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Housing Hotter Than Expected, But Prices Will Cool Down
In a teleconference sponsored by the Homeownership Alliance, the chief economists of several housing organizations last week conceded that they had underestimated the strength of housing activity this year, primarily because long-term mortgage interest rates have stayed lower than they expected in the face of an ongoing effort by the Federal Reserve Board to boost interest rates.
“Looking back it is fair to say that performance of housing has exceeded collective expectations,” said David Seiders of NAHB. Home sales, starts and price appreciation have all been galloping ahead of predictions made by the economists on a previous conference call in mid-January.
With the cost of mortgage financing remaining relatively low and the economy generating jobs and 3.5% growth in the Gross Domestic Product for the balance of this year, Seiders forecast 1.98 million housing starts in 2005, up 1% over 2004. New single-family production is headed for a record 1.61 million units in NAHB’s revised forecast for 2005 and new single-family home sales, excluding custom homes, are expected to hit a record 1.2 million.
The federal funds rate, now standing at 3%, will get notched up by the Federal Reserve to 4% by the end of this year, Seiders predicted, and will be pushed somewhat higher next year.
Froth in the Markets
On the issue of the recent double-digit housing price appreciation that has been sparking morbid speculation about prospects for a housing bust in the nation’s biggest boom markets, David Lereah, of the National Association of Realtors®, conceded that “there’s froth in the markets, but froth can be healthy. It’s not a bad word. The media have been carried away with the word,” which could suggest “effervescence rather than the popping of bubbles.”
“The housing sector is very, very healthy,” Lereah noted, and the double-digit jump in home prices that has occurred in 66 markets over the last year is not a sign of trouble, but an indication that demand has outstripped supply, with the unsold inventory of existing homes now running at a lean 4.2-month supply.
In addition to low mortgage rates, Lereah said that there is “a long and varied menu list of why there is strong demand” for housing today, including demographics and population growth and an active market for second homes. Second homes accounted for 36% of all existing home sales last year, he said: 23% for investment and 13% for vacation.
Agreeing with other economists that concerns over speculation in some especially torrid housing markets — which tend to be concentrated in California, South Florida and the Northeast corridor — are overshadowing the fundamental strength of the nation’s housing market, Lereah said that “the typical investor is still a typical investor, looking to purchase a house with a median price of about $150,000.” Most investors are still buying small, modest homes even though the spotlight is on people who are spending several hundreds of thousands of dollars in exceptionally hot areas, he said.
Lereah is forecasting a record 6.89 million existing home sales this year and expects housing production to exceed 2 million starts. He added that price appreciation will remain strong over the remaining months of the year, but “eventually that’s got to come down.” From the first quarter of 2004 to this year’s first quarter, prices increased 12.5%, according to the Home Price Index of the Office of Federal Housing Enterprise Oversight. Prices advanced at an annual rate of 8.8% during the first quarter.
In general, economists participating in the conference said they expect to see home prices increase in the range of 7%-8% this year.
Price Weakness
David Berson of Fannie Mae said that the growing number of investors in some markets does pose some risk because these buyers are more likely to pull out if housing weakens, but “we have never seen significant price weakness without a decline in job growth and a weakening economy.”
Berson said he expects to see no price weakness in hot housing markets if their economies remain strong.
As of now, there are “no signs of any slowing in the housing market at all,” he said, and housing should stay strong for the next several months. It would take a big decline in housing activity in the second half of this year to prevent single-family activity from hitting new records.
Freddie Mac's Frank Nothaft said that the pace of home price gains will continue to gradually moderate over the next couple of years. He also cited a one-in-three chance during that period that some region of the country will experience stagnant or declining home prices related to economic weakness.
Mortgage originations to purchase homes will hit a record this year, Nothaft said, but total originations will be down by almost 8% resulting from a decline in refinancings. Although they will account for 40% of the mortgage market this year, that will be the lowest share of refinancings since 2000, he said.
Bigger Initial Discount Rates
Adjustable rate mortgages (ARMs) will account for one-third of the mortgages originated this year, Nothaft said, and their volume will remain close to last year’s level because lenders are offering bigger initial rate discounts on them. A 2% discount is being offered today on one-year ARMs, he said, compared to two-years ago when the initial discount on those loans was close to zero.
Hybrid ARMs, which are carrying a rate of about 5% for an initial five-year period, are accounting for about 40% of conventional ARMs originations, Nothaft said.
Long-term mortgage interest rates, which just hit a 14-month low, are headed higher during the next six months, Nothaft predicted, and should be near 6% by the end of the year. Before summer is out, the Fed will increase the federal funds interest rate at lease two more times, bringing it to 3.5%, he said, and there is a possibility of a further increase in the fall.
Cautious Lending Practices
While commercial banks have earned record profits in seven of the past nine quarters, reaching a quarterly high of $35 billion, and have plenty of liquidity to meet the “strong and steady” demand for residential and commercial loans, they are “cautious in their lending practices and know that this has been a long housing boom and it is entering the mature part of the cycle,” said Paul Merski, of the Independent Community Bankers of America, which represents 5,000 bank members in 17,000 locations.
“Bankers do, in fact, worry about repayment despite what you have been reading in the national press,” Merski said.
Community bankers are big lenders to home builders, he said, and they have been watching their housing inventories closely and haven’t seen any problems there, with the supply remaining tight relative to demand.
Concerns about so-called “exotic” loans have been “well overblown in the media,” Merski said. “If you look at some of the discussions on ARMs, ARMs are a very successful product, and most are hybrids with five years before the rate adjusts. It’s not like overnight people are going to be experiencing rapid increases in mortgage payments.”
“More troublesome,” he said, are zero downpayment loans, which have always had a higher default rate but account for only about a 5%-7% share of mortgage products.
“The interest-only loans that are being criticized are not that much different than 30-year fixed, when little of the principal is paid off in the early years anyway,” he added.
Bank regulators, the Fed and the Federal Deposit Insurance Corporation closely monitor banking lending practices, Merski said, and they have found that credit quality is good and improving.
“Bankers do anticipate a reasonable cooling off in prices, but no crash,” he said.
Payment Shock Risks
Mitigating some of the risk from interest-only and other creative loans compared to 10 years ago, said Nothaft, “most loan applications go through automated underwriting systems that balance various risk factors on the loan application.”
Berson said that interest-only mortgages do open up the risk of payment shock when the initial loan period ends if interest rates are rising, as they are expected to be later this year and next. However, the incomes of most households will have increased over the initial period, which is typically five years. Even if the value of the home declines and the buyer ends up owing more on the property than it is worth, “households tend not to default as long as they have jobs and can make the payment,” he said.
For Lereah, interest-only loans are a source of worry. Survey data such as findings from San Francisco-based LoanPerformance showing that 47% of buyers in San Diego and 45% in Atlanta are using the loans are “startling,” he said.
Interest-only loans “are becoming a bigger part of the home lending landscape,” Lereah said. On some of the loans, the initial periods last for only one or two years, he said, “so there is some interest rate shock.”
Also, “lenders have not been in a rising interest rate environment for 10 years or so, but many brokers selling to households are not delivering the true scenarios that could happen to an individual household. I do think it is a serious problem, and hope regulators and lenders step up to the plate and be very careful in how they are marketing these loans. Consumers need to better understand the implications of interest rate shock,” Lereah said.
Seiders said he shared that concern, but what’s even more worrisome is that “a lot of these exotic loans really are made or arranged by brokers and don’t go through the mainstream of the depositories or Fannie/Freddie underwriting.” They are being sold to investors, he said, who may not understand what’s in them.
On the supply and demand front and its implications for home prices, Seiders said that despite constraints such as land shortages and government regulation, builders will continue to increase the supply to help to bring things back into better balance. Average annual housing construction in the range of 2 million units is sustainable over the coming decade, he said, based on growth in population, households and immigration.
“Average annual house price appreciation is 4%-5% a year,” said Nothaft. That’s “a reasonable expectation for someone making an investment in housing. Don’t expect the high levels of the past few years to be sustained.”
To listen to a recording of the roughly hour-long call, click here.
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