Stagnant wage growth will limit future house price inflation
House prices generally rise along with wages. When wages go up, people use their borrowing power to bid up home prices. Of course, this requires three simplifying assumptions. First, interest rates must be steady. Steadily dropping interest rates can increase borrower leverage in the absence of increasing wages. In fact, most of the increase in prices from 1990 to 2012 can be directly attributed to falling interest rates. Homebuyers in 1990 made the same house payments as a buyer in 2012, but prices in 2012 were considerably higher due to the decline in interest rates from 10.5% to 3.5%. It doesn’t look likely that interest rates will fall below our recent record lows, certainly not enough to recreate the excess leverage created from 1990 to 2012.
The second simplifying assumption is that the percentage of income put toward housing remains constant. Most people in California borrow the maximum a lender will give them. During the 1970s when California inflated its first housing bubble, lenders allowed DTIs upwards 60% because they expected borrowers to have 10% raises every year due to inflation. Recent regulations in the qualified mortgage rules cap total DTIs at 43% of borrower income, and the GSEs currently only allow 31% to be put toward housing payments. Unless lenders find a loophole, DTIs should be much more stable in the future.
The third simplifying assumption is that wages and interest rates are applied to conventionally amortizing mortgages. During the bubble in the early 90s, interest-only loans were popular and some Option ARMs existed in the market. During the Great Housing Bubble, Option ARMs proliferated and DTIs got wildly out of control. Since both interest-only and negative amortization loans were banned by the new qualified mortgage rules, it’s unlikely these products will cause prices to inflate wildly again.
That leaves us only with wage growth to push prices higher. If we assume stable interest rates (perhaps a poor assumption as rates will likely rise) and we assume stable DTIs and conventionally amortized mortgages, then prices will only rise to reflect wage growth. In the short term, prices may rise because many markets are still undervalued, but over the long term affordability limits will be more rigid, and house prices will only appreciate if people earn more money.
Given our weak economy with high unemployment, we probably aren’t going to see much wage growth over the next 5 to 10 years.
The U.S. Federal Reserve has put a lot of its eggs in the housing basket. After all, a healthy housing sector brings benefits to the economy. Home-building provides jobs, mortgage financing offers revenue to the banking system, and households feel more financially secure if the value of their home isn’t freefalling into the abyss.
By keeping mortgage rates super cheap, the Fed has propped up housing demand. And after years of few projects, builders are breaking ground on more homes.
Tuesday brought news that housing starts in May rose 6.8% to an annual rate of 914,000. While much of the gain came in apartment projects, single-family homes edged up 0.3% to 599,000.
Some fret the recent rise in mortgage rates could scramble the Fed’s goal. The 30-year fixed rate edged up to 4.15% last week. What is the impact if the 30-year fixed rate jumped from its recent low of 3.5% to 4.5%?
The impact on the national market would be small, but the impact on our local markets where prices are much closer to affordability limits will be strongly impacted. A borrower who could afford payments on a $643,341 mortgage at 3.5% interest rates can only afford to borrow $570,154 at 4.5%. That’s about an 11% drop in buying power.
A new single-family home costs, on average, $310,000. With a 10% downpayment, the monthly payment increases by $161. With a 20% downpayment, the rise is $143.
The extra cost wouldn’t darken the housing outlook except it is running up against puny growth in incomes.
Consider the trends in home prices and incomes since housing’s bottom in 2011. The average new-home price is up about 17%, while per capita income has increased just 2.8% (or about the same pace as inflation).
Assuming the average household income has risen just as slowly as per capita earnings, the typical family needs to devote more of its monthly budget to housing costs even with no change in interest rates. A larger debt burden will make banks more reluctant to write a mortgage.
The constraint will fall harder on adults aged 35 or younger who make up the usual cohort of first-time buyers. They have higher unemployment rates than other adult workers. And many also carry large amounts of student-loan debt.
With many households still priced out of home-buying, it is no wonder apartment-building is doing so well.
The over-indebted recent college graduates are priced out, they are debted out. The amount they are likely spending on rent could make a housing payment. Most markets still have costs of ownership lower than comparable rentals. They can’t qualify because they have too much debt in student loans, car loans, and credit cards.
The Fed has little direct power to lift income. (Indeed, rapid wage gains without commensurate productivity growth would raise inflation alarms among the more hawkish Fed officials).
It wouldn’t just raise inflation alarms among hawks, it would cause real, measurable inflation the doves couldn’t ignore.
Yet unless prospective home buyers see better income gains, affordability will limit just how busy home builders will be in the future.
It will also greatly limit how much prices go up in the future… If they go up at all.
An Option ARM true believer
The former owner of today’s featured property paid $430,000 in 2002. He put $43,000 down and borrowed the rest. On 2005, he took out a $598,500 Option ARM with a 1% teaser rate. When that was due to reset, he took out another Option ARM for $650,000 in mid 2007. He extracted about $250,000 with those two refinances, and he was likely making payments far less than a rental due to his teaser rate.
He quit paying sometime in 2009, and he was allow to squat for three years. Not a bad bonus to go with all that cash.
[idx-listing mlsnumber=”PW13117295″ showpricehistory=”true”]
$682,500 …….. Asking Price
$430,000 ………. Purchase Price
5/22/2002 ………. Purchase Date
$252,500 ………. Gross Gain (Loss)
($54,600) ………… Commissions and Costs at 8%
$197,900 ………. Net Gain (Loss)
58.7% ………. Gross Percent Change
46.0% ………. Net Percent Change
4.1% ………… Annual Appreciation
Cost of Home Ownership
$682,500 …….. Asking Price
$136,500 ………… 20% Down Conventional
4.24% …………. Mortgage Interest Rate
30 ……………… Number of Years
$546,000 …….. Mortgage
$138,290 ………. Income Requirement
$2,683 ………… Monthly Mortgage Payment
$592 ………… Property Tax at 1.04%
$50 ………… Mello Roos & Special Taxes
$142 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$106 ………… Homeowners Association Fees
$3,572 ………. Monthly Cash Outlays
($551) ………. Tax Savings
($754) ………. Principal Amortization
$208 ………….. Opportunity Cost of Down Payment
$105 ………….. Maintenance and Replacement Reserves
$2,581 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$8,325 ………… Furnishing and Move-In Costs at 1% + $1,500
$8,325 ………… Closing Costs at 1% + $1,500
$5,460 ………… Interest Points at 1%
$136,500 ………… Down Payment
$158,610 ………. Total Cash Costs
$39,500 ………. Emergency Cash Reserves
$198,110 ………. Total Savings Needed