The Yield Curve Movements as it Relates to Home Buying

Mortgages don’t look quite as cheap as they used to.  As of December 9^th, the national mortgage averages look as thus:

The Federal Reserve has observed that the economy is doing better than anticipated, and now there are discussions about allowing the Quantitative Easing (QE) program to phase out.  Reactions to this have resulted in more sell offs in the bond market, which have further resulted in the rising yield curve.  If you are like me, and don’t necessarily believe that the Fed is driving the car, just look at the money flows over the past 12 months:

Since mid-year people have been ditching bond-investments, directly and indirectly putting all the more pressure on yields.  So buying a home has become marginally more expensive.  However, before we become too reactive to this evidence, let’s appreciate the counter-factual: the values of homes, too, have been rising!  This is the inverse, the opposite, of what we saw coming out of the S&L crisis of the early 90’s—instead of more expensive prices with lower affordability, back then it was lower prices with stronger affordability trends!

Here is a neat way to frame it, my way of framing it, using a matrix:

Home Ownership = Best Hedge against Inflation

The trouble with prices of assets (e.g. a house) as they relate to inflation is that they do not move evenly. Unless you enjoy reading fiction, you can throw out your textbooks on linear, static outcomes because it simply isn’t reality. If all prices immediately adjusted to and reflected supply / demand preferences then the only thing one would notice are rate adjustments made between debtors and creditors. The interest rate quotation on a mortgage is supposed to be that equalizer. Yeah, ok…

Real problems come when monetary influence either allows for an unsustainable expansion, or contraction, due to controls on the supply and velocity of money (M2) outstanding. The criticisms towards housing on a national scale are founded on the claim that mortgage credit become too cheap and easy to obtain. Definitely a legitimate point, but the superlative one, made above, is that prices and inflation do not move evenly! This isn’t a simple modus ponens - if ‘p’ then ‘q’ - outcome those journalists and economists with this broad brush strokes like to portray. There is a fundamental reason, not merely technical, as to why prices move.

Whether one is in the government-driven or market-driven camp, inflation is present so long as money is printed. Whether one believes that inflation goes up because some “smart guy” pushes a button - lowering rates, opening the discount window, and printing cash; or whether it’s the markets that dictate inflation due to constrains in supply or faster movement in demand… inflation will be present. The long-long term implication is that real assets, which include residential property, are a direct reflection of that phenomenon.

Socioeconomic speculation aside, some short-term predictions suggest that the Federal Reserve (eminent controller of inflation) is reaching an impetus, where it may lose all control and we may experience either hyperinflation, supposing the economy were to boom again, or, worse even, dis-inflation (deflation) as monetary contraction will eliminate the supply for a market, thus constraining demand in a worse fashion. This is precisely why I say not to dwell on the monthly sentiments of the academics in charge. Bernanke one month ago said that the deadline for the $85 billion per month QE program would be extended and we saw the 10-year treasury drop back down, even lower than the low of 2.60% where we were before. I don’t know how people propose to time such affairs.

Rather, what I want to leave you with is this meditation: if we go from today’s low interest rate, low inflation environment to a high interest rate, high inflation environment, will you be happier that you bought your home today or will have waited?  

Rationale for a Housing Recovery

The U.S. Housing market will continue to recover.

Here are two reasons why:

1.      The credit cycle is strengthening, and

2.      Inventory levels are favorable 

Nominal Mortgage rates are what we see in the newspaper. Real mortgage rates adjust the nominal by subtracting annual inflation from the median house price. That takes into consideration that debt to buy a home costs less (in real terms) as the asset being purchased increases in value.

The recent period of negative real mortgage rates signifies that people who have bought property, measured on a nationally aggregate basis, have made great purchases of property. This is one metric that actually objectively says, “…now is truly a good time to buy a home.” Despite the recent slowdown in price appreciation, the cost of financing side is still in our favor.

And for the inventory part: 

The recent housing rally doesn’t need to become as lofty as the previous to manage respectable appreciation from this point either. Fundamentally, there are reasons behind demand - income levels, ability to qualify, etc. - but technically speaking, the lack of supply issuance (above chart) suggests that there hasn’t been housing starts (construction metric) for quite some time. Due to this lag, don’t be surprised to see appreciation in housing on the fact that there is a delay to new supply (click on charts to enlarge). 

A Common Misconception about the CPI & OER

There is a tendency, well, everywhere, to throw numbers in the face of friend and foe alike, generally in an attempt to produce that silent, “man, you-are-totally-right-and-I-will-never-doubt-you-again” response. Not that it actually happens anyhow. What I’m saying is that numbers tend to demand respect without being qualified. And any chance I can aid in adding clarity to a figure or concept is always a fair excuse to elaborate:

The Consumer Price Index, or CPI, is one of the most loaded figures invented by man. The paradox here is that peoples’ past consumption decisions determine the metric’s current output (demand pull or cost push), and based on that output, people have a tendency to change their future decisions because of it. Or we can just call it what it is: past behavior is a predictor of future behavior.

Visually illustrated:

Distinction is the reason one studies philosophy:

There are two separate housing-components within the CPI index—the common conception of what it is, and the ‘Owners Equivalent Rent’ (OER).

The dirty secret here is that the CPI does not track home prices per se, because the OER concept is really just a proxy.

This portion that makes up nearly one-fourth of the index value is an answer to the question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” You should be asking your agent this question so you have a better idea at arriving at the appropriate negotiation value for your home (future blog to elaborate).

I want to make one more argument. See the following chart:

Major premise: The Home Price Index (HPI) is the nominally appraised market value of a property. This is what willing buyers and sellers agree upon. Nationally speaking, this is what drives the perception of the “housing market.”

Minor premise: The Owners’ Equivalent Rent, which we acknowledge has limitations, represents the rent-demand pricing power built within an existing home. The increase in home qualification standards, supply constraints, and the change in existing home owner behavior has justifiably increased the fundamental case to establish a floor price on home values.

Argument: the OER specific to one’s region is the qualification number to the CPI. This is the equivalent of the earnings power rising for a company over time. As long as the OER shows strength over time, and it has, then the nominal price of a home will eventually reflect that intrinsic value.

Pre-Qualification

Whether it’s your first or fifth property, everyone really should get pre-qualified. The primary reason to get pre-qualified is because one wants to know how much of a home they can buy. Though the reason(s) one buys a home can be multiplicative or singular in nature, the process in route is pretty standard. Talk to me if you need help in going through the steps. Below I want to elaborate on a few insights around this process:

                                                                                                          

1.      Getting pre-approved & pre-qualified are not the same thing! Getting pre-qualified determines that one is likely to qualify for credit, while the pre-approval implies that a credit decision has been rendered.

2.      The appeal of a bid made on property in many cases does go up when the letter from a lender is ready to go. However, in many cases it will not offer an advantage because it is required.

3.      Debt-to-income ratios are what it’s all about: financial institutions want to know where you were so they can understand where you will be. The bank is actually building your balance sheet for you! You are allowed to ask for your personalized report.

4.      The pre-approval is not ironclad. It does not guarantee that you will get a loan. {A banker joke: keep them on hold until you get income projections, and when you get the projections just ignore them.}

5.      Historically speaking: the mortgage-lending business arose in the 90’s on the value proposition that “real estate agents should spend more time with clients and less with the banks…” Call it right or wrong, but the fact is that there is another layer in the process. An agent’s responsibility is to aid in the financing process however possible.

6.      It is ultimately a loan officer, and not a mortgage underwriter that approves your loan. Depending on the institution one can feasibly influence approval through qualitative arguments.

7.      Student-loans are a very important consideration. Recall the importance of debt-to-income before and after the home purchase.

If you are only interested in the how questions, please come and speak with me so that I can walk you through the process. Here I have given a few of the why explanations surrounding the process.

Until next time.

Case-Shiller in Review from Financial Crisis Lows

Below is a chart highlighting the home price gains that each city has experienced off of its financial crisis lows.  San Francisco is up by far the most off of its lows at 47%, followed by Phoenix (37%), Detroit (36%), Atlanta (32%) and Las Vegas (31%).  As of June, 2013:

 

Rents Soaring – Time to Become the Landlord

The Wall Street Journal published a very informative article a few weeks ago on the strong rents being paid (and realized) in the major metro areas of the country.  The areas that saw the steepest rent increases in Q2, 2013, from a year earlier:

·         San Francisco: 7.8%

·         Oakland, Calif.: 6.9%

·         Denver: 6.1%

·         Seattle: 6%

·         San Jose, Calif.: 5%

·         Portland, Ore.: 4.4%

·         Houston: 4.3%

·         Austin, Texas: 4.1%

·         West Palm Beach, Fla.: 4%

·         Fort Worth, Texas: 3.6%

As we all know, the strong tech sector is helping fuel the rising costs for tenants.  Why not, then, be on the other side of the table, and purchase / own property to lease out (YOU be the landlord)?  There has never been a better time than now given the historically low interest rates.  Create partnerships, talk to your spouse or family members to pull together the funds, get creative with financing – anything is possible, make it happen.

The Power of Leverage in Real Estate

Used appropriately, the value of leverage is undeniably powerful. There is a reason why companies are recapitalizing their balance sheets today to take advantage of some of the best financing they have seen in decades. The fact is that by lowering the cost of capital and buying prudent assets with the money, one can magnify returns. Let’s look at a case within real estate:

Buying a one-million dollar home; putting 20% down; financing with a thirty-year mortgage at 4.25%. The key assumption here (debatably the biggest assumption of all) is that the value of a home will grow at 3%/yr…in my estimation this is a modest, even pessimistic assumption – particularly in San Francisco given the supply constraints coupled with persistent demand. Finally, maintenance and taxes are ignored here because we would like to begin and end this conversation as a generalist. 

The facts, the lessons:

1.      Timing: The Loan-to-Value (LTV) decreases at an increasing rate as time passes—where the magnification of leverage comes from. When the home appreciates relative to the amount, the percentage of debt outstanding is crucial…timing is very important in real estate.

2.      Mathematics: It takes fifteen years to pay half of the paper off. But at only 3% per year home appreciation, in year ten (five years sooner) you will already be a 50% equity owner.

3.      ROI: The ROI in this example is roughly 44%. Again, this assumes a pessimistic outcome of home appreciation that barely outpaces the long-run rate of inflation. As it is said: “Plan for the worst, hope for the best…”