In 2012, we saw the continuation of a housing recovery in California, with solid sales volumes and price increases throughout much of the state. More importantly, short sales, loan modifications, price increases and even foreclosures helped many get our of being underwater on their homes. Many would say this recovery is artificial. And, while there is no question government intervention played a major role, it appears unlikely that intervention will end anytime soon; so the recovery is likely to persist-save the possibility of a black swan.
The biggest change in 2012 was the dramatic decline in foreclosure sales, and as a result, bank owned properties (REOs). The “foreclosure wave” that many others predicted has yet to materialize in California. Instead, over the past 12 months, notices of default plunged by 48.9 percent year-over-year, foreclosure sales fell 27.7 percent y-o-y and REO inventories declined 34.9 percent y-o-y. While we correctly predicted that there would be no foreclosure wave, this decline was steeper and sooner than we expected.
For 2013, we largely expect more of the same. Demand will remain strong thanks to low interest rates and affordability. Housing supply will remain constrained, largely due to foreclosure intervention. Prices will rise, though likely at a slower pace. But unlike 2012, we expect sales volume will decline due to further decreases in supply.
Demand will remain relatively strong, despite structural issues
- The Federal Reserve is clearly committed to monetary-stimulus programs that will keep mortgage interest rates at or near record lows. Low interest rates have and will continue to positively impact demand.
- In many parts of California, rents remain higher than payments, despite recent price increases, making housing attractive both to buyers and investors. This positive impact on demand may be offset by further price increases.
- Early foreclosure “victims” may now qualify again for a mortgage, and choose to return to homeownership. This new set of buyers will increase demand for scarce inventory.
- Negatively impacting demand is the reality that homeowners with equity are not moving up at the rate they did during and before the credit bubble, and instead are hunkering down.
- Nearly a quarter of all homeowners are underwater, owing more than their homes are worth. While these homeowners may be able to short sell, they are typically unable to repurchase, and are forced instead to rent negatively impacting demand.
- Demand also continues to be constrained by tighter mortgage lending standards. Given that most mortgages are still government backed, and that the government backed entities are still struggling with losses that are blamed on loose lending standards, we don’t expect mortgage lending standards to ease anytime soon.
Supply will remain tight, with the inventory of homes for sale at record lows
- Government intervention will continue to play a huge role in the foreclosure market. The National Mortgage Settlement Program, the Home Affordable Modification Program (HAMP), and the California Homeowner Bill of Rights legislation that goes into effect on January 1, 2013, will all continue to put downward pressure on foreclosures and foreclosure inventory. Foreclosures have been a significant source of supply since 2008, and these continued declines will hurt sales volume in 2013, likely dropping foreclosure supply to half the level seen in 2012.
- Similar to the impact on demand, the hunkering down of homeowners with equity, and the inability of underwater homeowners to sell, except through short sale, will negatively impact supply.
- Short sales will likely increase in 2013. We believe this is the sole bright spot for housing supply. Banks ultimately want to clean up non-performing assets, and short sales provide clear benefits to banks over foreclosing including: faster disposition, better recovery of value, less political opposition, and reduced risk of homeowner lawsuits. That said, short sales are at risk, as the tax exemption established under the Mortgage Forgiveness Debt Relief Act of 2007 is set to expire at the end of this year. This tax exemption allows mortgage debt forgiven by a lender in a short sale, loan modification or foreclosure to be exempt from federal taxation. we see the risk of this occurring as low, and believe Congress will choose to extend the Act for another year. Still short sellers and their Realtors should push to close currently pending deals before year-end, just to be safe.
Housing prices will rise, but increases will be constrained
- Continued demand, combined with the continued constraint of supply, should result in prices continuing to rise throughout 2013, though likely more moderately than in 2012.
- The increase in home prices will continue to be constrained by appraisals. As bidding wars push prices beyond those supported by recent sales, getting purchase prices to appraise will continue to be a challenge. 2012 saw a willingness of buyers to bring cash to the table to overcome this issue. Not all buyers have ability, which will make this market especially difficult for first-time buyers.
- The increase in home prices will also be constrained by affordability and return on investment (ROI). The key ingredient to fast rising prices in 2012, was the fact that house payments , even after taxes and insurance, were lower than rent in many areas. This also led to very strong demand for rentals by investors seeking, and finding, high returns on their investment. Demand from these buyers has been the critical driver behind price increases to date, but as prices rise affordability and returns drop.
Other factors in 2013
- We believe more households will become renters in 2013, through short sales and foreclosures, than will become homeowners. This will continue the strong demand for rentals, and continue to put upward pressure on rents throughout much of California.
- Trustee sale investors will continue to see strong competition at the steps. However, as prices continue to rise, they may see the large rental buyers move away from the auctions, and perhaps even California, as they seek better returns elsewhere. This lessening of competition may help offset declines in foreclosure volume for the traditional trustee sale investor, who focuses on restoring foreclosures for homebuyers.
- Trustee sale investors also need to be aware the FHA’s anti-flipping waiver expires on December 31, 2012, and to date there has been no announcement to extend the waiver. In 2011, however, the announcement to extend the waiver was made on December 28, so we remain hopeful they will again extend it. We actually believe it would be better to let the waiver expire to discourage flipping, and instead exempt trustee sale and sheriff sale purchases, which are non-market transactions and require a professional purchaser to flip the property in order to make it available to most homebuyers.
- As the end of 2012 approaches, debate over the mortgage interest deduction is intensifying. We believe the debate is mainly political posturing. Many Congress members have second homes in Washington and benefit more than most from the mortgage interest deduction. We highly doubt our elected leaders will vote against their self-interest, and when the push comes to shove, they will vote to keep the deduction. We also think it would not be smart to do it now. That said, we do think the mortgage interest deduction benefits banks, at the expense of homeowners by encouraging debt rather than real ownership.
- We expect taxes to rise in 2013, more for some than others. In addition to the unknown tax increases associated with the expiring Bush tax cuts, the Affordable Care Act will impose an estimated $260 billion in new taxes in 2013, and the passing of Proposition 30 will significantly increase taxes for higher income earners in California. Higher taxes take money away from consumers, constraining job growth and possibly keeping a lid on demand for housing. With higher income earners clearly being targeted, the most affluent neighborhoods are likely to be the hardest hit.
The risk of a black swan should not be overlooked
The term “black swan” comes from Fooled by Randomness by Nassim Taleb. The idea is that rare, unexpected, events are actually the norm, and should be expected. Today we face a number of risks that no one, including us, expects will happen. We summarize some of these are here because we believe Mr. Taleb is right, and we should always prepare for the unexpected.
- While hopefully resolved before the start of 2013, the so-called “Fiscal Cliff” creates real uncertainty for next year. If Congress fails to act within the next couple of weeks, taxes will increase by an estimated $500 to $700 billion, almost certainly sending the U.S. economy into recession. Most expect some sort of compromise, even if just pushing the issue into the future. We are concerned the economy will tough, regardless of the outcome; and that much of the current political posturing is less about any real attempt to resolve the issue, and more about making sure the other party takes blame for what’s ahead.
- The Middle East continues to be highly volatile. A crisis there could send fuel prices skyrocketing; and any US involvement would also result in new spending and debt that the country can little afford. Resulting impacts to the economy, and possibly interest rates, would not be favorable to housing.
- The Eurozone debt crisis continues to make headlines. In this interconnected world, it would be unwise to think that further problems there could not impact us here.
- Something else, even more unexpected than those we’ve outlined above.
Despite the risks, government intervention, higher taxes, and the other issues that keep up at night, we remain relatively bullish on the housing market for 2013. We have little doubt that fewer people will be underwater by the end of the year, and that housing will have proven a relatively safer investment than entrusting your money elsewhere.
And no, there will still not be a wave of foreclosures.
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