unorthodox slice of the population that “invests” in real estate using tractor-trailer trucks full of cash-money slopping around the financial system put into play specifically for this purpose. Over the past few years so much cash-money has been deployed into the housing sector by unorthodox parties, that in many regions ma and pa end-user hasn’t stood a chance to buy. Especially, if they need a mortgage loan, which of course presents numerous risks to the seller vs the all-cash buyer.
In part, this is why I believe we could be back in a house-price bubble right now and not even realize it. And also because everybody is looking at the wrong thing…house prices. Sound confusing? It’s not, really.
A brief history of the “mortgage-loan, house-price governor”.
1) In a normal housing market, in which at least 80% of all house purchases are done with “fully documented” mortgage loans, house prices are solidly rooted to contemporary “end-user fundamentals”. That is, the mortgage loan with it’s LTV, appraisal, DTI etc guidelines is the “house-price governor“.
Bottom line, when the majority of houses are purchased with mortgage loans it is virtually impossible for house prices to wildly detach from end-user fundamentals unless credit goes haywire like from 2003 to 2007. Sure, there have been exceptions to this over the decades. But, for the most part housing is a pretty simple asset class that for decades leading into the change of the millennium remained mostly in-check to fundamentals and a great inflation hedge.
People will say that this is an unfair analysis because post-crash “mortgage lending is too restrictive”. I say “compared to what?” The mostly thoughtful mortgage laws enacted by the Government post the great mortgage collapse still leave mortgages today — through the GSE’s and FHA — easier than most periods in history. Sure, non-GSE/FHA, bank portfolio lending (loans that the banks make to keep on the books) has suffered because of the lack of a robust securitization market and much tighter capital requirements. But, if a borrower has a downpayment, documented income, and good credit — three things that always should be present when buying a house anyway — mortgage lending is back. It simply isn’t as easy as from 2003 to 2007, which astoundingly is what everybody points to when saying “mortgage lending is too tight”. This is so radical to me, as they also point to bubble-years peak house prices as a benchmark to where prices should go. However, they fail to realize that if prices did return to 2006 levels — and 2006 was in fact a “bubble” — then housing would be in an even larger bubble than back then! Those looking/hoping/lobbying for a return to 2003 to 2007 mortgage lending will not only be disappointed, but if it somehow happened, would end up very sorry it did. Be careful what you wish for.
2) Enter 2003 to 2007, when the “mortgage-loan, house-price governor” was removed by the introduction and wide acceptance of exotic loans; in particular stated income, interest only, pay option arms, and HELOCs. Through the power of exotic lending, the ‘incremental buyer’ always earned $200k a year and had more-than-enough dollars in the bank when it came to qualifying for a loan to buy a house…credit went ‘haywire’. This allowed house prices to completely detach from fundamentals. Then, when the mortgage loan governor was strapped back on in 2008 — on the sudden loss of all the exotic loans over a short period of time — house prices quickly “reset to end-user fundamentals“. House prices quit plunging in 2009, as affordability using new-era 30-year fixed rate, fully-documented loans recoupled with real income and asset levels. This “bottom” should have set the stage for housing to once again be rooted to fundamentals / governed by contemporary mortgage lending guidelines. But, they couldn’t leave well enough alone.
3) Enter, the 2010 to 2013 “all-cash”, new-era “investor” era, which was almost identical to the 2003 to 2007 era in the effect it had on house prices . That is, during this period the incremental (the ‘majority’ in many markets) all-cash buyers work without a ‘house price governor‘, instead base their purchase and pricing decisions on individual, random, emotional, uneducated, or hopeful models or guesses. Some buy for appreciation, some for rental income, some to flip and some because they have to in order to get paid at their fund. In any case, without a mortgage loan governor the price they pay for a house is more often than not, subjective vs objective.
House prices being up 25%, 50%, or more in the past two years should have everybody sounding loud warning signals, as this is a tell-tale sign housing is being led around by the nose by something ‘other than’ end-user fundamentals. It’s not like employment or income gains in the past two years in the regions that experienced the greatest price gains — not coincidentally the same regions that were the ‘bubbliest’ in 2006; crashed the hardest in 2009; had the greatest institutional investor interest from 2011-13; and that were first to experience significant demand destruction beginning mid last year — grew at levels to support such gains. Rather, they simply assume this is the new-normal — in an era when anything in any financial market is possible — and point to the 2006 peak as proof housing is not overpriced yet.
In short, it’s very easy for an all-cash individual or institutional buyer to overpay for a house by 10%, 20% or even 30% in the heat of the deal, when competing against a dozen other all-cash buyers, and using flawed assumptions and return “models”. Overpaying for a house to this degree is impossible if mortgage loans and appraisals are required. As the bubble blows and prices become detached from reality there are always greater fools that can and will chase the market keeping it elevated for a period of time. But, outside of the all-cash cohort the number is finite unlike the 2003 to 2007 era when everybody could always overpay using exotic loans. Some will say “all-cash purchases for rental investment are rooted to fundamentals…that’s rents”. I say “hogwash”. I have seen many single family rental assumption models from some of the largest investors, and they are beyond rosy. I can easily change a few numbers in their Excel spreadsheet models and turn a 6% annual return into an 6% loss. Most all-cash, buy to rent or flip, flop, flap or frolic investor assumptions and models I have reviewed make the most bullish Wall Street sell side stock analysts look downright pessimistic.
Bottom line: It’s very easy for a demand cohort — as flush with easy liquidity as this era’s all-cash cohort — to push national house prices well above what the average end-user can pay. And that’s exactly what’s happened over the past two years and why in leading indicating regions, in which new-era investors flocked first, demand is plunging and supply surging. Just like in 2007.
4) All-Cash buyer demand
This chart from Black Knight (formerly LPS) says it all…the all cash cohort — without a “mortgage-loan, house-price governor” — has been fully in control of the US housing market for a long time. It’s very easy for a demand cohort — as large as this era’s all-cash cohort — to push national house prices well above what the average end-user can pay.
Housing market history is littered with instances of investors and first-time buyers flooding into the housing market all at once on some sort of catalyst, only to leave all at once, over a very short period of time. In ‘this’ housing market, however, first-time buyers are not a presence. This in itself, should be a huge red flag to anybody analyzing this sector. But, if the all-cash buyer cohort has finally eaten it’s fill and it’s demand drops back to historical levels, there is not another demand cohort to pick up the ball and run with it. In other words, if the all-cash speculators leave — or even downshift a bit — I am worried that certain housing market regions all over the nation — particularly the ones that have experienced a parabola in house prices over the past two years — could have substantial house price downside ahead.
5) House prices are more expensive today than in 2006 on a monthly payment basis using the popular loans of each era… a true apples to apples comparison
Those looking at “house prices” — especially relative to 2006 — for signs of a “bubble” are looking at the wrong thing. That’s because to the end-user, the monthly payment is generally more important than the price. As such, when comparing the ‘cost’ of houses today vs 2006 one has to normalize the data for a true apples to apples comparison.
On an absolute basis, investors have significantly lightened up their purchases in all of the leading indicating regions I track so closely. This paradigm shift from an “investor-driven market” to an “end-user driven market” is causing considerable consternation.
That’s because when all cash investors, without a “mortgage-loan, house-price governor”, hand the market off to the end-user cohort with a fully functioning mortgage-loan, house price governor a “demand void” can appear. Not necessarily because the demand isn’t there. Rather, because average house prices are too high for the average, fundamentally-driven end-user to afford. This is what’s happening now. And based on how expensive houses are today relative to 2006, this should prevent any further upside this spring and summer, especially with rates up 100bps from a year ago. In fact, we are seeing seasonal weakness in offer prices much further into the year than typical meaning house prices have a strong chance of going negative YoY in the summer.
The Bubble Data
The chart below compare the ‘cost to own‘ the average priced house today vs 2006 using the popular mortgage loan financing of each era. When normalizing the data in this manner — vs simply assuming everybody always used market rate 30-year fixed loans, which clearly wasn’t the case from 2003 to 2007 — one can see clearly just how expensive houses are today.
Bottom line, in the first ‘results’ column, house prices in 2013 were 11% lower than in 2006 yet the monthly payment was 35% higher and the monthly payment needed to qualify was 29% greater. Taken one step further, see the second “results’ column to the far right. That is, to buy the 2006 bubble priced house using today’s mortgage finance vs the popular loans of the 2006 era, the monthly payment is 54% higher and the monthly income needed to qualify 44% greater.
Every time I review these data after updating prices in our database each month, I am amazed. I ask myself, “if 2006 was a bubble then based on the data below if if costs more per month to buy today’s average house why isn’t the sector in a bubble again?”
In closing, I do think higher house prices are mostly always good. That’s of course unless the reason for the rise is “unfundamental”.
General consensus has once again returned to the overwhelming belief that “house prices always go up and 2007 to 2009 was a fluke”. That’s plain wrong and dangerous.
I am not calling for another house price crash even though I think that housing is back in a bubble based on the monthly payment comparisons between now and 2006. What I am saying is that housing runs a real risk of price downside if the new-era investors — that have largely supported the entire sector and run up house prices beyond the reach of the average end-user through cheap and easy liquidity over the past three years — take their balls and bats and go home.
On the other hand, bubbles can deflate while house prices remain flat if the underlying fundamentals improve rapidly…strong employment, income gains etc. But fundamentally-driven housing markets take a lot time to develop, especially after so many years of running on unfundamental stimulus. Perhaps our economy can “grow into” today’s house prices over the next few years. Perhaps not.
As we saw in 2007 nobody can predict what house prices will do and the general consensus is usually the wrong one. Be careful out there. Buy a house because you need shelter and buy what you can truly afford using a 30-year fixed mortgage. Don’t buy because everybody else is unless you can clearly afford it — both financially and psychologically — especially if next chapter for this housing market is a consolidation of the past few years of gains.