In my last column, I reviewed the profound implications employment data has on the fundamentals of the real estate market. While no other metric has more of a direct impact on both commercial and residential market dynamics, there are several other indicators that we keep a close eye on, each of which provides insight into the possible direction of commercial real estate.
The U.S. housing market is one of those indicators. This market generally represents a chicken-and-egg relationship with our economy and, therefore, our employment market. One school of thought is that as housing prices rise, equity rises; a “wealth effect” is created; and the consumer spends more, bolstering the economy. The other school says that if the economy is expanding, jobs are created, providing more wealth for people to buy homes with, which exerts upward pressure on home values.
Most economists believe that the housing bubble was largely responsible for our most recent recession and the near collapse of our financial markets. Fingers were routinely pointed at several of the participants who were thought to be culpable for exacerbating the problems. They included bankers, mortgage brokers, real estate brokers, appraisers, mortgage-backed securities originators and ratings agencies.
Only a small segment of legislators or the media placed any blame on, or even mentioned, governmental intervention and policy as a–if not the–major contributor to the housing mess. One perspective could be that the government created the playing field and the guidelines; and the aforementioned private-sector players simply filled roles created by the opportunities that misguided government initiatives created.
Trying to influence the national homeownership rate and attempting to motivate the private sector to create affordable housing, rather than doing so directly, were two of these misguided policies that, to a significant degree, led to our recent crisis.
In the mid-1960s, the homeownership rate in the U.S. hovered around 63 percent, a rate that steadily increased to about 66 percent in 1980. Given the oppressively high interest rates at that time (single-family home mortgage rates were as high as 18 percent), the rate of homeownership fell back to 63.5 percent by 1986. For nearly a decade, the rate was relatively flat at about 64 percent. During this period, many on Capitol Hill thought that increasing the homeownership rate would be good for the country and the economy. Additionally, outside pressures began to emerge to dramatically affect U.S. housing policy.
In the early 1990s, housing advocates and community groups such as ACORN pressured Congress to force lenders to move away from conservative underwriting standards. The advocates concluded that only the most restrictive underwriting would be utilized unless Fannie Mae and Freddie Mac moved aggressively to motivate banks to expand their historical underwriting standards. In 1991, an open ear was given to these factions by the Senate Committee on Banking, Housing, and Urban Affairs. The result was a law imposing affordable housing mandates on the GSEs via the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.
Naturally, in 1993, we began to see regulators move away from requiring adequate down payments, good credit and an ability to meet monthly mortgage payments. So much for common sense underwriting principles.
By 1995, HUD, in conjunction with the private mortgage industry, announced a National Homeownership Strategy to loosen underwriting standards nationwide. These policies were implemented in tandem with the GSEs agreeing to back these mortgages either directly or by purchasing loans made by banks based upon these loose standards. Lenders were happy to play ball as they would originate these sketchy loans only to immediately sell them to the taxpayers.
I know that Fannie and Freddie are not technically “the taxpayer,” but who’s kidding who?
THESE POLITICAL INITIATIVES have led to disastrous results for the housing market. Judicious underwriting became a thing of the past in the housing bubble years of 2004 through 2007. Here, traditional fully documented loans with 20 percent down payments gave way to low-quality, poorly documented mortgage products. These included Alt-A, subprime, option-ARMs and, my personal favorite, the NINJA loan. The NINJA is the no-income, no-job, no-assets loan.
Fannie and Freddie were active contributors in the decline of mortgage standards as they, at the urging of Congress, continued to purchase and securitize boatloads of these low-quality mortgages.
The result of these actions led to a tangible shift in the quality of American mortgages. For example, in 1990, only 0.5 percent of home loans were made with down payments of 3 percent or less. This percentage ballooned by 2006 to about 30 percent. Nearly one-third of borrowers had acquired a home with virtually no money down, leaving us in a condition ill-equipped to handle falling housing prices. These 2006 and 2007 vintage loans, for example, accounted for 24 percent of Fannie Mae’s business but 67 percent of its credit losses.
Easy money and low rates followed and the housing bubble was inflated. In 2004, some in Congress became concerned that the government’s role was becoming too dominant in the housing market and some even predicted that a bailout might eventually be needed. Barney Frank famously responded by saying, “Let’s just roll the dice with Fannie and Freddie.” That roll of the dice has “crapped-out” as the taxpayers have already poured about $145 billion into the GSEs to cover losses, and there doesn’t seem to be an end in sight. It is estimated that the tab will rise to just under $400 billion over the next 10 years.
In fact, Fannie and Freddie’s track record are worse than the rest of the market. It is estimated that approximately 25 percent of all borrowers obtaining home loans are presently underwater, meaning that their mortgage balance is greater than the value of their home (remarkably, 40 percent of these have loan-to-value ratios in excess of 125 percent). This percentage for loans held by the GSEs is about 35 percent. In 2008, Fannie and Freddie were placed into conservatorship, which is a purgatory between implicit nationalism and bankruptcy. “Conservatorship” is also just a nice way of saying that their losses will be covered. Given this reality, not many people were surprised when, after decades of promoting and defending the social mission of them, Mr. Frank recently called for the abolishment of Fannie and Freddie.
The present administration’s attempt to address the nation’s housing problems has accomplished, on purpose, what had previously happened by accident. The first-time home buyer’s tax credit has put many people into homes with virtually no skin in the game.
In fact, an examination of the numbers shows that the government was actually paying people to buy houses. When the tax credit was implemented, the average home price in the U.S. was $178,000. Mortgages were primarily provided through the F.H.A. at that time, which required a maximum of a 3.5 percent down payment. Therefore, on the average home, a down payment of about $6,200 was required. The first-time home buyer’s tax credit was $8,000. The result was that buyers were handed a deed to a house and a check for $1,800. We have seen that movie already and know how it ends.
Based upon this tax credit program, which steals transaction volume from subsequent periods, was it any surprise that home sales plunged 27 percent after the expiration of the program? Unfortunately, this drop has surpassed even the most bearish of expectations. Home builder confidence has been down for two consecutive months, and housing starts have been running at less than 500,000 on an annualized basis in recent months, less than one-third the pace in 2006. (Of course, the housing market varies greatly market to market, and several states have been hit much harder than others, like Nevada, Arizona, Florida and California. In New York, our housing market has held up fairly well.)
Foreclosures continue to provide significant headwinds to the housing market. Over the past year, the foreclosure rate has been about 4 million units, nearly four times the long-term average. Some market observers positively point to the fact that foreclosures appear to be slowing. We must, however, be cognizant of the fact that the popularity of short sales and deed-in-lieu-of-foreclosure transactions are displacing foreclosures at an increasing rate. Various reports project additional foreclosures ranging from seven million to nearly 10 million over the next several years.
A variety of mortgage modification programs have been virtually ineffective. The president’s signature Home Affordable Modification Program was supposed to help four million distressed borrowers. While nearly 1.3 million have applied for help or received temporary assistance, real help eludes them. Over 50 percent of participants in this program re-default within 12 months of modification.
GIVEN THESE CONDITIONS, economists have projected a growing likelihood of a double dip in the national housing market. A double dip would have negative implications for our commercial real estate market. Let’s connect the dots.
We have previously discussed the importance of employment on commercial real estate fundamentals. Small businesses are the leading contributor to job creation and growth in the U.S. The fact is that home equity withdrawal and credit card borrowing are the primary financing sources for the majority of small businesses. Given new regulation in the credit card industry, which was ironically initiated to “protect” consumers, credit availability has shrunk and that which is available is more expensive than it was. Therefore, small business has restricted access to this form of financing. This places even more importance on home equity.
To the extent that home equity grows, it provides existing and potential small-business owners with a source of financing for job creation. Additionally, home equity creates a “wealth effect” that stimulates personal consumption. With consumer spending making up nearly 70 percent of our gross domestic product, this has important implications for our economy at large. Second-quarter 2010 G.D.P. growth was adjusted downward from an initial estimate of 2.4 percent to just 1.6 percent. This is far below the 6 to 8 percent growth rate normally seen at this point in a recovery. An increase in consumer spending would lead to healthy G.D.P. growth.
Therefore, strengthening conditions in the housing market would be good for job creation, the economy and, consequently, the commercial real estate market. It is actually quite remarkable that the housing market is not stronger given the extraordinarily low interest-rate environment and the significant drop in value seen in most submarkets. Today, the 30-year, fixed-rate mortgage averages just 4.36 percent, an all-time low.
Getting back to the chicken-and-egg dynamic, can the housing market improve before the job market improves? Conventional wisdom suggests this will be difficult. For those of us in the commercial real estate sector, a healthier job market and stronger housing market can’t come soon enough.
Robert Knakal is the chairman and founding partner of Massey Knakal Realty services and in his career has brokered the sale of more than 1,075 properties, having a market value in excess of $6.5 billion.