Saturday, January 19, 2008

Housing 101

According to DataQuick, Long Beach had the third highest number of sales for November 2007 in all of Los Angeles County. That’s very impressive, and could demonstrate Long Beach really is immune from the surrounding housing meltdown, as some on this blog have intimated.

And the fact that the median home price only dropped 1 percent (to $505,000) between 2006 and 2007, is strong evidence supporting that.

However, although the run-up of property values (fueled by a now non-existent easy-money lending binge) was not as severe in LB as surrounding counties, the current state and national economic factors will virtually guarantee further downward pressure on Long Beach housing prices. Here is why I believe that:


Do you know why landlords in Alamitos Heights don’t charge $4,000 a month for a 1 bed/1 bath?

Because the local income in Alamitos Heights wouldn’t be able to support that rent.

And unless wages went up dramatically, or all area landlords suddenly increased rents by 300%, that studio apartment would sit unoccupied until the price came down to a level supported by local wages.

If monthly rents are too high for a majority of the residents, demand drops like an anvil, and landlords lord over empty units. Once rent drops to a level sustained by local wages, demand goes back up, supply diminishes, and we hit a happy medium until the next cycle begins. Landlords are conscious of this balancing act, and have determined that the generally accepted supply/demand sweet spot for rent is around 25 to 30% of the area’s median monthly income.

The median gross household income in Long Beach is around $43,000, meaning a monthly income of $3583. Median rent for the city is about $855 according to Well what do you know? $855 monthly rent is almost EXACTLY 25% of monthly income!

Smart folks, those landlords.

The same economic principle applies to buying a home. If the median income earner has to spend 50%, 60% or 70% of their paycheck on a mortgage, they would be overwhelmed trying to pay other bills and stay financially solvent--especially given the inflationary factors at play (how much did your fill-up cost last week compared to last year?).

So, if the median buyer can rent a home for half the cost of a mortgage (and substantially increase his discretionary income and quality of life) the choice is obvious. He’s going to rent. And so are his friends.

Some may say “pride of ownership” and the stigma of renting are intangible factors making “stretching” a housing budget worthwhile. Fair point. The desire to "own" something and build equity are strong emotional factors, and is something I am willing to "stretch" in order to achieve.

But stretching to the point that there is not enough money left over for car payments, gas, utilities, oil changes, hair cuts, entertainment, maintenance, health care, clothing, groceries, car insurance, etc. is not a sustainable financial situation. Just ask the millions of former homeowners who “stretched” into a home they couldn’t afford and were foreclosed on. My guess is a majority would have much rather had the “renter” stigma than losing their house, down payments, and credit scores.

As you can see, there has to be a healthy relationship between wages and housing prices, just as there is a direct correlation between wages and rent prices.


The size, location, and quality of a rental are directly limited by how much money you earn. After all, if you can’t come up with a Belmont Shore rent payment every month, you simply won’t be a Belmont shore renter.

The same is true of buying a home. If your monthly income can’t cover a Beverly Hills mortgage, you won’t be buying 90210 property.

However, during the last six years or so, that rule changed. We saw the growing implementation of “creative” loans using ticking-time-bomb rate resets and interest-only schemes that restricted equity building. These loans kept the monthly payment low and allowed people who would have otherwise not been able to afford a house suddenly buy a home at 6x, 8x, and even 10x their income. The traditional measure for a sound housing investment is 3x or 4x annual income.

The only thing preventing all of us from driving Ferrari Enzos is finding a lender offering 55-year, interest-only loans. An underemployed circus monkey could afford anything if the financing is creative enough.

With foreclosures at an all time high, we all know how those negative-amortizing, interest-only loans turned out.

Most of those creative loan products that allowed otherwise financially unqualified people to enter the market or "move up" are now unavailable, and when you add economic factors like layoffs, increased jumbo (defined as $417,000 or more) loan rates, rising foreclosures, short sales negatively affecting comps, and signs of a recession…prices will come down even further in LB than the cuts we’ve already seen.

And by the way, with jumbo loans now out of reach for many people, how would a median family be able to buy a median home? Without access to a jumbo, they would have to cough up a down payment of $88,001.

Well what do you know?

An $88,001 down payment is juuuuuust shy of 20% on a $505,000 home. Twenty percent used to be the standard down payment for a home loan to protect lenders and ensure owners had enough “skin in the game” to prevent walk-aways during hard times. Given the ass-kicking lenders and banks are currently taking and the rising housing inventory rotting on their books, twenty percent is likely the standard to which lenders will soon return. When that happens, even more of the buyer pool will evaporate.


Another traditional lending standard was providing loans ONLY if the monthly mortgage payment (including principle, insurance, taxes, HOA, etc.) did not exceed roughly 28% of monthly income.

Here’s an example of a typical “median plus” buyer in Long Beach:

Annual Pre-tax Income = $50,000 / Divided by 12 = $4,166 per month income

$4,166 Monthly Income x .28 = $1,166 allowed for housing expense

In other words, if your monthly pre-tax income is $4,166 per month but you want to buy a $275,000 home requiring a $2,000 monthly mortgage…NO LOAN FOR YOU. The reason lenders did this is because they, who are much smarter than you or I, figured out that 28% was the “magic number” where families could buy a home and still afford to live without sustaining on Mac ‘n Cheese or defaulting on the loan.

Pretty smart. But some lenders forgot about why that number was so “magic” and why some people are destined to be renters forever. Banks and lenders, in competition with each other to claim their piece of the rapidly accelerating real estate cash cow, veered from this lending standard and approved much larger loans to unqualified people which, 10 years ago, would have gotten a broker instantly fired.

So, as droves of people are foreclosed upon and the government scrambles to bail them out, lenders (at least the ones that are still in business) are returning to more conservative lending practices focused on larger down payments and realistic debt-to-income ratios.

What does a return to traditional lending standards mean for Mr. and Mrs. Median Buyer? It means at these astronomical median prices, they aren’t qualified to buy.

When they and their median neighbors are locked out of median homes due to lending restrictions, there simply will not be enough buyers to snap up an increasing supply of homes. Increase in supply = decrease in demand.

What does a return to traditional lending standards mean for Mr. and Mrs. Property Seller? It means at these prices, they don't have many people to sell to and demand is dwindling.

And the only way to solve that is to do what our Alamitos Heights landlord would do when his apartment fails to find a renter at $4,000 a month: lower the price to meet local incomes.

Without creative lending practices, Long Beach’s median home price of $505,000 cannot be sustained by the median income of $43,000. Period. That means prices will come down, and will continue to do so until a realistic middle ground is reached.


Does all of this indicate right now is an unwise time to buy? Yes and No.

Yes, it is unwise because as you can see by my basic calculations, Long Beach housing prices are still very inflated when compared to local rents and median incomes. As we have hopefully learned by now, when you can purchase a home for around the same cost as renting it—YOU SHOULD DO IT. That has always been the traditional measure of a sound real estate investment, and always will be. We have many price reductions and rent increases (already underway) to go before that equilibrium returns.

Conversely, now IS a good time to buy because the housing bull in me says incredibly low mortgage interest rates (and FED Chairman Bernanke’s virtual guarantee that he will drop the key rate even further) is a very enticing incentive. If you lock in to a 30-year-fixed at 5.5%, you will be sitting pretty in a few years as rates climb back up to combat inflation.


What happens when those rates do inevitably rise to fight inflation? A person with even the loosest grasp of economics will tell you higher rates negatively impact prices. That means your and your neighbors' property values will decline even further.

The fact is, the FED lowering interest rates does not tackle the basic economic problem: If the median buyer cannot afford the median home, a few hundred dollars in interest savings per month will not make it so.

Plus, the fact that homes aren’t selling well despite conforming 30-year fixed rates at 5.5% and jumbos at 6.5% means houses are still overpriced. This is why prices are falling, and why I suspect they will continue to do so.

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