Bruce Norris is joined this week by Jordan Levine. Jordan is the Senior Economist at the California Association of Realtors. They are a statewide trade organization of real estate professionals with more than 190,000 members. Jordan started in the research and economics department of CAR in 2016. As Senior Economist at CAR, Jordan analyzes housing market conditions, macro-economic trends, and public policy issues through the use of external data from the public and private sector and survey researches conducted by CAR.
Bruce asked Jordan how he would categorize 2018 for California real estate. He said it was a tough year. As was forecast at the beginning of the year, they thought there was going to be some headwinds. The year ended off on a relatively somber note with sales on the decline. In the last couple months, they actually saw sales get down to double digits. Sales had been struggling for a long time; but as we got towards the tail end of 2018 there seemed to be a demand side component to this issue. This is something we should expect to continue to see this year.
Home sales were not doing that great to being with the last couple years, but it was pretty much all attributable to a lack of supply. When they got to 2018, they saw listings start to come back. Despite this, we were still seeing sales decrease. It is no longer just the supply constraints holding the market back, and this was the big shift in 2018.
Bruce asked if the expectation that demand would be there if there was inventory was a miscalculation. If you had excessive demand over supply, you would think we would have had a serious price increase. However, this did not happen. They knew that rates going up would put a pinch on affordability. One of the calculations they were making at the end of last year was the economy being in relatively good shape all through 2018. We have such a big structural deficit in terms of the supply of housing out there they thought were churning out enough of these high-wage jobs that should have helped a lot of people at least get into the market. You cannot really underestimate the consumer confidence element of the housing market. This is one of the biggest purchases any household is ever going to make.
There are several question marks regarding consumer confidence, including the psychology out there on the part of the buyers. This really plays a big part in this. Even in the face of very historically low levels of unemployment and all-time high levels of jobs, you still have people worried about which direction the market is going or have been completely priced out because of the rates and higher prices seen over the last couple years. Both of those factors really undermine sales in the second half of the year. There was still a relatively healthy economy, yet folks were still having trepidations about jumping into the market. You see this with the competitiveness that exists that it is no longer just a supply-driven issue.
He had mentioned the longer-range cycle. 400,000 sales for California is not really what they have done in the past. One cycle said “ended in ’89,” in 2006 we had sales that were really high and it took 4 years of really aggressive sales to peak out in sales. In this cycle, we have not had a peak. We have had all boring years, and Bruce wondered to what this can be attributed. Jordan said it is sad when you think about it. If he goes out on the road to these beaches, he shows the graphs for jobs and the graphs for unemployment. The jobs one is going straight up while the unemployment one is going straight down. Meanwhile, we have basically had flat home sales for the better part of the last 7-8 years. The economy is doing well and people want houses, but we are butting up against this multiple decades long supply constraint. If you look at the state’s estimates, they think we need 180-200,000 units built every year just to tread water on affordability and not even start reversing course on the challenges we have.
Unfortunately, we have not come anywhere near that since 2008 since we have been down in the recession. We have not built at that level since going back before the downturn. Unfortunately, we have this economy that continues to boom and nowhere to house these people. Therefore, the housing market we have goes to the highest bidder. As a result, you do not have as many folks able to jump into the market. You also do not have folks who are really excited about selling. They may have a lot of equity built up in their home, but if they have to turn around and become a buyer in the same market it all comes out in the wash. In some cases, you give up things like property tax benefits you have accumulated over time. The overall supply constraint is really discouraging, both for sellers and buyers. The eroding affordability is really what pushes out the buyers.
Affordability is really at 27%. Historically, this is not really low for California. It is not at an all-time low, but unfortunately it means 80% of households out there cannot afford the average home. This becomes really problematic when you think about it from the standpoint of growing homeownership. When you go back to the 2005-2006 timeframe, things were at an all-time low. However, just because we have not hit those extraordinary lows, things are still way down from where they were prior. In 2009, the historic opportunity for folks to get into the market was only half of the Californians who could afford that average house. That has been more than cut in half just during the course of this cycle.
In 1980 and 1989, we reached 17% affordability and did it again in 2005. This is a more realistic historical number for California. Bruce asked Jordan if he thinks we are going to reach that level this time or if we do not have enough energy in the market to go there. Jordan said when you look at the demand side of the equation, we are definitely expecting price growth to slow. When you look at things like listing price growth, that tends to lead what he sees on closed sales anywhere between 4 and 6 months. If you look at that number, it looks like price growth is poised to dip into that low, single digit range. He does not think there will be a big decline in home prices, but they will peter out as some buyers are in a “wait and see” mode.
One of Jordan’s presentations talked about the misconceptions that buyers have about the financing that is available and the down payment required. Jordan said that is one of the reasons he is still optimistic about the market. California has had a really challenging market for many years, yet there are still folks out in the industry making money and being successful. This is one area of both challenge for realtors going forward and an opportunity. Jordan said when CAR does their research, they find that 30-40% think you need at least 30% or more just in terms of a down payment to get into the market. Another 20-30% think you need at least 20% or more.
A lot of folks have not heard about opportunities to get into housing with relatively low-down payments. When you look at the median price here in California, which is around $550-$600, people see this and are thinking how they do not have $200,000 within their savings account and therefore homeownership is not an option. Even in these challenging conditions, one of the things they know and have seen consistently in up markets and down markets is people still want to become homeowners. This is still synonymous with the American dream; so even with all the challenges out there including higher prices and rates and less affordability, people still want to get into housing. When you ask folks who thought you needed these big down payments to become a homeowner, almost 70% said they would get into housing if they had a smaller down payment. Unfortunately, this same percentage had never heard of things like FHA and other low-down payment loan options. Even in these challenging times, there is opportunity to peel folks off into homeownership by some good targeted education out there. Bruce said when you are in the industry and around it all the time, the assumption is everybody knows this. When you realize they don’t, that becomes a big issue and you have to consider how you will get that information out.
Rent increases have been crazy in the last five years. Bruce asked if this spurs buying activity or out migration. Jordan thinks it is both. You are seeing both the desire for folks to circumvent the constant increase in rents that have gone on by getting into housing. You are also seeing a lot of exits from California. The Census recently released numbers for 2017, and it looks like that out migration trend continues to accelerate. We have been in the six figures for the last five years in a row where more than 100,000 people have left the state. This number is getting bigger and was recently at 130-140,000 last year. This is part of the downside of people still wanting that American Dream and wanting homeownership. A lot more people are willing to go out of California to achieve that.
We are losing the domestic migration game, but we are winning immigration game. Bruce wondered why there was a disconnect here. Jordan said if you look at the demographics of who is leaving, it really does come down to a housing story. The vast majority of folks leaving California make under $100,000 a year while the folks coming in tend to have higher income. They are supposed to like California’s climate and livability and quality of life, and they are in a position to be able to stomach the high cost of housing. Then, you have folks who cannot afford the high cost of housing and need to go elsewhere in order to achieve that same quality of life.
It is interesting when you think about all of the criticisms of California, of which there are many valid ones. You hear about our tax rates being the thing driving people out when it is really the people on the lower end of the income spectrum who benefit most from California’s super progressive tax structure who are being forced to leave. This tells Jordan it is not just taxes, but also the cost of housing they are really having to stretch to make happen. In many cases, people cannot afford homeownership as evidenced by the fact we have not seen that rebound in the homeownership rate here in California like we have in many other parts of the nation.
Bruce said one of the other statistics he found interesting but was also shocked by was the high percentage of sellers who leave the state. Those who were here enjoyed the price increase. When they cashed in their chips, 3 out of ten said they were leaving. Bruce wondered what the main reason for them leaving was. Jordan said there is definitely a tax component there, but the cost of housing in other states makes retirement look more attractive. If you can cash out a significant amount of equity, go somewhere, pay cash, or have a very small mortgage and put the equity in the bank to use as a monthly cash flow, then this is an attractive option.
At his upcoming seminar, Bruce will be discussing the budget. He spoked to lenders about what they consider when figuring out how somebody qualifies. There are two categories that are not on their charts. They do not consider daycare costs as a standard regular cost, like an automobile payment. They also do not consider healthcare costs. Those two items have grown pretty big. Even though the lenders do not consider it, the person saying they cannot afford that mortgage is considering it. The fact of the matter is we are spread pretty thin across every category. Prices have gone up faster than incomes. Rents have also gone up faster than incomes, and healthcare costs continue to outpace incomes. Even though people are doing better than they were 5-7 years ago, they are not really able to pull ahead since there is this ongoing battle to keep up with ever-increasing costs.
Bruce has been around since interest rates were 17 ½, so he smiles a little when people tell him this is a high interest rate environment. When you look at the impact of it going up, it can do one of two things. It can discourage people, or it can actually spur activity. Bruce wondered which was happening, to which Jordan said if you have seen the rates coming down over the last couple weeks there has been a big surge in mortgage applications. This can get some buyers off the fence. However, with how much prices have risen it is also at the margin for some people to look for cheaper housing or wait and try to get into a better financial position. It’s possible you are seeing both things happen at the same time.
Jordan remembered back in the 80s when his dad would talk about his 12 ½% mortgage rate. It is not the absolute level of interest rates that are going to submarine the housing market. At 5%, it is still very affordable to use other people’s money to buy real estate. At the same time, we are also in the midst of this affordability crunch. This is really a double whammy since we are coming off the back of multiple years of 7-10% price growth depending on the market. Now, you are talking about a 50-100 basis point increase in rates, and that really makes that cost of homeownership not just go up by the 8-9% that your home prices went up, but more like 14-15% when you absorb the higher rates.
The Fed has raised short-term rates eight times in two years. However, the ten-year T-Bill is 2.7% today. Bruce wondered why there was a disconnect between the long bonds and short bonds. Jordan said the thing to keep in mind about the long end of the deal curve is that it is rally influenced largely by global capital flows. For better or worse, the U.S. still remains a safe haven and people are putting money into longer term bonds. There is a glut of savings outside U.S. where a lot of wealth is being created. It makes sense to park that money in the United States. This is not just if you think the United States will be stable, but also if you face your own domestic exchange rate risk it makes bond and Treasury book relatively faster. This is why it bleeds through and you have seen long-term rates go up a bit. It is definitely not a one-for-one transfer because the Fed is not the one holding all the cards when it comes to long-term rates.
Bruce asked if he thinks there will be an inverted yield curve occurring in 2019. Jordan said this has been a pretty reliable predictor for recessions. We have seen the short-term rates go up, so he thinks the Fed will want to do another rate increase. They want more rounds in the chamber to fight the next recession. However, they are also aware of the fact that they do not want to over do it and invert that yield curve. The thing to keep in mind is that the current expansion is very long by historical standards. You typically don’t see ten-year long expansions. However, at the same time recessions do not just happen out of nowhere. He thinks the yield curve is definitely a good indicator to watch. However, the yield curve inverting is not necessarily a causal factor that drives a recession. It is more of an indicative factor we use to see how overheated the economy is and what the short-term risks are. He is looking for a shock to happen to drive a recession, not for the economy to go into a recession out of the blue. He thinks the fact that the yield curve did invert slightly a couple weeks ago is suggestive of the fact the economy may be running a little bit hot and they are worried about short-term.
Bruce asked what effect the Fed reducing its balance sheet will have. Jordan believes it will take some of the liquidity out of the housing market, especially the unwinding of these MBSs, but this should help keep rates from increasing. They will buy back a lot of these things, put more money into the system, and this is why they are relatively conservative when it comes to the interest rate forecast when you have things ending up somewhere around 5 ¼ this year versus some people forecasting much higher rates.
Bruce said usually when we have a recession, the Fed has 4-5% interest rate deductions on the short end to help things out. If we don’t get to 3% before that happens, Bruce wondered what the Fed would do. Would we go into negative interest rates, or would we have more quantitative easing. Jordan said you will have a combination of both. They will need to get creative, depending on the severity of the recession and where the intervention is needed, whether on the corporate or commercial real estate side or corporate debt side. Banks don’t seem to be engaged in a lot of risky lending activities at this point, so it will not be the same flavor of intervention that they need. However, they will need to look at more creative ways of using their balance sheet like last time around if things get bad enough.
Bruce next asked if he was concerned about the corporate debt structure. Jordan said he is because if you look at the financial obligations ratio, it is still very low. This suggests the economy is not in bad shape, but this is a function of the very low rates. We know there are a lot of these balloon loans that will come due on the commercial real estate side. Jordan thinks when you look at the bigger picture on the corporate side and where these accolades and valuations are at relative to the amount of corporate profits being generated, then you could see our recent reprieve being because of the bump in profits associated with reduced taxation and tax reform. This is a one-time jump-up before it goes back to firm performance.
Unfortunately, if you look at things like the Wilshire 5000, it is fifteen times the value of all the corporate profit out there. It is relatively high, not all time, but companies are worth about 15 times the amount of money they are making. Usually it is around 10. If this starts to unwind, it could have implications for the broader economy and definitely for the housing market through the wealth effect, especially on the demand side. We are seeing demand wane a little bit now with very low levels of unemployment. If these companies wake up one day and realize they are not worth as much as they thought they were and have to cut jobs, this could make the unemployment structure go up and we would really have a bigger issue on the demand side of the equation.
Bruce finished by asking him if there is anything outside the world of real estate that concerns him. He said the stock market is the big one. The key is to not panic, and he advises realtors to get their clients focused more on long-term. The rates are still low, and it is a great time to lock in a 30-year fixed rate. He does not think we will be back in the 3 ½% range anytime soon. We also know people still want to buy and own their own homes, and there is an opportunity through the education piece to make that happen in challenging times. Over the long term, real estate is still a good bet. Jordan did a speech the other day with a guy who had been a realtor for 35-40 years. He totally blew Jordan out of the water because he came in and told him the best time to buy real estate was 20 years ago, but the second best time was the day he talked to him.
Over the long term, the market may go up or down over the next couple years, and there are a lot of question marks out there. However, if you can get into a home where you can afford that payment and get in at these low rates, then you have an opportunity to do really well by your family balance sheet and the next generation in terms of accumulating wealth and staving off rent increases. Even in these challenging times, there are a lot of reasons for buyers and sellers to be in the market. The real estate community will have to hustle in 2019. We cannot just ride on cruise control and expect things to happen automatically. If you get out there and do what we have had to do for the last 5-6 years anyway, which is to hustle, make it happen, and carve out your own market territory, then 2019 can be a great year.