Tuesday, April 12, 2022

Real Estate and the First Time Buyer

Home ownership is the key to wealth development in the United States.   Record high home prices are distorting the real estate market such that many first-time buyers are unable to buy a home.  A national average housing price correction of 10-20% may be in the offing, but inflation and rising interest rates will more than offset the benefit of lower prices to make housing more unaffordable.   Potential first time buyers will need to be sophisticated, agile, and disciplined to position themselves for opportunities that may arise in what will likely be a volatile market in the next few years.

Home prices are high by nearly all measures, but there is wide regional variation.  The CoreLogic Home Price Index (HPI) posted the highest year-over-year growth in its 44-year history by the end of 2021. CoreLogic last week reported 65 percent of regional U.S. housing markets are overvalued based on earnings to price ratios.   Zillow reported in February, 2022 that 481 cities nationwide have a typical home value of at least $1 million and 49 more may join the list this year.

How Did We Get Here?

A perfect storm of decreased housing supply and increased demand was underway in 2020.   The U.S. had a systemic housing supply shortfall of approximately 3 million homes caused by ten years of under production;   homeowners held their houses longer – 13.5 years in 2020, up from approximately 10 years before the housing collapse of 2008;    Millennials, the largest generation by population, entered their prime home purchasing years in that timeframe and accounted for 37% of home purchases in 2020.  At the same time, mortgage interest rates were historically low in the 4% range following the 2008 market collapse.  Enter the Covid-19 pandemic and associated governmental policies to further intensify the underlying issues of housing supply and demand.

When Covid struck a systemic housing supply shortage was exacerbated by labor and material shortages.  Remote work policies incentivized people to flee dense and locked-down urban housing markets to airy suburban first or second homes.   The Federal Reserve lowered interest rates further - resulting in sub-3% mortgage rates.  This further incentivized Millennials to buy their first home, and many others in the market to buy second or third homes. Investors shifted into high gear.  According to the National Association of Realtors investors purchased 22% of homes in January 2022, up from 15% the previous year.

There is scholarly work back to the 1800’s describing a 16 year housing market cycle captured in the adjacent illustration. 

Fundamentally, the cycle revolves around rising population demand for housing and the new construction that must provide that housing.   The disconnect between these two from 2006 to 2016 was the systemic problem that underpinned rising prices.

The U.S. has a systemic housing supply and affordability problem that will take long term efforts to rectify.   Housing starts rise and fall between low rates of about one million and high rates of about 2 million.  An annual rate of about 1.2 million is required to just sustain the demand of increased household growth and life-cycle replacement of aging homes.   Housing starts dropped precipitously between 2006-2009 to about .5 million and did not attain replacement rate until 2016. This ten-year low rate of housing construction created a shortfall of about 3 million homes that we are still dealing with today. 

The latest housing reports in February, 2022 indicate a housing start seasonally adjusted annualized rate of 1.769 million in February of 2022, the highest since June of 2006.  High material costs are hindering further growth and building permits dropped 1.9% in February.  This may indicate a stabilization in housing construction.   It is essential that housing construction significantly exceed replacement rate levels of 1.2 million to make up for the 2006-2016 shortfall.  

A sustained housing start rate of 1.75 million homes for six years is required to address the housing supply shortfall.   Policy makers need to support sustained housing construction and a broad portfolio of affordability, but that is a topic for another day.  If interested in this topic watch a video presented by Harvard Extension for some basic ideas on the issue.

First time homebuyers, essential to the housing market, were hit hardest in this hyper-inflated market.   In 2021, According to the National Association of Realtors, sales to first-time homebuyers fell from traditional levels of 40% to 27% in January, 2022. 

Who Are First Time Buyers?

The median household income of sixty percent of America is less than $85,000.  Households at that level of income are highly challenged to purchase a home in the current market.    In high-cost areas of the East and West Cost many households in the top 20% of median income earners, with incomes exceeding $141,000, are challenged to afford a home.  

The bottom fifty percent of households in America earn less than $60,000 per year.  A tried-and-true rule of thumb for households buying a home is to spend about 30% of gross income on housing.  Assuming a $60,000 household income about $18,000 per year can be allocated to Principle, Interest, Taxes, and Insurance (PITI), and HOA fees.  Insurance and taxes vary by region but let us assume the allocation of about $1,250 per month to principal and interest.  This results in a maximum home purchase price of about $300,000 at 4% interest.

How Will Rising Interest Rates Impact the First Time Buyer?

The price challenge is not the only battle the first-time buyer is facing.  Affordability is dramatically impacted by mortgage interest rates.  Those rates are rising rapidly. 

The Federal Reserve (FED) is raising interest rates to tame exploding inflation that hit 40 year highs in February at 7.9%.  The FED’s own policies and federal fiscal policy exacerbated pandemic social and economic disruption to create inflationary high demand.  The war in Ukraine only exacerbates the situation. The FED is trying to raise rates in a manner that will achieve a soft landing out of inflation, but there is growing concern their actions may result in a recession.  

The FED began increasing its prime lending rate in quarter percent increments in March and will likely further raise rates .25 to .5 percent at each of its six remaining meetings this year.   This will not stop inflation from rising.   The sentiment of many is that inflation will get worse before it gets better, and rate increases may be needed into 2024.  Larry Summers, former Clinton Administration Treasury Secretary and Obama Administration key economic advisor says, “To beat inflation, the Fed has to raise interest rates higher than the rate of inflation,” as was required in the 1980’s under FED Chairman Paul Volker.   

In response to the FED’s actions, mortgage rates have quickly climbed to a national average of 4.72%.  They appear to be on their way toward more historical average levels in the 6-8% range (the historical average is 7.81%).   

Increased mortgage rates decrease purchasing power dramatically.    Assuming a consistent $1,250 per month allocation of gross income to principal and interest the adjacent chart shows how powerful interest rate rises can be. 

Will A Housing Price Correction Help?

If prices dropped 10% rising interest rates would offset any benefit to make housing less affordable.  See the table below for the impact of rising rates on mortgage payment and total interest paid over 30 years. 


Will There Be A Price Correction?

The housing price spike is inconsistent with historical norms.   Home prices from 1979 to 2019 appreciated at an average annual rate of about 4.25% from $62,600 to $327,100.  Of course, there were peaks and troughs in that period.  The 2008 housing collapse saw a 33% decrease in the CoreLogic Home Price Index.   Any correction in the present will not likely be as extreme, but when compared with historical appreciation, a national average correction of up to 20% is possible with dramatic state variation.  

Housing markets are regional and local, rural to urban.  The national average price decline in the 2008 collapse was widely varied among states with a range from -2% in South Dakota to -60% in Nevada.  There was also a timing variation from peak-to-trough of three years from September, 2005 to September, 2008.   All markets will not slow or depreciate at the same time or at the same pace.  There are specific market characteristics that indicate the risk of price decline is higher in the Northeast, South, and Southwest according to CoreLogic.

What about the first-time buyer?

The first-time buyer is likely renting and regrets not building equity in a home.  They see inflation pushing rents up rapidly.   They see prices and buyer competition remaining high.  They suspect prices may fall at some point.  They get conflicting advice on whether to get in the market now before rates increase further or wait until prices drop (assuming they do).   The situation is complex, there is no crystal ball, only estimates of what is to come.   Most of it is out of the first-time buyer’s control.  

Try to resist the fear of missing out (FOMO) emotion and stick to as much as possible to hard facts.  Apply solid rules of thumb on how much of your income should go to housing.   Continue to look for houses but evaluate them very critically to ensure value is real.   Avoid worry about that which is beyond your control and instead focus on what you can control:   get your house in order, continue to look, critically assess properties, watch your local market closely, and be prepared for the opportunity that comes your way.

Prices may decline; however, as indicated in this paper, price declines would have to be much more than 10% to offset rising interest rates.  This can be calculated as discussed earlier.  Regardless of how deep it goes, it will have an impact on the purchasing climate of multiple offers, cash buyers, and above asking price offers.   Houses will begin to remain on the market longer.  Less competition will increase seller uncertainty and increase flexibility.  It may just be enough to find an opportunity.

There are ways to battle rising interest rates and make yourself a better borrower.   Though the national average interest rate is 4.72%, you can obtain a mortgage at a lower rate.  Join a credit union.  Credit unions are often the lowest cost lenders.   For example, Navy Federal Credit Union offers a conventional loan rate as low as 3.75% today – nearly a full percent lower than the average.  Work on improving your credit score.   If prices decrease enough and you save a little more, maybe you can get to a 20% down payment and avoid Private Mortgage Insurance (PMI) and get a better rate.  Know the difference between the Interest Rate and Annual Percentage Rate (APR) and shop for best APR.

Increase your income and savings rate for a larger down payment.   Seek out the promotion now, get the new job now, take the second job now, always raise your hand for the overtime.   Get your house in order and cut expenses.  Get a roommate, get married, meet at a friend’s house instead of the new brewery, make your coffee and lunch at home, etc.   Frugality is a key component to the building of wealth.

Refine your search area and become an expert on everything real estate in the market you desire.   Have a good relationship with a Buyer’s Agent that works that area.  Build spreadsheets on sales in the local area.  Watch for lengthening time on market.   Do a comparable home analysis on each home you think you will bid on.   Be an expert!

Consider a move to another market that is not inflated but is growing and may be a better place to buy a first home while the market transitions.  Particularly for remote workers there is a great opportunity to explore other markets for a few years.  Make it an adventure.  A move does not have to be permanent.   After the housing market works itself out you could always move again to a more ideal location that suits your personal desires.

There are two types of appreciation – natural and forced.  Natural appreciation is the growth in the market.   If there is a price decline in the market of 10-20%, there will be greater opportunity for natural appreciation when the market returns to normal.  This will increase equity more quickly and offer better opportunities when lower rates offer refinancing opportunities.  Forced appreciation reflects the equity you create in property by the improvements you make.   Look at houses for what you can make them with your own effort rather than looking for the HGTV perfect house that some flipper has renovated.  Look for the worst house in the best neighborhood.

Consider unconventional methods.  One option is to find an off-market house and convince the owner to make a sale.  Your Buyer’s Agent may be willing to use their mass mailing resources to send mailers to a neighborhood of interest to you in the hopes of finding a potential seller thinking about selling.  They could avoid the hassles of listing on the open market and both the buyer and seller could benefit from reduced transaction costs.

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