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The Housing Mega-Bubble Is Definitely Not Different This Time - It's Much More Of The Same

Submitted by Mark Hanson via MHanson.com,

How do you know when you are in a real estate bubble?  That’s fairly easy.  Knowing when it will pop is the hard part.

  • Air pocket between present, bubbled-out house prices driven by the “unorthodox, unfundamental, incremental demand using unorthodox capital” and fundamental, end-user, shelter-buyer affordability has never been larger.
  • At peak bubble, all that it takes is a narrow and shallow stream of a few dumb money buyers to keep the prices of thousands of houses bubbled out, indefinitely.  Most everybody else is just hanging on for the ride, unable to transact due to the unaffordability.  Then one day market suddenly runs out of dumb money buyers, which is the Wile E. Coyote moment.
  • SF Bay Area is not an example of a healthy, fundamentally-driven “housing market”, rather a stimulus-fueled commodities market.
  • Just like in 2007/08, if the “unorthodox, unfundamental, incremental demand using unorthodox capital” suddenly went away, house prices would revert back to what end-user, fundamental, shelter buyers with traditional financing can afford, which is about half of what houses cost today.
  • Why is everybody so sure that the current age of “unorthodox, unfundamental, incremental demand using unorthodox capital” is here to stay?  They were all wrong in 2007.
  • Housing bubbles don’t exist in isolation;  when the known bubbles finally pop, it will take the rest with it.
  • If everybody in the US had to buy real estate using the same amount down and fully documented 30-year fixed real estate loans, house prices could never detach from end-user, shelter-buyer, employment and income fundamentals in a city of region.  There would be — could be — no bubbles.  It’s when the “unorthodox, unfundamental, incremental demand using unorthdox capital” enters the market, prices quickly detach from end-user fundamentals and bubbles form swiftly, exactly like we saw from 2003 to 2007 and exactly what we are experiencing today. 
  • To believe this isn’t a bubble is to believe that all of the hot momo money from insti’s, high/biotech, flipper, flappers, fraudsters, and foreigners buying houses is fundamental and here to stay, which is exactly what everybody thought in 2006.  Or, to believe that interest rates will keep falling 1% per year going forward, which would lend an element of support to prices.
  • It’s not different this time. In fact, it’s exactly the same, including how everybody is absolute and resolute in their belief that house prices always go up and can’t experience another 2007-2010 type crash again.

 

Backing out the “unorthodox, unfundamental, incremental demand using unorthodox capital” that has driven the lion’s share of house price gains for the past four years, I look at what the fundamental, end-user, shelter buyer can afford using the typical down-payment, mortgage guidelines/terms, and mortgage rates of the period.  That’s because at the end of the day, the typical, end-user, shelter buyer must be able to support the market once the unorthodox, transitory capital (hot, momentum, foreign, institutional et al), exits the market, which it always does for some reason or another.

House prices, based on “comparable sales”, are always worth what the last few houses in the immediate area sold for.  As such, when house prices achieve bubble status and sales volume peaks/ebbs – happening now — all that it takes is a narrow and shallow stream of a few dumb money buyers to keep the prices of thousands of houses bubbled out indefinitely.   Then one day market suddenly runs out of dumb money buyers, which is the Wile E. Coyote moment.  This is in contrast to a normal market, in which most can truly “afford” houses in the cities in which they live, and they sell and rebuy based on fundamental reasons, such as moving up due to career advancement or a larger family.

Analyzing average household income vs house prices in order to establish the “true, end-user, shelter buyer affordability”, when I throw the data in a spreadsheet — like I do for my provocative and widely misunderstood national resale and builder “affordability” comparison worksheets and charts — it’s easy to discern whether the average household income in a city or region can technically “afford”, or support, the average priced house using 20% down and a 43% DTI ratio for the mortgage.  And in most every highly populated region in the nation – the exact regions that were the most bubblicious in 2007 — house prices are significantly over-valued and absolutely reliant upon the “unorthodox, unfundamental, incremental demand using unorthodox capital” to keep the party going.

Moreover, on a post-crash basis, sales volume has gone up and down on stimulus events, rate plunges, and hangovers, but has achieved nowhere near the growth analysts forecasted with ZIRP and QE in the background for so many years on end.

Remember, back in 2013, when volume was more-less the same as this year, sell-side predictions were for 700k new home sales in 2015 and last month we got a run-rate of 468k SAAR and have averaged only 505k SAAR ytd.   Substantial house price gains amidst surging supply and lackluster demand must always be viewed skeptically because something “unfundamental” is likely occurring.

A good example of a region with many mega-bubbled cities is the San Francisco Bay Area where only a fraction of the populationthe incremental buyer;  high/bio tech professional with record high stock prices, institutional or private speculator, foreigners with strong dollars, flippers, fraudsters — can afford to pay whatever they want.  The problem is that most “everybody else” is simply hanging on for the ride, mostly stuck in place, unable to sell and rebuy in the same city, or region, because house prices are out of their reachThis is not an example of a healthy “housing market”, rather an example of a commodities market.

Just like in 2007/08, if all of the “unorthodox, unfundamental, incremental demand using unorthodox capital” suddenly went away today, house prices would revert back to what end-user, fundamental, shelter buyers with traditional financing can afford, which is about half of what houses cost today.

And just like sheep, when “something” happens that kicks-off the selling wave, they will all sell at the same time.   And at this time, the small cohort of “unorthodox, unfundamental, incremental buyers using unorthodox capital” will be overwhelmed with supply.

Everybody knows that the 2003 to 2007 housing bubble was an era of high-leverage, unorthodox financing, which super charged affordability making houses always affordable to everybody all of the time.  Why is everybody so sure that the current age of “unorthodox, unfundamental, incremental demand using unorthodox capital” is here to stay?   I am old enough and lived in the SF Bay Area long enough to know that the current conditions driving house prices are the exception and not the rule.  I saw the same thing in late 90’s, which jump-started and bled into 2003 through 2007.

On a national basis, it’s consensus that certain regions are “isolated” from bubbles popping.  It doesn’t work like that. Conditions that create regional real estate bubbles float all boats.  In other words, when the known bubbles finally pop, it will take the rest with it. Just look how cheap houses got in 2010, below replacement cost.

Some will say, “you are full of crap, based on rents house prices are cheap”.  Well, that’s of course, unless, rents are in a bubble too.  I believe they are.  It’s obvious in major metros.  But, look at Phoenix Arizona, for example, where over 50% of households can’t afford the average rent on a two bedroom apartment, based pm data put out by ARMLS in Q2’15.

Item 1)  Example of the massive air pocket under house prices in two bedroom communities outside of San Francisco

Example A)  My City, Bay Area, NorCal

Average house price:   $1.45mm  
Average household income: $180,000 yr
Loan Term:      30 year
Downpayment:  $290,000
Homeowners Ins: $1000
Prop Taxes: $14,500
Car Payment:  $700
Credit Cards: $400
Other: $500

 

Result:  Typical, end-user, shelter buyer can “afford” a $778k house

 

DOWNSIDE RISK:  = $672k ($1.45mm – $778k), or 46%

 

Results Bottom line:   This very qualified end-user, fundamental, shelter buyer profiled in the data above, can only “afford” a $778,000 house with 20% down and a mortgage loan. Yet, the average house price is $1.45mm.

 

The difference between the present average price of $1.45mm and $778k, or $672k (46%), is how far house prices can fall if all of the “unorthodox, unfundamental, incremental demand with unorthodox capital” exited the market like it did in 2008-09.  And I went easy on the car, credit card and other debts.

In short, house prices this far above the average buyer’s qualifications is the exception and not a durable phenomenon.

Example B)  Menlo Park, North Silicon Valley, Bay Area, NorCal

Average house price:  $1.95mm
Average household income: $170,000 yr
Loan Term:      30 year
Downpayment:  $300,000
Homeowners Ins: $1000
Prop Taxes: $14,500
Car Payment:  $700
Credit Cards: $400
Other: $500

 

Result:  Typical, end-user, shelter buyer can “afford” a $740k house

 

DOWNSIDE RISK:  = $1.21mm ($1.95mm – $740k), or 62%

 

Results Bottom line:   This very qualified end-user, fundamental, shelter buyer profiled in the data above, can only “afford” a $740,000 house with 20% down and a mortgage loan. Yet, the average house price is $1.95mm.

 

The difference between the present average price of $1.95mm and $740k, or $1.21mmk (62%), is how far house prices can fall if all of the “unorthodox, unfundamental, incremental demand with unorthodox capital” exited the market like it did in 2008-09.  And I went easy on the car, credit card and other debts.

In short, house prices this far above the average buyer’s qualifications is the exception and not a durable phenomenon.

*  *  *

Item 2)  The 2003 to 2007 and 2011 to 2015 periods are more alike than anybody recognizes;  “unorthodox, unfundamental, incremental demand using unorthodox capital” drove massive real estate bubbles in both instances.

The last and cruelest false-start of all.

  1. 2003 to 2007 was a story of “unorthodox, unfundamental, incremental demand” (every ma and pa with a heartbeat) using “unorthodox capital” (fed induced high-leverage, exotic, easy credit 1st and 2nd mortgages) for speculation, creating a situation in which house prices detached from true, end-user, employment and income fundamentals.   When the “unorthodox, unfundamental, incremental demand using unorthodox capital” went away over a relatively short period of time and the end-user, owner occupant, fundamental buyer took back control of the market by default, house prices re-attached to that cohort – “reset to end-user fundamentals” — and fell by 30% to 50%.
  2. 2011 to 2015 has been a story of “unorthodox, unfundamental, incremental demand” (institutions, buy to rent, flippers, high/biotech bubble workers, mortgage fraudsters, foreigners with strong foreign dollars et al) using “unorthodox capital” (“cash”, stock/options portfolio loans, levered credit looking to historical low UST yields as benchmarks, and end-users with mortgage rates at historical lows vis’-a-vi’ QE) for speculation, creating a situation in which house prices detached from true, end-user, employment and income fundamentals.  When the “unorthodox, unfundamental, incremental demand using unorthodox capital” began going away late last year and the end-user, owner occupant, fundamental buyer began to take back control of the market by default, house prices began to re-attached to that cohort and reset lower.  But, the consistent drop in rates in 2014 and plunge in Q4’14/’15 postponed the inevitable and breathed a last rush of life into the sector at the prefect time;  Q1 and Q2 ’15 going into the busy season.  This gave the perception of a durable recovery with escape velocity when on the contrary this is the last and cruelest false start of all, with little fundamental, underlying demand behind it, meaning a weak year-end 2015 and start to 2016. Just like at the end of Bubble 1.0, this housing market is on the precipice of “resetting lower”, ‘by how much this time’, is the question.

 

Item 3)  One last thing to think about.  If everybody in the US had to buy real estate using the same amount down and fully documented 30-year fixed real estate loans, house prices could never detach from end-user, shelter-buyer, employment and income fundamentals in a city of region.  There would be — could be — no bubbles.  It’s when the “unorthodox, unfundamental, incremental demand using unorthdox capital” enters the market, prices quickly detach from end-user fundamentals and bubbles form swiftly, exactly like we saw from 2003 to 2007 and exactly what we are experiencing today.

To believe this isn’t a bubble is to believe that all of the hot momo money from insti’s, high/biotech, flipper, flappers, fraudsters, and foreigners buying houses is fundamental and here to stay, which is exactly what everybody thought in 2006.  Or, to believe that interest rates will keep falling 1% per year going forward, which would lend an element of support to prices.

 

In sum, housing has gone from a sector with more tailwinds than ever before to the power of 10 to a sector with gale-force headwinds hitting in the form of an uncertain Fed;  a plunging foreign demand cohort;  an institutional demand cohort that is mostly sidelined;  and an end-user, fundamental demand cohort looking at out-of-control house prices 30% above their fundamental ability to buy against an uncertain and weakening global economic backdrop.