Is This The Top Of The Real Estate Bubble 2.0?
If this is not a sign of the "greatest fool" syndrome in the real estate market, I don't know what is. By the way, the above article is real and is a testament of the naïve money coming in late to the party once again!
The first thing I want everybody to grasp is that middle class families taking on thirty-year mortgages drive the real estate market. That is what I call a financial asset in strong hands, because in the majority of the cases a family that buys their first home or trades up to a bigger one is going to hold it for at least 10-15 years if not for the length of the mortgage. This is what establishes a floor in the real estate market and makes it an investment that is going to slowly appreciate at the rate of inflation.
Who Really Drives A Sustainable Recovery In Housing
© March 2014 Systemarket. http://www.systemarket.net
The above chart represents 100% of working households in the United States. In the chart, 50% of working families in the U.S earn between $30K - $62K per year. The bottom 25% earn between 0 and $22K while the top 25% earners make $77K and above.
Clearly, the largest segment in this chart drives the housing market. The moment you price this large group out of the market real estate prices would become unsustainable.
In order for a middle class family to be able to afford a median priced home two factors must be taken into consideration; jobs and wages. First of all, the house needs to be at an affordable level in relation to wages earned by the household. In other words, in order to keep constant liquidity in this market prices can not rise so far above the rate of inflation to a point in which the yearly wages of a middle class family can no longer afford the price of a median home. This is what is called the ratio of wages to housing.
Wages To Housing Ratio
Simply explained; The wages to housing ratio is the number of years needed to pay the original price of a median home in full, not including interest. This ratio cannot be above 3-4 times 100% yearly household wages. For example; for a middle class family earning $50K per year the maximum price that they should be looking at when buying a home is between $150K and $200K. It is no coincidence that for the past 50 years the long-term average of the Shiller Home Price Index has been $100K while the average household income in the U.S. has been $49K. Those numbers give us a metric of 2 as a long-term average in the wages to housing ratio. Therefore, a reading of 3-4 already pushes this metric into its upper range. Any readings in this metric above 3-4 are impossible to sustain for a long period of time. In February of 2014, the median home price in the U.S. was $189K and the median household income was $51K. That gives us a wages to housing ratio of 3.7. This means that nation wide median home prices are not a bargain any more, they are actually near the upper range of this metric.
Now, let's move to areas where this metric is off the charts. Where median housing prices are at unsustainable levels. I am going to start with Alameda County, this is where I live. According to the U.S Census Bureau, the median household yearly income in this county is around $72K. According to Trulia the price of a median home in Alameda County is $611K as of February of 2014. The wages to housing ratio in this county is 8.5, double of what is already a reading at the upper range of the metric to be sustainable.
The above image speaks for itself. The price of a median home in San Francisco is a cool million! If you take in to consideration that the median household yearly income in San Francisco County, according to the U.S. Census Bureau, is $75K then you have a wages to housing ratio of a whooping 13.3. These metrics are impossible to sustain and at some point gravity will take hold and revert these metric to the mean. When that happens, it will be incredibly painful for those who are levering this much in the San Francisco real estate market. The same is happening in some of the former bubble markets such as Arizona, Nevada, Florida and California. Housing prices in some of these places have increased in the last year alone by 23%. Even the bankrupt paradise of Detroit saw home prices skyrocket 17.3% at the end of 2013 compared with a year earlier. The question is, have the incomes of middle class families increased that much in the past year? The answer is no, on the contrary, median household incomes have been declining since 2007.
To make matters worst, as of Jan 10, 2014, new mortgage rules have gone in to effect.
These rules are designed to protect consumers from predatory lenders (and from themselves). But at the same time they are going to keep a large number of families from entering in to the real estate market. Here are some of the main rules that are definitely going to affect the number of mortgage approvals in a negative way. Lenders can no longer offer risky loans that go beyond 30 years, promote "teaser" rates that are interest only or have negative amortization schedules that eventually are going to lead to higher monthly payments. And in my opinion the rule that is going to keep a large percentage of middle class families from obtaining a mortgage for years to come; the debt to income ratio is now critical. Under the new "ability-to-pay-rule," borrowers cannot exceed a 43% debt to income ratio which is your total monthly debt divided by your total monthly gross income before taxes. Furthermore, borrowers must provide proof of credit worthiness with current paycheck stubs, credit history, employment status, bank statements and proof of other assets along with the down payment.
With that in mind it's worth taking a look at the debt situation for most Americans. In 2014, 56% of Americans had "sub prime credit." Even though most financial institutions would have their own definition of sub prime. As a general rule, a credit score bellow 620 is usually consider sub prime. Total consumer credit in the U.S.A. has risen by a whopping 22% over the past three years. With median incomes being in a downtrend and the real unemployment rate at 12.7% a good portion of middle class families have been forced to use their credit cards to make ends meet. The average credit card debt in the U.S.A is $15,279. The average student loan debt is $32,250. As you can see by these numbers alone, a high percentage of middle class families will have a hard time qualifying for a mortgage.
Middle Class Families Are Absent From The Housing Recovery
The most irrefutable proof that this so called "recovery" in housing has been driven by Wall Street hot money and not middle class families as a real recovery would be is the fact that mortgage originations are at 18 year lows! They are at 1995 levels and down 65% from the 2005 highs. This corroborates the point that I have been trying to make all along that in the real world real people need a mortgage to buy a house. This chart proves that middle class families are not applying for mortgages.
Chart courtesy of Elliot Wave International. https://www.elliotwave.com
What is most disturbing is that as reported by Realty Trac, all cash purchases accounted for 42% of all U.S. residential sales in December of 2013. This is definitely not a normal market behavior. Before the crisis of 2008-2009, all cash purchases were never more than 10% of all U.S. home sales. Furthermore, distressed sales (foreclosures and short sales) rose to a three-year high of 16% of all residential sales. In a normal market the normal percentage of distressed sales is less than 3%. I can tell you that in a strong housing recovery distressed sales would not be 500% higher than normal.
Therefore, if middle class families are not behind the recovery in the real estate market, then why have prices risen so fast in the past couple of years and who's been behind this so called "recovery?" Enter, the Fed's QE programs.
The following is Wikipedia's definition: " QE is an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Central banks implement quantitative easing by buying specified amount of financial assets from commercial banks and other private institutions, thus increasing the monetary base and lowering the yield on those financial assets. This is distinguish from the more usual policy of buying or selling short-term government bonds in order to keep interbank interest rates at a specified target value."
How QE Is Affecting The Real Estate Market
In other words the FED is basically printing money out of thin air then using these newly printed dollars to buy distressed assets from the "to big to fail banks." So, it is replacing the garbage assets financial institutions have in their books (MBS) with new dollars. Now the theory is that this new money is suppose to provide a boost to the economy by filtering to mainstream Americans through loans. The problem is that banks are not lending it because they know that most Americans are in no position to repay these loans back. They are using all this liquidity to speculate in the stock market and housing markets.
As an example, Blackstone, one of Wall Street largest hedge funds, have been buying single-family homes for rental income. Blackstone has spent more than $2.5 billion on 16,000 homes deploying capital from the $13.3 billion fund it raised last year. The other two big players are Colony Capital LLC and Harbors Investment Corp. In addition to the big Walls Street boys we are also seeing high net worth individual investors looking for yield by buying foreclosed homes. Adding to that we also have the new breath of flipfloppers that come along with every housing bubble.
The FED increased its balance sheet by $3.2 trillion since the bursting of the first financial bubble and this hot money had to go somewhere. Based on the current fundamentals of the real economy, we can deduct that this money didn't trickle down to the 99%, it went strait to the hands of billionaires, millionaires and the well connected Wall Street bunch that are part of the 1%.
All this hot money is causing the abnormal price appreciations in real estate that we have been seeing during the last couple of years. This trend is not sustainable. One of the main reasons is that investors and speculators, unlike families buying a home with a mortgage, are "weak hands." They are not in it for the long haul. What most of you need to understand is that for an investor capital it is "raw material" and they will not risk it in any one investment idea to the point at which they allow a loss to grow large enough to put in danger their speculative activities. Therefore, the moment that real estate prices start to turn down the great majority of investors that have been buying real state for the past three years will start selling to realize their gains and to protect their precious capital. That is why they are "weak hands," they won't hang around long enough to take large losses. This is going to create a huge supply of inventory that won't be absorbed until prices are low enough for middle class families with mortgages to take them off the market. When this happens it won't be a V shape like recovery, it will be more like an L shape recovery that will take many years to play out not months.
I want to finish with the above chart, which in my opinion says it all. As you can see, through most of the nineties home prices were mostly stable and slowly rising. Median household incomes, after being in a small downtrend from a top in 1988 started to rise in the mid 90s. It's important to notice that incomes took off before home prices did. During the monumental housing bubble of the early 2000's, median household incomes were rising along with median home prices. In addition, the FED had lowered interest rates after 9-11 and banks lowered or better yet eliminated any possible lending standards they could think of to fuel the biggest housing bubble in U.S. history.
Median household incomes initially peeked around 1999 and briefly declined until 2005 were they took off again, while home prices kept on pushing higher. Median home prices topped in 2006 making an all time high. But the curious thing is that median household incomes made a lower high with out taking the high it made in 1999, an impending signal that housing had just made an important top, which was indeed correct. Median household incomes have consistently fallen since 2007 while housing prices had rebounded and in some hot markets have already reached the previous highs made in 2006. What the chart tell us is that middle class families are not participating in this latest housing bubble and its all been a game for the speculators and Wall Street hot money.
The reality is that the gap that you see at the right hand side of the chart between median household incomes and median home prices will close at some point either by incomes catching up with home prices or home prices coming back to reality. One thing I am 100% sure of is that the median household income in the U.S. is not going up 40% any time soon.