Why Continued Positive Comments About the Housing Market Scare Me

As a broker I make my living assisting clients purchasing and divesting of their real estate holdings. In this market of ever seemingly positive news I should be thrilled. Yet as a 20+-year broker licensed in two states I have some serious concerns on the macro level, which truly reverberates beyond home sale statistics.

At present the Denver market as well as the US market looks very healthy. Demand is high, employment and wages are growing, and mortgage rates are low.

However based on reports out this past week, if one reads between the numbers and taking into account history and growth trends, the market is quite challenged. Not at present but longer term we may be setting ourselves up for a dramatic shift in the economy and wealth accumulation.

There is continued strength in the overall national housing market with prices 6% higher than the same period one year ago. Some local markets continue to show double-digit growth in prices. Metro Denver’s year over year was 7.9%. Such numbers are driven by the simple law of supply and demand and specifically the limited supply at the lower end of the market. Thus lower end homes are witnessing significant price appreciation due to more competition while higher end listings are languishing or having price reductions (see my last blog).

While I have mixed feelings on Zillow and similar sites, their insights and digesting of data is always an interesting read: “It sets up a situation in which the housing market looks largely healthy from a 50,000-foot view, but on the ground, the situation is much different, especially for younger, first-time buyers and/or buyers of more modest means,” wrote Svenja Gudell, chief economist at Zillow in a response to the latest home-price data. “Supply is low in general, but half of what is available to buy is priced in the top one-third of the market.”

So why is the inventory and supply on the lower end of the market so challenged? A few reasons and many can be seen in your local neighborhood:

Conversion of Inventory from Home Ownership to Rental: During the Great Recession which many of us brokers also call “a housing crash”, investors from large hedge funds to Ma and Pa purchased 100’s of thousands of foreclosed properties. While some were fix and flips, the vast majority became income-producing rentals. At present according to the U.S. Census there are 8 million more renter-occupied homes than there were in 2007.

Granted some renters may be scared off from purchasing and while the investors could cash out and after paying simple capital gains have a nice windfall, at present the cash-flow on rentals is one of the most attractive investments in the market coupled with the underlying equity appreciation of the real estate; thus the motivation to sell is limited. In turn lower end and moderate homes are not coming on the market in meaningful volume.

New Home Sales are Down: In August 2017 there was a 3.4% monthly drop concerning new home sales. If demand is so strong shouldn’t new home sales be booming? Well, it is again simple economics and in this case pricing.

In August just 2 percent of newly built homes sold were priced under $150,000, and just 14 percent priced under $200,000.

Builders advise they desire to build more affordable homes yet profit margins or the lack of is causing constraints. Builders blame the higher costs of land (exurbs with lower cost land is falling out of favor with 1st time home buyers who desire to be closer to urban centers), labor, materials and regulatory compliance i.e. building and zoning codes (and this is before the hurricanes decimated Houston, southern Florida, Puerto Rico and the US Virgin Islands which will demand laborers and materials to rebuild leading to eventual inflation in those industries and supply chains.

One could argue that market forces will eventually realign the housing market. Yet when this will happen is anyone’s guess. Considering we are still in a “Goldilocks economy for housing i.e. jobs and income continue to grow, interest rates remain at historically low levels, financing rules have become more flexible and inflation remains tame at below 2% annually. So what is the problem?

At present our inventory of new and existing homes is static with numbers similar to those found in the mid 1990’s a full 20+ years ago HOWEVER during those 20+ years the country’s population has expanded by 60M. Couple this with a mismatched market as home prices will not come down as long as there are buyers out there willing and able to spend more and more money for less and less house as we have witnessed in hot markets i.e. San Francisco Bay Area, The Northeast and other markets.

Longer term is my concern. We have witnessed locally in Denver our market moving from purchasers to renters. Good for investors not so good for individuals concerning personal wealth. Homeowners are known for making big-ticket purchases i.e. appliances and upkeep and maintenance sustains the construction sector i.e. additions, roofing and so forth.

If we move towards a renter oriented housing market fewer Americas will be able to save and grow their money associated with the ownership and upkeep of a personal owner-occupied residence. Due to demand rents may continue to rise (as less inventory on the market) and thus renters will have less disposable income to spend which will ripple through the economy beyond housing.

Yet Denver may be the litmus test for the national economy as follows:

Upper-End of the Market: is slowing dramatically as prices rose to fast and thus not sustainable. Upper-end buyers are usually market savvy and thus will be more cautious entering the market. Even in the Country Club neighborhood I have witnessed price-drops and re-listings at lower prices all in an effort to generate activity; would have been rare one year ago

Lower-End of the Market: Supply is outstripping demand with the average home in Metro Denver over $410K; yet incomes/wages have not kept up as the average worker is slowly being shut out of the market and thus will be a perpetual renter,

Rentals: The vast majority of new rental buildings are priced at luxury levels (just look at the cranes in Cherry Creek North). Yet that market is slowing and many of the existing buildings are struggling to attract tenants and now offering rental incentives. Yet additional buildings continue to come out of the ground.

Zoning and Entitlements: In Denver while zoning has allowed additional density and not without controversy i.e. slot homes in Cherry Creek, while beneficial to rental development, most rentals are oriented to single and couple households, with few exceptions most new multi-family buildings are not designed for families or larger households.

The above is just some food for thought. Add an existential crisis and this housing “House of Cards” may come to an ugly resolution. While I am not predicting another housing crash, the off-balance market is not sustainable and the overall repercussions to the overall economy have not been considered, quite dangerous.

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Denver Now 3rd for Year over Year Price Appreciation. Sustainable?

The most recent Case-Shiller Index for Metro Denver shows continued strength in our market which is now at #3 behind Seattle and Portland for price appreciation. Within the last year the price appreciation for Denver has been 7.9%, which is very, very healthy (nationally the increase was 5.6%). Even more interesting is the following statistic from the report: “Denver’s Case-Shiller home price index in May rose to a new record of 198.32. That means that local home resale prices averaged 98.32 percent higher than they were in the benchmark month of January 2000, based on non-seasonally-adjusted data.”

Yes as a broker I should be celebrating. However I have been curious about business and real estate cycles as I have learned over the year’s lessons from history should be respected.

Case in point a charming house on a nice corner lot in one of Central Denver’s most desirable neighborhoods recently came in the market. The house is of a desirable size with 2,000 SF above grade and a fully finished basement with 1,300 SF. In addition the home is located within a most in-demand public elementary school which is within walking distance.

I decided to do a title search to see the activity on this house as it relates to the Case-Shiller index. Fortunately I could go as far back as 1992. Here is the history based on public records, please note the information reads as follows

Transaction/Date/ Price/Gain/Loss over Prior Transaction in $/%/ From 1992/ % Int. Rate:

  • Sold June 1992 – $225,000 Average 30 Yr. Mortgage Rate = 8.51%
  • Sold Nov 1993 – $238,500 + $13,500 or +6% gain/ 30 Yr. = 7.16%
  • Sold Aug 1999 – $480,000 + 241,500 or +101% / 113% gain from 1992/ 30 Yr. 7.94%
  • Sold Oct 2003 – $690,000 + $200,000 or +43% / 206% gain from 1992/ 30 yr. 5.95%
  • Sold Sep 2007 – $825,000 + $135,000 or +20%/ 260% gain from 1992 / 30 yr. 6.38%
  • Foreclosed Nov 2010/ 30yr. 4.3%
  • Sold Aug 2011 for $625,000 (- $200,000) or (-24%)/ 170% gain from 1992/30 yr. 4.27%

Placed on market July 2017 for $1,950,000/ 30 Yr. 3.88%

Assuming a sale for $1,900,000 + $1,275,000 or 204% Gain/ 740% gain from 2002

Thus from 1992 to 2007 which many consider the pinnacle of the last market upturn before the Great Recession, the gain over the 15 years equaled $600,000 or 73%.

In the three years from the pinnacle of the market to subsequent foreclosure in 2010 and sale the following year in 2011 the home lost $200,000 or 24% in value in 4 years. Yet from 1992 the increase still equals $400,000 or a 200%+ gain over 19 years.

If this home sells for close to asking in the 6 years of most recent ownership, looking at a $1,275,000 gain or $204% over their purchase and 700+% over the 1992 sales price.

Again I assume there have been renovations. Of note I am not factoring inflation as the $225,000 in June 1992 would equate to $393,000 in 2017.

However if one were to graph the history of this home it is unique as it shows true cycles in the market. In 1994 Denver and all of Colorado was experiencing a similar economic boom as we are enjoying at present. Granted the present expansion cycle is exacerbated coming off the Great Recession however I continue to argue fundamental business cycles have not ended.

Yes we are in a Goldilocks fiscal environment with historically low interest rates. I purposely included the average interest rates at the time of each transaction based on the 30 yr. fixed rate. Also with unemployment at record lows eventually we should see inflation tick up. During times of inflation housing generally increases in value HOWEVER when mortgage interest rates increase there is historically an inverse relationship i.e. rates go up on mortgages prices can come down concerning housing as more of the monthly is debt service.

Thus one may conclude the phenomenal increases in values may be attributable to the influx of capital and population to Denver, attractive pricing when compared to coastal cities and all coupled with cheap borrowing costs. However is this growth sustainable?

Ask me in the next 12-18 months.

Personally I would be a seller at present and only a buyer assuming a longer-term hold i.e. over 3-5 years at minimum while locking in the low-interest rates. Just my humble opinion.