Bruce Norris is joined again this week by Ralph McLaughlin. Ralph is the Chief Economist for Trulia and leads their housing and economics research team. He provides house hunters with key insights about the economy as well as housing trends and public policy. His educational background includes a BS in geography and regional development from the University of Arizona. He also has a PhD in planning, policy, and design from the University of California Irvine with a specialization in urban development. He has more than a dozen publications and research papers in the field of housing, economics, land use, and housing policy. He was previously director of the certificate in real estate development at San Jose State University.
Episode Highlights
- How does affordability affect the housing market as a whole?
- How do yields and investments benefit or hurt real estate?
- What are the different terminologies of flipping houses?
- What are touch and go properties and how are they different now from 10 years ago?
- Are the different demographics favorable towards real estate?
- What is the buying activity for the Generation-X demographic?
Episode Notes
Bruce said one of his pet peeves is in regards to affordability. He asked Ralph his thoughts on the subject in relationship to what it does to the housing market. Ralph said affordability can at times introduce gridlock into the housing market. There was a report produced two months ago that looked at the inventory shortage. If you look at existing inventory, it is low and near a four-year low. It is down by about 35% over the last three years. One of the interesting points is that it is low for those on both the lower and middle end. If you are looking to buy a starter home or a move-up home, they are down by 40-45%. We want to see why this is the case.
There are three explanations, one of which has to do with affordability. The first two are in regards to for sale homes potentially being suitable for starter and trade-up buyers. These were bought up by investors during the downturn because they were a relatively good deal for investment. That is a share of homes that will probably not come out of the market any time soon since they are used for investment. This is historically significant because it is historically different. It really coincides with a significant drop in homeownership rates after 2007. If you had many who bought entry-level homes who could not buy them before and they were foreclosed on, if investors bought them back they will hold onto it and take that cash.
Those who bought the homes may be owner-occupiers who did not go to foreclosure but still have them. A much larger share are still underwater depending on where you are in the country. They could be between 25 and 30%. That is an additional share of homes that could potentially come onto the market but are not because they are still underwater.
The third is an idea related to affordability that Ralph has investigated. In some markets, premium homes are actually growing more expensive relative to trade-up homes. These types of homes, in turn, are growing more expensive relative to starter homes. This matters because if you own a home now and are thinking about trading up, should the home you are thinking of trading up to be more expensive you will not go through with it. You are more likely to renovate and remodel your existing home, making it the way you want it to be since you cannot afford the next step up.
We are actually seeing many markets where price breadth has grown much worse over the last four years and they have seen a much larger drop in inventory. This is why affordability matters. It can introduce a gridlock into the market, which prevents people from selling their homes and buying another one.
One thing interesting is that these were special interest rates historically while we are talking about affordability problems. One thing that has changed is the ratio to which lenders will allow somebody to get a yes answer. Bruce asked Ralph when he takes a look at a fixed-mortgage rate, are there places where earnings are set to grow to where pushing your budget and getting in makes a lot of sense because in few years it will not be at that ratio where you started. Ralph said the report about that was one they had a decent amount of slack on because the headline was not so great. That was the case for possibly buying a home that you cannot afford. If you are looking to buy a home in a market, it may be unaffordable to you now but it may be even more unaffordable in 3-5 years. If you are in a place now where income growth is fairly solid for a young household, that could be a decent deal to lock in your price now. The kicker all depends on any household circumstance and whether their prospects for income growth are strong relative to what prices may do over that same time period.
They have found in some parts of the country where it does work, such as in San Francisco and Southern California, since prices have risen much more strongly than other parts. It may actually not be a terrible idea to push the bounds of what you could possibly afford. It goes under the premise that lenders are responsible, so they are not going to outrageously lend you money for something you cannot afford. There is a spot between 32% of income and 40% of income for servicing the debt that a lender would consider. The question for a household is whether it makes sense to spend 40-45% of your income on a house if you can get a loan for it. In many cases this could be beneficial in areas such as California and some parts of the Northeast.
Prospects for income growth over one’s life are actually very strong. This means it would be beneficial to buy something that is less affordable now and lock in that rate and price point. As your earnings grow over time and your payments stay fixed, those payments become affordable relatively quickly within 2-5 years. This was the premise of his report, and this speaks to the importance of considering buying a home now when rates are low since you can lock in low fixed payments. These are the kinds of things that are bragging rights.
Bruce became an investor in 1981 and refinanced a house that was free and clear, thus being able to receive a rate at 17 ½%. Bruce does not know if the people today can really appreciate an interest rate that starts with a 3 being as special as it is since they are used to it. Those who were born around that time really don’t have any idea. A few years ago Ralph asked his dad what interest rate he paid on a house in California back in 1985, and it was around 13-14%. It is pretty unbelievable for those who have only really known interest rates between 3-5%.
Bruce and a friend went to the Library of Congress in Washington, D.C. to look up ads from 1850 forward. Here he would look for advertised real estate interest rates so he could chart and find out himself. Therefore, he knows for a fact these are really exceptional interest rates. Bruce said one of the things interesting to him is the expectation of what is going to happen and how this may change somebody’s actions. In one example, Bruce spoke in front of a group of Chinese investors. During the Q and A after the talk, a gentleman stood up and said he bought a $1 million house in San Jose two years that is now worth $2 million. He wanted to hold it until it was worth $7 million. His expectation was that it was going to be a reality, and he did not have a context that was clear until he talked with him later. He was from Beijing, and everything had gone up 15 times where he was.
When things work out well, it is human nature to credit yourself for it, and he happened to land in the right area. When money comes into an area and it is predominately from a hot market, Bruce wondered if this really impacts the local price and if this type of area is more at risk. Ralph said it really depends on the extent to which those kinds of investors are playing ball in any given market. If there are areas where those investors make up a very large share, but in other areas there is certainly some risk. In other areas where they are not playing that big of a role, it is tough to see how about 10% of those transactions are from those kinds of investors. However, Ralph does not think this is enough to really drive that market.
Bruce said the other factor is they did not have leverage, they just paid for it. Unless they are forced to sell for any particular reason, even if prices do not go up to meet their expectations, they will likely just hold onto it. It is only when you get to a situation where some catastrophic event happens and they would be forced to sell. If they own a significant number of properties in a given market, this will lead to large price changes. The issue of leverage is one of the most important points about whether or not these investors effect the market.
Bruce asks how yield and other investments benefit or hurt real estate. Bruce asked if you are looking at doing bonds, participating in the stock market, or owning a rental, he wondered if the timeframe with the crash has coincided with opportunity that says owning a rental is a better yield than most things. Ralph said in some regards this has helped real estate, especially with interest rates being low. This makes it very difficult for people to have a decent return on a safe bet. When savings and bond rates were 5-7%, this was a fairly decent investment vehicle. You would have to have a high return on other investments to want to explore the other investments.
When those rates are marginally above 0, it certainly makes investing in other assets like real estate more attractive, especially if the acquisition costs of those investments like real estate were historically low and under-valued. This is why we did see a very large push for investment in rental properties in 2010-2012. Interest rates were very low at this time and the acquisition costs of those assets was low and arguable undervalued because of the crisis. In addition, the demand for those assets for renters was high. People lost their homes, but they still needed a place to live. This created a very ideal atmosphere for investing in real estate. We saw a very large activity at that time by all-cash buyers and real estate investors. This window is narrowing since rents are going up quite a bit. This is good for investors, but homebuyers may want to think about trying to get out of rentals and into their own homes because of the relative affordability of renting a home vs. buying.
Bruce and Ralph continued their discussion on flipping, of which there are different terminologies. You have a standard flip and an economic flip. Ralph said this is one of his favorite topics to write on and he looks forward to doing the report every year. What he is seeing right now is about 5% of the transactions in the U.S. are flips. That number in 2005 and 2006 was nearly double that between 8-10%, so Ralph does not think we are in territory near where we were ten years ago. The point of concern is that the market is overheating if 10% of it is flipped.
There is also a qualitative element to it they are interested in exploring, which are the types of flips. You can think of an investor buying and selling a property in a short period of time and taking two approaches. One would be a traditional flip where an investor buys a property that has deferred maintenance. You would add value by fixing the house and selling it. This is actually a positive economic activity in the world of flipping since there is value being added to the housing stock by the activity of the flipper. The other type of flipping speculative flipping, which is where the investor is not doing anything to the property and buying it just because they think prices will increase.
There have been markets over the last few years that have seen sharp increases in flipping. Particular cities that were hot spots ten years ago were Miami and Las Vegas. The reason why Ralph said he is not as concerned at this point is he suspects most of that flipping activity is traditional. A lot of those markets had foreclosures and the properties probably had deferred maintenance. Investors are seeing these as deals where they can add value and sell. This is why he is not completely concerned with flipping in those markets since most of those flips are traditional.
The difficult thing from a data perspective is figuring out whether or not a flip had work done to it. That is something he will embark upon later this year to get more detail on what is happening in the flipping market. Fixing properties, expanding square footage, and doing high-end improvements are almost required in California to end up with a profit. From the street, people would probably be loaned $3-$5 million a month to investors, and the lender would see the projects they are taking on and how long it takes to sell them. These are not just touch and go’s.
Ralph asked Bruce if he sees a significant difference with the touch and go’s with what is happening now versus what happened ten years ago. Bruce said part of it was a builder who mispriced a product or something that was taking a long time to build. Bruce said he would tie up a new construction home in Riverside at $300,000, build it, and nine months later it was worth $400,000. This was his flip. That product does not exist today at those margins.
Bruce asked if demographics today are favorable toward real estate. We have this big baby boomer generation that may downsize or ultimately not own something inside of 20 years. This gigantic millennial generation coming in has yet to decide if they want to own anything. These are interesting combinations. There has been a lot of attention paid to millennials for better or worse. They do represent the biggest potential pool of homebuyers of all demographics, at least in the U.S. They are not buying homes at the same rate as Gen-xers or the boomers were when they were their age.
The big question is whether it is a generational shift or something else. Ralph has run many surveys year-in and year-out, and millennials are very upbeat about owning a home. They want to own homes. This is why Ralph does not think it is a generational issue nor are they shunning home buying. He thinks it is more the economic circumstance of millennials that are keeping them from doing so.
The second point that is not as discussed much that would affect boomers retiring is the activity of Gen-xers. This was the group that was most affected by the downturn. They were the ones buying homes while millennials were not buying many 10-15 years ago. The Gen-xers were not only the ones buying homes but also the ones losing their homes. This is why they are being watched very carefully to see if they are coming back into home buying. There are some signs they are; and this is important because they are the ones most likely to be buying the homes boomers want to sell when entering retirement. This is why Ralph said they are trying to pay as much attention to generation-x as they are to millennials and boomers. As the economy continues to recover and millennials eventually get married and have children, they will probably eventually buy a home. They will just do it at a later point in life than their parents did. Their formation of households is different since they are not married yet.
One of the reasons why a large share of them is still living with their parents. The percentage of this is higher than it has been in the last 30-40 years. It is really difficult to find a partner let alone have kids if you are still living at home. Ralph thinks this will eventually rectify itself when the economy recovers. This is one output gap that will probably correct itself overtime since they will not be in the backroom when they are 50.
For more information, you can view his reports at www.trulia.com/blog/trends. This is where you will find all his latest work. Thank you for joining us.
