Keys to the Real Estate Market - Affordability & Liquidity

Now that the real estate market in Pleasanton, Dublin, San Ramon, and the Tri-Valley has seen a dramatic uptick in activity, especially in the lower price segments, it’s time to examine two of the most important factors in the health of the local housing market… affordability and liquidity. As is usually the case in economics, markets tend to be self-correcting over time.

For example, when the local housing market saw the extreme run up in prices between 2002 and 2005, the demand for housing was over-heated, and the supply was constricted. A factor that contributed strongly to this run up in prices was affordability. Interest rates were kept low by the Fed, and new mortgage instruments such as interest-only adjustable and option arm products with built-in negative amortization exploded onto the scene. The net result was that mortgage loans became more affordable (artificially so, as it turned out). All of the sudden buyers could purchase (I would say afford, but that might be a poor choice of words) a larger house than their income could justify in years prior. And liquidity was very high, primarily because loans were easy to obtain. Didn’t make enough money? No problem, just do a stated income loan. Need a down payment? No problem, just get an equity line on your current home. No down payment? No problem, just get 100% financing. Liquidity was also high because sellers could free up their equity easily through a sale or a refinance. The result, as we know, was the extreme run up in home prices, peaking in 2005.

So what happened? Why did home prices peak, and the market run out of steam? Again, one of the main factors was affordability. The strength of a real estate market comes from the bottom up. When first time buyers get priced out of the market, the market stalls. If the seller who owns a condo can’t sell because it is hard to find buyers who can afford $600,000 for an entry level condo, that seller will not be able to buy up into a bigger house (say $800,000). This impacts demand for the next price level up, which then impacts the price bracket above that, and so on. In fact, many experts measure the health of a real estate market by its affordability. Indeed, few markets can sustain strong appreciation without strong increases in personal income (or strong drops in interest rates, which is the back door way of increasing affordability). The other factor is liquidity. If potential buyers can’t sell their existing homes, then in effect they are not liquid. And when mortgage loan qualifications become much more stringent, it in effect reduces liquidity as well, as it become difficult to get mortgage financing.

Scroll forward to March of this year. Most markets saw a 20% to 30% or more reduction in home prices since 2005. This had to happen. Home prices had basically outpaced affordability. When this occurs, there are only 3 scenarios for the market to stabilize. Either income has to rise (not easy during a recession), interest rates have to drop, and/or home prices have to decline. Interest rates did in fact drop, reaching historic lows. But this was offset as mortgage loans became extremely hard to obtain, with banks and mortgage companies enacting much more stringent underwriting to curb the abuses of 2002 - 2005. That left home prices as the main adjustment mechanism to bring the market back into balance. And adjust they did.

The good news is that every down tick in home prices made homes affordable to more buyers. See this graph, which shows the California Association of Realtors Affordability Index, which represents the percentage of the population that can afford the median priced home in the specific county.

It is the law of supply and demand. Home prices adjust until demand increases, and the market hits equilibrium or stabilization. By March of this year, many of the entry level condos in Dublin, for example, had dropped from the $600,000 price range at the peak to the mid-$300,000’s, making these homes much more affordable and attractive. Combined with low interest rates and the first time buyer tax credit, many buyers have jumped into the market. As the low end of the market has improved, the strength has started to percolate up to higher price ranges, helped along by the Fed raising the Conforming loan limits to $729,750. This helped the liquidity in the market, as now it was much easier to get loans (at least up to $729,750), and there was equity being freed up because sellers were able to sell their homes more easily. And now some of the sellers (those who were not under water) have become buyers, able to buy a home in the next price segment up. This has created the current situation where the market is improving, and the improvement is moving up the price brackets as the activity on the low end improves.

At the moment, the market starts to slow once you start to get much over $1 million. Again, it is wise to think in terms of affordability and liquidity. In a recession (which we are still in by the way) buyers naturally become more cautious and conservative. So they are much more sensitive to the affordability question, and not as inclined to push the envelope on increasing their debt load. And mortgage rates in the jumbo loan arena have been very high, especially fixed rates. Most buyers in this price bracket are opting for shorter term loans (5 to 7 year fixed loans) because the rates are much better, and thus the house is more affordable. There is also the question of liquidity. Lenders have tightened the criteria for jumbo loans as they have become more difficult to sell in the secondary market. Now it seems buyers must wear flowing robes and walk on water to qualify for a jumbo loan. And if a buyer currently owns a home, it is much more difficult to finance the new home unless the current home is sold. In effect, there is less liquidity in the market. Add to this the fact that most of the buyers in the upper price ranges are equity buyers who come in with large down payments, and most buyers have seen a good deal of their net worth erode over the last 7 or 8 months. So in effect buyers are not quite as “liquid” as they were before the stock market crash in October.

It will be interesting to see where this market heads. Are we truly at the bottom? Only time will tell…