August 04, 2007

Nostradamus in the House. Looking at 4 Potential Scenarios for Southern California Housing.


I couldn’t resist the “in the House” pun but it is becoming apparent that people are placing their bets on what is going to happen now that the housing bubble is bursting. It doesn’t seem like there is any debate regarding that we are in fact, living in a bubble. Subprime lenders are realizing once rates went up, people just said screw it and let the mortgage notes role on in without payments. No complicated economic theory behind it, just common sense which seems less common as each day progresses. With the foreclosure process taking anywhere from 3 to 6 months, folks don’t seem too concerned about getting their credit ravaged like Barry Bonds at a Dodger game. I mean why would someone fight vigorously to defend a home that in all likelihood, isn’t worth what they paid for it. For honor? The person that gave the mortgage is likely no longer employed and the note is chopped up like sushi in the mortgage backed securities markets. It isn’t like your local WaMu personal banker is going to give you a call and say, “Hey Mike, is everything okay? What is going on?” The personal touch is gone. The more likely scenario is your going to get a legal letter from the lender in your mailbox saying pay up or else. Most people in subprime loans feel screwed so they are simply returning the favor to lenders. I mean what are they losing? Their credit? They are freaking subprime to begin with! Its not like they are feeling an emotional ache in their heart that their 580 credit score will drop to 400. And you wonder why the market is tanking? With $1 trillion in loans resetting this year, 2008 and 2009 we can expect much of the same.

So it is established that the housing market is no longer a viable rock solid investment. So what can we expect to face here in Southern California or any other large overpriced metro area in the country? In this article, we will use the clairvoyant power of Excel and run four likely scenarios that will occur here in Southern California. We will use the current median price, current income, and try to predict future scenarios. Consider it a housing premonition.

These are the key reference points we will use:

  • Current Southern California Median Single Family Home Price: $502,000
  • Current Southern California Media Income: $60,000*
    • Los Angeles County Family Median Income: $43,518
    • Orange County Family Median Income: $58,605
    • San Diego County Median Family Income: $51,939
    • Ventura County Median Family Income: $59,379
    • San Bernardino Median Family Income: $43,179
    • Riverside County Median Family Income: $46,885

(Source: Census.gov)

  • Income growth of 5 percent annually.

*We’ll be generous and use an upper-limit since we are looking at the ENTIRE region.

Scenario #1 – Housing Goes up 10% Each Year for 5 Years

You may be thinking to yourself, there is no way this can ever happen. Well keep in mind that we did have 5 years and 2 months of 10+ percent year over year gains in Los Angeles County so not only can this happen, it did. In addition, before 2007 hit full stride, we had many housing pundits predicting double-digit growth! Each month after more and more negative housing news, they slowly scurried away and now they are silent in the dark green jungles of mortgage implosions. Irresponsible public policy and financial negligence led to this mess. But let us humor these heroes and take a look at how these scenarios would look if we let them run their course for another 5 years:

Median Home Price: 2012

year

income

2007

$60,000

2008

$63,000.00

2009

$66,150.00

2010

$69,457.50

2011

$72,930.38

2012

$76,576.89

While the current annual income to home price ratio is hovering around 8.3, by the time 2012 hits it will be approximately 10.6! Keep in mind we are also using a higher reported family income. If we were to use current Census data the housing to income ratio would be much higher. What will the mortgage cost look like?

10 percent down with 30 year fixed at 6.5 percent:

Budget 2012

Price

$808,476

Down Payment

$80,847

PITI:

$5,441

Net Income After Taxes:

$4,785

You think we have affordability issues now? Just wait if we hit this scenario. Let us take a look at a more conservative 5 percent annual increase.

Scenario #2 – Housing Goes up 5% Each Year for 5 Years

Now we are being more conservative. As a matter of fact, Southern California is currently up, 2.4 percent year over year. Housing bubble? Not here in the ever resilient SoCal market. Let us take a look at a 5 percent annual appreciation rate (which is more historically accurate):

Clearly this scenario seems more probable. Let us run the numbers once again with the 5 percent annual appreciation rate:

Budget 2012

Price

$640,693

Down Payment

$64,069

PITI:

$4,311

Net Income After Taxes:

$4,785

Okay, now at least we aren’t running into monthly household budget deficits. But the basic monthly nut will consume 90 percent of our net take home pay of the hypothetical median income family. Talk about taking it to the house. Let us now look at some more bearish predictions. First, let us examine a 5 percent annual decline.

Scenario #3 – Housing Goes down 5% Each Year for 5 Years

Even at a 5 percent decline annually over 5 years, we now see the median house price hit $388,438. Many in Southern California haven’t seen the fabled $300,000 mark in many years. Can it be possible that we have a blast from the past? Let us break down this scenario:

Budget 2012

Price

$388,438

Down Payment

$38,843

PITI:

$2,613

Net Income After Taxes:

$4,785

Now this is looking more reasonable. And all we saw was a 5 percent annual decline over 5 years. Not exactly a horrific crash or bubble bursting. In this scenario, the monthly housing nut will only take 54 percent of our net income. Seems like we are approaching a more realistic and reasonable environment. For the heck of it, let us do our maximum doom and gloom scenario of 10 percent annual declines for 5 years. After all, we did see 10+ percent increases for 5 years (sometimes even 20+ percent annual gains) so why not on the downside?

Scenario #4 – Housing Goes down 10% Each Year for 5 Years

Now most folks cannot imagine this scenario. Are you telling me we can actually be in the $200,000 range? If we follow the above scenario that is where we will eventually end up. $296,426 doesn’t even get you a studio apartment so how can it ever purchase a single family home? Let us see how the household budget works out:

Budget 2012

Price

$296,426

Down Payment

$29,642

PITI:

$1,994

Net Income After Taxes:

$4,785

We actually have a monthly payment of under $2,000. Now, the housing nut only takes up 41 percent of the median family’s net income. Keep in mind in more prudent times, most financial advisors recommend that housing not consume more than 1/3 of your household income (some go with net and some use gross). Either way, even with our massive decline of 10 percent year over year for 5 years, we are finally reaching parity with ancient financial standards.

I hope the above gives you an idea of how ludicrous it is to expect 10 or even 5 percent continued annual appreciation rates. Unless income starts going up by 10 or 15 percent a year, the positive scenarios will simply not happen. There are two questions that I’ll throw out:

1. Do you think housing will slowly decline or will it happen faster and more abrupt?

2. Do you think interest rates will go up? Because if rates do go up, the above scenarios will make it even more difficult for the average family to purchase a home and not stretch their budget like Gumby.

Related Articles:

The Housing Tipping Point

10 Real Homes of Genius in 5 Southern California Counties

The History of The Los Angeles Housing Bubble

The Foreclosure Story: $130,000 Income and Going Through Foreclosure

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22 Comments:

Michael said...

By 2010 you'll have prices back at 2000-20001 levels. Sounds ridiculous but the excesses have to be purged.

gmorles said...

Interesting scenarios and you make your point: prices will not go up. But the more likely downtrend scenario would be down 20% or 30% (maybe 50%) on year 1. When bubbles burst... they explode!

Musnbny said...

We will have to see. There are different types of situations that bring a person/family to sell a home.

Some people, if they cannot sell their homes at the price they want will simply take them off the market, rent them out, or continue to live in them themselves. No loss and no gain realized on their original purchase. I'm not sure what percentage of potential sellers this will reflect, but this group will be likely to contribute to slower price declines. Inventories will decrease due to this group.

The people who need to liquidate an estate due to death in the family and those that must relocate to another living situation (new job, nursing home, etc) will want to sell their homes quickly. Those who bought a LONG time ago will probably do fine as they will have the fewest qualms with taking less and outpricing their neighbors to get their barn sold. (These are the folks that will help with new, more realistic comps to bring the whole thing down.) Those that bought within the last few years are more likely to be "screwed." I'm not sure what percentage of homes on the market will be reflected in this group but this group should add downward pressure to home prices.

The people who lose their jobs, or got themselves into a toxic loan and thus face foreclosure will obviously help drop housing prices with the continued increases in inventory and eventually the banks holding the real estate will have to drop prices to get them sold.

Home builders may have a price neutral or price lowering effect in the market depending on how they adjust their product. If they sell a cheaper home with shoddy workmanship and cheaper building materials, they might put downward pressure. However, if they continue their stupidity of lowering prices at a snail's pace, they may have very little effect at all. They will be irrelevent if people continue to be unable to buy their homes. They will become insolvent businesses. Good bye, whatever.

Now, if the fed intervenes and drops interest rates dramatically as Jim Cramer thinks they should, this clearly lessens the contraction of demand and more will be able to buy houses, even at inflated prices.

As the Daily Bulletin noted in their article on housing today, many of us are petrified and continue to sit on the fence. Many of us will live in the homes for many years. The journalist didn't get it quite right. I'm not afraid to buy a house because it many decline in value in the short term... in fact I don't care. As long as I can sell it in 35 years when I'm headed to an assisted living facility... What I'm afraid of is commiting too much of a percentage of my monthly income to housing therefore assuring I must sacrifice other things that are important to me. Why would I buy a house for 850K now that I might be able to buy for 750K in the summer of 2008?

So, all you nostradomasus out there, how do we figure out what percentage of sellers fit into the various categories and how many of them there will be? If we can figure that out, we can probably determine which Dr HB scenario will play out.

mikey said...

I think I'll miss Tanya Memme most of all.

Tyrone said...

I agree, Mikey, Tanya will be missed. She lost her Sunday time slots on A&E, but I'm looking at her right now--juicy!!

momjoe said...

What about 50 or even 90 year loans? Back at the height of this insanity I had a co-worker tell me I better hurry up and buy or else I'll have to get a 90 year loan to afford a house.

I'm not living under that kind of yoke but I wouldn't surprised if some people start to think that is the norm and have no other choice.

Steve said...

90 year loan sounds great. Show me where to sign up! Just give me 750,000 at 90 years for 6.5% with no pre-payment penalty and NO PMI of course. That'll bring the monthly payment down to a rent payment, I'll most likely sell in 5-10 years and the lender will get next to nothing for tying up their $750,000K for 10 years.

Oh wait they will need to triple the interest rate to cover that scenario so the payment won't go down.

Why is it so hard to buy stuff that you can't afford?

silverlake_guy said...

Regarding your questions:

1. Do you think housing will slowly decline or will it happen faster and more abrupt?

I think housing prices will drop significantly by the end of 2007. Why? Because the stock market is going to tank soon. The market is ripe for a major correction and will lead housing into a sell-off panic. Once the media digests and spins the stock/bond market correction (crash?), home sellers will be slashing prices trying to capture "equity" before it vaporizes. The competition induced by fear will lead to larger price drops. If you have 200K in equity you better drop your price 100K and make the sale... less you'll risk winding up with nothing. Sellers cannot be greedy when prices start nose diving. When will the stock market correct? The exact day can't be predicted, else the market would react and have corrected already. It's looming out there and will happen soon.

2. Do you think interest rates will go up? Because if rates do go up, the above scenarios will make it even more difficult for the average family to purchase a home and not stretch their budget like Gumby.

Yes, up, up, up. They have no choice. It is very simple. Interest rate equals risk. The risks and uncertainty are growing everyday. The Fed can't cut rates to stimulate the economy, else they risk weakening the dollar further to foreign invaders.

Looking_in_EDH said...

I think musnbny has hit the nail on the head.

It all comes down to perceived value and a certain comort level of expenditure in relation to income.

In my case, i sold in late 2003 due to a relocation. My new job was a tech startup with limited visibility, so I decided to defer a home purchase until the prospects became clearer. Then I watched in horror as the housing bubble too off! The same home that I sold in CA for $550K sold exactly 2 years later for $800K (so a bounty of tax free $250K to the buyer).

The exuberebce has been diminishing since early 2006. The value equation has been creeping slowly towards sanity over the past year. The crescendo of subprime meltdown news and palpable fear in the stock market are potent accelerants ... Shiller is right, you can map the psychology of bubbles by the buzz factor (i.e. media chatter)

I know it has been a prudent decision not to get back into owning a home. I've been renting till now and watch the market closely -- it do sense a certain trend towards realism in home pricing.

Based on what I see, I would say that we have reverted to late 2004 pricing in my area (N Cal suburb of sacramento). You have to comb through the Zillow history to discern this trend.

My prediction is that we'll drop at least 10% by next summer. I'll get serious about buying in 2h 2008.

feeling better said...

Here is another factor to consider; Americans have been running prices up with speculation. The demand inflated prices. Given low rates and a desire to invest in real estate, we could have another speculative market, NOT!!!!!!!!!!!!

The lenders are doing away with 90% of the programs that allowed for this type of activity; we have literally wiped out 50-60% of the potential buyers for homes. No stated income programs, no NIV programs; lenders are simply taking away all those offerings.

My point is this: If the super optimistic American culture fired up again, and decided to buy real estate like crazy, they could not do so. Mortgage companies simply aren't offering the programs that were used to inflate our real property over the past 7 years. I am a loan officer and you would not believe what lenders are doing. Stated income is a thing of the past; you figure it out.. no stated income…. Bye bye 50-60% of the buyers..

feeling better said...

part two:

Here are the buyers who are left in the market place:

1) cash buyers
2) Full documentation buyers ( try buying a home with the DTI's that were mentioned above ( ain't going to happen)
3) Monster down payments on reduced doc fast and easy programs

Conclusion: The money just dried up !!! No money, no loans. no loans.. no home purchases... This problem is more serious than anyone could ever imagine. By the way, is this economy 65-75% consumer driven? Where's the money going to come from to make those purchases that have kept the US economy going??? The piggy bank dried up folks...

Looking_in_EDH said...

If you go back 5 years or so, the bulk of real estate activity was determined by "normal" economic patterns (i.e. mostly driven by demographic and GDP factors).

Around late 2002, the lending standards deteriorated to a level that started to fuel the speculative inferno.

I agree that the speculative activity is quiclky getting eliminated by the lending spigot turning off. This was a distortion that probably skewed the buying pattern by 30% or so in the Sacramento area.

The other problem is the group of buyers who purchased in late 2004 and 2005/2006 who are undoubtedly seeing their equity dwindling month by month. What % of this group can withstand financial distress -- that's the big unknown.

feeling better said...

Listen: W eare in for a depression; thats teh truth. The fringe media has been foecasting this for years. There isnt anything that will save our economy from a huge fall. I, for one, hope it is severe and quick. Prolonged will be ugly. If it is quick, the general public will jump back in.

planobcl said...

Even your 10% decline scenario seems impossible. It is financially straining to put 41% of your take home pay to the mortgage each month. This is insanity. I put 30% into the place now, and I still feel burdened and oppressed. I don't have credit cards, only the basic bills and a small student loan payment. I have no car payment and only a small insurance payment each month.

Debt will break even the strongest back in your best scenario.

John said...

Who's to say that incomes will appreciate 5%? Anything that we can do here, manufacturing, bio-tech, IT, can be done either in India, China, or Mexico at a fraction of our labor costs.

Dr Housing Bubble said...

I think the scenarios show that it will be very difficult to sustain any kind of appreciation in the housing market. We will see a bifurcation of housing in Southern California; we will see high priced homes continue on a torrid pace while lower to middle income homes significantly depreciate.

Why will this occur? Well for one, the mortgage market implosion will squeeze credit out. In addition, Wells Fargo taking the lead and upping the rates on jumbo products will again, knock out a lot of people here in the state. This will hardly impact any states where median home prices hover from $200,000 to $275,000. Here in SoCal? The median is $502,000 so it will impact every entry home buyer.

The market is done here. Short-sales and inventory are rising as you can see from the short-sale count on the site. I agree with many here that we will see significant drops happening quicker since foreclosures will add pressure to the overall entry market. The higher end? My guess is that it will stay strong for the time being so watch out for skewed numbers.

The market is up and down at the moment. Reports state that AHM is going into bankruptcy and other lenders are showing their cracks. Not much the market can do except wait to hear the Fed blow some more wind this week.

D. A. said...

I've always that that extended term loans were ridiculous. There's a lower limit to what the payment can be on a mortgage. Consider a $500,000 mortgage at 6% with an infinite payment term (that is, each payment only covers interest, no principle). The interest on that loan ends up being $2500/month. That's your lower limit on the loan. A 30 year mortgage increases that amount to just under $3000. A 40-year mortgage to $2750 and a 50-year mortgage to $2632.

So you end up adding 20 years onto your mortgage to save less than $400/month. If you can't afford the 30-year mortgage, you can't afford the house.

Realist said...

Dr. Housing Bubble,

I agree that the bubble will burst... and am hoping for really big pop. I don't know if forecasting using family median income is the most accurate way, though. I say this because prices aren't set by every household in the area. Prices are set by those who choose to or are forced to sell, and the people who are financially ready and willing to buy. A retired couple living off of $2000 per month, living in a paid off house will not be looking to buy a house. That couple's family income brings down the median family income for the area. I think that a more accurate measure would be income levels of people that have bought houses within the last couple of years. I don't know how those numbers could be obtained... especially with the liar's loans distorting reality. But these numbers would likely represent the incomes of real buyers. Once those numbers are obtained, forget about the 41% of income for housing. Calculate it at the 28%-33% of either net or gross (I was a child back when lending was responsible, so I'm not exactly clear on what a sane ratio is really supposed to be). I think that these old fashioned ratios will return, though, and I welcome them.

Jeremy said...

Hey - You're figuring a 6.5% interest rate for a 30 year fixed... Not to be rude, but what are you smoking?!? Rates are going to go up because banks are widening their spreads in order to make up for the losses of the subprime. 7% is a great rate nowadays - as of this past week. On top of that, stated income loans are a thing of the past. So, this will be a huge burden. Everything you write of is true - But, everything will be worse because of the tightening of credit and spreads increasing.

Dr Housing Bubble said...

@d.a.,

You’ve pointed out an important point that after 30 years, whether doing a 40 or 50 year loan doesn’t really do much in terms of the monthly nut. Yet if you calculate mortgage charges, you’ll realize that you are making the lender a lot wealthier. Just run a simple savings calculator and see how much $100 saved per month is worth after 30, 40, or 50 years at 7 percent. You’ll see exactly why this is smart for lenders, bad for you.

@realist,

It is the case that housing prices are set at the margins. In any given point in time, not all homes are for sale. In fact, only a very small portion. But this portion is impacted by interest rates, appreciation, and market perception. At this point, no longer are people buying expecting double-digit returns, or having the ability to get extremely dangerous loan products. So what we are seeing, is a margin squeeze on the housing market. Does this impact everyone? Absolutely not. But it does impact those looking to buy and sell.

@jeremy,

Glad you caught that. In fact, this highlights the point even further. I was generous on the loan terms and also overstated income by nearly 10 percent to highlight the point that even with “the perfect world” scenario, housing is in Wonderland here in LA. Even with that, you can still see how outrageously priced homes are in LA County.

By the way, I've seen a few rate sheets and stated income and shady loans are still being used (not to the extent of last year but incredibly, they are still somehow being funded).

vinny said...

The Housing market runs in seven year cycles. If you take June 2005 as peak which is was the cycle will not even hit bottom until 2012. By then housing prices will have declined by some 40 to 50%. Layoffs in the financial industry are soon to pick up pace, as will housing prices. It took a long time to get to this point, and it is going to take some time before we rebalance. At least one major bank and many hedge funds will go bust before we reach bottom. Hang on to your hats it going to be a very,very rough ride.

Vinny

JR said...

Dr. HB,
I believe the housing prices and incomes you cite in your scenario analysis are all in nominal terms, which is fine but potentially misleading. A 5% annual drop in nominal prices is actually a much larger drop in real prices.

It would be interesting to look at a scenario where nominal housing prices stay flat over a number of years, following an initial decline in prices caused by an initial shakeout of unqualified homeowners. In this case there certainly would be a decline in home values, even if only in real terms. I believe this would be accompanied by a period of time with greatly reduced home turnover.

Those who won't need to sell, just won't sell.