Friday, June 24, 2005 | This is part two in a two-part series.
Rents vs. home prices
Now let’s step back and look at the issue of home prices an entirely different way. All of the usual suspects – population, housing supply, income and the desirability of the city -should affect the price of renting a home as well as buying a home. So rent prices, when compared to sale prices, should indicate whether or not sale prices are too high given the demographic factors. Not surprisingly, they do just that.
Amazingly, growth in rent prices has actually been slowing since 1999, even as sale prices began their parabolic rise. From 1999-2004, sale prices rose over three times as much as rents, and from 2003-2004 alone sale prices rose a staggering seven times faster than rents. The declining growth in rents concurrent with a phenomenal increase in sale prices provides yet another indication that those sale prices are not remotely justified by fundamental factors.
Interest rates
For starters, monthly payments have risen steeply even against a backdrop of declining rates. As the following chart shows, the monthly payment on a 30-year mortgage for the median-priced San Diego home has risen by 79 percent, even though the mortgage rate decreased by 22 percent over that time.
Of course, few people attain fixed-rate loans these days given that adjustable-rate mortgages offer such low payments. However, even the drop in short term rates has not nearly offset the rise in home prices. Since 1999, the rate on a one-year ARM has dropped 34 percent – but ARM borrowers still would have seen monthly payments increase by 66 percent.
To make the most extreme comparison: the monthly payment for a median-priced San Diego home using an ARM in 2004 would have been 43 percent higher than the payment on the same home using a fixed loan in 1999. This, incidentally, coincides with an increase in per capita income of 21.6 percent, meaning that, even accounting for switching from a fixed loan to an ARM, monthly payments rose twice as fast as incomes during this period.
To my mind, however, an even bigger flaw with the idea that current home prices are justified by low rates involves the implicit assumption that rates will stay this low. This is a very complex topic that will be dealt with in later articles, but suffice it to say that there is a very real possibility that interest rates could rise significantly. It is absolutely possible that rates will remain low for years to come, but it is a mistake to blithely assume that they will remain low, or that they will creep upwards at a smooth, housing-market friendly pace of 50 basis points per year. Should rates rise significantly, or should underwriting standards get back to a point where it is necessary to make a down payment or to assume a non-interest-only loan, monthly carrying costs on homes at current prices will prove impossible for many market participants to handle.
The current environment of low rates and easy lending does not explain away housing prices. Home price increases have already rapidly outstripped any offsetting reduction in interest rates, and the necessarily temporary nature of generational low rates and underwriting standards ensures that neither factor can provide justification that prices are sustainable at this level going forward.
A classic speculative bubble
– 80 percent of mortgages were adjustable-rate, meaning that many borrowers were speculating that their salaries or home equity would increase faster than their mortgage interest payments.
– 47 percent of mortgages were interest-only, meaning that many borrowers were speculating that their salaries or home equity would increase faster than their mortgage interest payments and the eventual addition of mortgage principal payments.
– 27 percent of mortgages involved no down payment, meaning that many borrowers could (and did) use ultra-low rate interest only ARMs with no money down in order to afford far more house than their incomes would typically allow.
– 37 percent of condo conversion buyers were investors, meaning that, given the comparatively low rents discussed above, the only possibility of these people not losing money is for condo prices to rise enough to cover the current negative cash flow.
And most importantly, as anyone who’s read a newspaper or gone to a party knows, it has become a widely accepted fact both in the media and among the San Diego populace that real estate A) never goes down and B) is the place to be if you want to get rich. This entrenched expectation of huge, risk-free equity gains has become priced into the housing market.
San Diego real estate is a market not driven by fundamentals. Home prices have been driven to current levels by ubiquitous optimism, a complete lack of risk avoidance, a staggering amount of debt accrual, low lending standards, an enormous increase in market participation, widespread misconceptions about what drives home prices, and an utter dependency on continued price gains. San Diego real estate is in the grips of a classic speculative bubble.
Rich Toscano is an independent real estate analyst living in University Heights. He monitors San Diego’s housing market at The Econo-Almanac for the Landed Poor