Housing Speculation is More Rampant Than You Think
As the "debate" over the existence of a housing bubble intensifies, both sides are likely to be proven wrong when it comes to predictions for housing declines should the bubble burst. Most bubble advocates believe that rather than collapsing, housing prices will either rise more slowly, fall slightly, or simply stop going up, thereby allowing stagnant incomes to catch up with surging prices. However, a closer look at the facts revels it is far more likely to burst with as big a bang as did the NASDAQ five years ago.
One of the main arguments (more wishful thinking than reasoned perspective) against a precipitous drop is that homeowners will not quickly unload houses in the same manner stock investors bailed out of losing equity positions. For example, Treasury Secretary John Snow recently argued against the existence of a housing bubble by claiming, "houses are not like stocks, pork bellies, or gold, and are therefore not prone to bubbles." He claimed that unlike buyers of those other assets, Americans are buying houses because everyone knows that houses are great investments. Setting aside the self-serving nature of his dismissal of even the possibility of a housing bubble, his comments ironically provided some of the most convincing evidence in support of a housing bubble that I have ever heard.
One reason few expect housing prices to collapse is the mentality that homeowners need to live somewhere and as such will be reluctant to sell their residences. This argument ignores that fact that so many of today's homebuyers do not occupy their properties as primary residences, and that relatively attractive rentals provide homeowners with viable, none-ownership alternatives for shelter. However, a more in-depth analysis revels that contrary to prevailing rhetoric, housing speculation is not only rampant, but also far more pervasive than the data suggests, perhaps even more widespread than was the case with tech stocks during the NASDAQ bubble.
According to a recent study by the National Association of Realtors, 23% of homebuyers specifically identified their purchases as investments. Another 13% identified their purchases as vacation properties. Since rental yields are so low, those buying properties as investments are by definition speculating. However, buyers of vacation homes, are also speculating, as inherent in the decision to buy such properties is the expectation of price appreciation. Absent such a forecast, it is far more economical to vacation in hotels. Further, as owners of rental or vacation properties do not occupy their properties as principal residences, a change in sentiment as to future price appreciation could easily cause such owners to sell, or worse, to walk away from mortgages in circumstances of negative equity.
However, the mere fact that owners occupy their houses as principle residences does not necessarily remove such properties from the category of speculative investments. For example, 58% of recent California homebuyers financed their purchases using ARMs (with percentages in pricier counties exceeding 80%). The primary reason given to justify such mortgages was owners' intentions to resell the properties in relatively short periods of time. Such buying is clearly speculative, regardless of the speculator's intention to occupy the property. Given high transaction costs and low relative rents available in markets where such mortgages are most pervasive, absent the expectation of rapid price appreciation, such short-term buyers would clearly be better off renting.
Also, the fact that so many buyers are using interest-only, or negative-amortization mortgages, suggests even greater degrees of speculation. Since none of the monthly payments on such loans reduce the principal of the mortgages, buyers utilizing them are no better off than renters. However, since they must also pay property taxes and maintenance, interest only buyers actually get the worst of both worlds. They rent property from lenders, yet get stuck with all the headaches associated with ownership. The only way interest-only buyers build equity is though price appreciation. In other words, they are the ultimate speculators.
The reasons for such unbridled, rampant speculation are clear. According to the Economist, a recent survey showed that the Los Angeles homebuyers expected an average 22% annual home price appreciation over the next 10 years. Given that medium home prices in Los Angeles already exceeds $500,000, such an appreciation rate would lift that figure to over 3.6 million, providing homeowners with over $300,000 per year in annual "income" simply because they own a house (tax free if they extract those gains though debt). Such unrealistic expectations provide compelling incentives to buy. It also helps explain why homeowners are willing to devote record high percentages of their current incomes to covering mortgage payments. When price appreciation is expected to produce annual "income" ten times greater than mortgage payments, the expected cost of such loans is zero. The new "reality" for many homebuyers is that rather than regarding homes as expenses, they rely on them as sources of income.
With current medium home prices in Los Angeles already ten times medium family income of approximately $50,000, one wonders just how typical Angelinos can afford to buy. The short answer is, they can't. That is why such a large percentage choose interest only mortgages. Again, since interest-only mortgages require no repayment of principle, borrowers are not really buying, since they will never actually own their homes. Such loans merely enable borrowers to pretend to buy houses that they cannot actually afford. Thus the illusions of legitimate home values and the sustainability of future price increases are maintained.
In fact, so intoxicating is the expected payoff from home ownership, that the incentives to lie to qualify for mortgages have never been greater, and as it so conveniently happens, easier to do. Trendy no-documentation mortgages allow almost anyone to buy a house, regardless of employment status, income, financial condition, or credit history. The fact that purchases can also be financed with zero down, means that speculators can gamble with no risk what-so-ever should prices fall. Also, the availability of cash-out refinancing means that owners can press their bets while simultaneously taking their winnings off the table.
Given such incentives, is it any wonder that housing speculation is so rampant? Should we be amazed that when reckless lenders offer buyers can't lose bets, with huge expected payoffs, that so many want a piece of the action? The fact that the majority of today's homebuyers are actually speculators in disguise, suggests that when the trend turns, prices will drop precipitously. Far from holding on to their homes, as even most housing bears suggest, owner/speculators will sell in droves, or worse, simply walk away from their bets, leaving lenders and tax payers to cover their losses.