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Thursday, April 13, 2006 | My wife and I enjoy watching Mythbusters, a Discovery Channel program in which two special effects experts build overly complicated contraptions in order to test the veracity (or lack thereof) of assorted urban legends.
I like to think of this column as a subject-specific version of Mythbusters, albeit much more depressing and without so many explosions.
With that in mind I’d like to spend the next couple of weeks taking on certain commonly held
This week’s myth is the claim that there hasn’t been a lot of speculation in the San Diego housing market. This is a line of reasoning typically invoked in order to soothe fears of a rush to the exits should the market start to turn down.
An example of its usage – just one of the literally hundreds of times I’ve read or heard the claim – appeared in San Diego Magazine last year, when a well-known local housing analyst asserted that speculation in single-family homes is “essentially zero, and on condominiums it’s 10 to 20 percent, but that’s fairly normal.”
Is he correct? To paraphrase a former U.S. president, that depends on what the meaning of the word “speculation” is.
I imagine that most people who cite a lack of housing speculation in our city are referring to the purchase of homes by buyers who do not intend to live in them. Given that San Diego rents are so low in comparison to home prices, non-occupying homeowners who bought in the recent past are probably losing money each month. The only plausible reason for owners to subject themselves to such repeated losses seems to be an expectation that future appreciation in either home prices or rents will make up the shortfall. These people are, without a doubt, speculating.
But the Merriam-Webster dictionary defines the word “speculation” as “assumption of unusual business risk in hopes of obtaining commensurate gain.” Are non-occupying homeowners the only class of people who are engaged in speculation?
During both 2004 and 2005, 80 percent of San Diego homebuyers used adjustable rate mortgages (ARMs). There is nothing inherently shocking about this statistic – until you consider the fact that those two years saw fixed mortgage rates lower than they’d been in two generations. (See Fixed Rates Chart)
Why would any buyer – let alone the vast majority of buyers – blow the opportunity to lock in lifetime-low mortgage rates for good? Why would they instead subject themselves to the payment increases resulting from the nigh-inevitable rise in adjustable mortage rates? (See Arm Rates Chart)
The answer is simple. Many buyers didn’t see the need to lock in low rates because they didn’t think they’d be in the mortgage for very long. Some assumed that they would sell their homes at huge profit and move to the next coach up on the housing gravy train. Others figured that they would soon refinance their mortgages to pull out all that equity they’d gained. In either case, a fixed-rate mortgage would be pointless. So why not stretch to get a little more house by employing an ARM.
It doesn’t make a difference whether or not these buyers intended to occupy the purchased home. They took on the risk of eventual payment hikes in order to increase their “bets” – the prices of the homes being purchased – in the hopes that price appreciation would cover the increased mortgage bills and lead to even bigger payouts. For better or for worse, they were very much engaged in speculation.
And there were even more daring housing-market participants than the holders of simple ARMs.
Interest-only mortgages allow buyers to stretch a little further. With a typical mortgage, each month’s bill pays down a piece of the amount owed (called the “principal”) in addition to the monthly interest. Interest-only borrowers, on the other hand, enjoy an initial period during which they eschew principal payments and, as the name would suggest, pay only interest.
Of course, at some point the monthly bills have to rise enough to start chipping away at the backlog of principal payments. Interest-only borrowers can thus expect a double-payment whammy: the addition of principal payments as well as the potential increase in the mortgage rate.
The reasoning employed is presumably very similar to that used by standard ARM-holders. The only difference is that interest-only buyers are taking on the risk of an even higher payment in order to stretch into an even nicer home for an even better payoff. Once again, regardless of where they live, they are speculating.
Almost half of all San Diego mortgages issued in 2004 were interest-only. I do not have data for 2005, but based on general lending trends, I strongly suspect that the 2005 ratio was even higher.
Moving a little further along the risk spectrum, we find negative-amortization mortgages, including the ever-popular option ARM. These mortgages take the interest-only concept a step further. During that glorious introductory period, borrowers do not have to pay down any principal. The added twist is that they don’t even have to pay all the interest. Unpaid interest is added to the loan principal, which will of course eventually lead to even higher payments as the borrower has to pay the original principal and the unpaid interest, simultaneously taking the hit on any rate increases.
This could add up to a pretty serious payment shock down the road. Some neg-am borrowers could realistically see their payments double. I wonder if there’s a word to describe the act of purchasing a home in the hopes that it will appreciate fast enough to allow one to bail out of the mortgage before the payments rise to a level that one cannot afford? Could it be…speculation?
No, the non-occupying owners have plenty of company in the speculation bandwagon. Not that they themselves are all that rare. Our good friends at the National Association of Realtors recently reported that 40 percent of nationwide purchases in 2005 were investment or vacation homes – in other words, homes that were not to be occupied by the buyers. I don’t know what the percentage is for San Diego, but if it’s even half of the national figure, that’s still an awful lot.
Not that it matters all that much. Even if we ignore the outright purchasers of investment property, the bill is filled by all those over-extended borrowers who have put themselves into risky situations in the hope of commensurate rewards. There’s no shortage of housing speculation in San Diego.
Rich Toscano is an independent real estate analyst residing in Hillcrest and working in La Jolla. He writes extensively about San Diego housing at Piggington’s Econo-Almanac.