We all know markets go up and down, but what really helps create value in real estate? Let’s look at the multi-layered cake concept to taste the answer. I’m not sure who came up with this analogy, but it’s definitely something I use regularly. Value in a real estate market is like a multi-layered cake since there are many “layers” in the market that help impact or create value. It’s easy to think of real estate in terms of being only about the relationship between supply and demand, but it’s also about interest rates, the economy, cash investors, foreclosures, financing, affordability, loan programs, lending guidelines, industry regulations, jobs, consumer confidence and so many other “layers” that end up playing a part in influencing the market.
Shifting Layers: When any of these layers begin to shift, it can create ripples throughout the market. This was seen clearly when the Federal Tax Credit came on the scene a few years ago. This credit created incentive for buyers to purchase properties, and it led to a brief uptick in values (until the credit expired). Another example would be a reduction in interest rates, which increases affordability and often leads to an increase in prices since more buyers jump into the market to compete for housing supply. Or consider a very recent example of FHA announcing it will now accept buyers who are only one year out from a foreclosure. This added “layer” in the market will help create value in the Sacramento area as a whole new pool of buyers hits the market to help absorb some of the increase of inventory as of late. Consider too that more FHA purchases will also simultaneously help pick up some of the slack from having less investors in the market. Can you see how some of these “layers” can end up driving real estate values one way or the other?
By the way, thank you to Realtor Joy Yip for letting me use a photo of her rainbow cake. I saw her cake on Facebook and knew it would be perfect for a blog post.
Question: Any stories, thoughts or questions? Feel free to comment below.
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Thanks Ryan for another excellent post. Unfortunately, bubbles are usually identified in hindsight…. after the damage is done. If imbalances within the system were identified earlier on and remedied, the bubbles simply would not occur. There would be nothing to discuss.
In 2006, very few saw what was coming within the housing market. There was very strong demand and supply was being created to meet the demand. I’m still of the opinion that we did not have a housing bubble per se. Rather, we had a financial bubble which spilled over into the housing market.
Between 2004 and 2006 underwriting is so pathetic that borrowers with virtually no credit history were given 100% financing to purchase homes that they truly could not afford. The bubble was a financial bubble because individuals were given mortgage financing when they truly did not deserve it or could afford to pay back the loan. When a relatively small number of homeowners began to default on their mortgages, entire neighborhoods were impacted by falling prices. This in turn led to wave after wave of foreclosures. Borrowers could not make their mortgage payments, which often times were the result of increasing monthly mortgage payments on adjustable-rate loans to subprime borrowers. Mortgage payments increased when the initial teaser rates expired. Lower prices impacted all homeowners in neighborhoods because the foreclosures led to more homeowners who could not sell their homes and pay off their mortgages – thus more foreclosures and short sales.
That bubble was a mortgage based financial bubble. It was a creation of the Wall Street wizards who were selling mortgage-backed securities and derivatives to unsuspecting investors all over the world. To this day we are still feeling the effects of the Wall Street greed that led to massive foreclosures and defaults in the residential real estate market.
In the current market, mortgage underwriting is far more thorough and comprehensive than it was ten years ago. It is unlikely that homeowners who financed their homes over the course of the past three years were put into mortgages that they cannot afford to pay back. Other economic conditions could occur that would impact the housing market. There are many things that we just do not have any control over.
In may area we are starting to reach a point in pricing where homes are becoming unaffordable to certain buyer segments. This in turn should be a natural braking mechanism. Prices will adjust to the incomes of local buyers. So long as financing does not ease to a point where it was ten years ago we should see a natural balance of pricing that reflects supply and demand of local markets.
Tom, that was a very thoughtful comment. Thank you for taking the time to hash out your take. You brought some real value here, and I appreciate it. I agree with you that this is a different mortgage underwriting situation than it was ten years ago. Adjustable rate mortgages were given out left and right (along with stated income loans). It was simply a recipe for disaster. In today’s market I appreciate that we don’t have an ARM ticking time-bomb and lending guidelines have been more strict. However, we do see a trend of FHA loans increasing, and that brings pause since buyers are not putting skin in the game with these loans. This reminds us buyers are struggling to afford the market at certain price segments. When looking back at price appreciation over the past four years, the market was certainly due for an upward correction since values did bottom out. It was cheaper to buy than rent, so an upward value correction was ripe. However, prices did increase more than they would have had it not been for cash investors gutting the market (which lowered inventory and created more competition) and historically low interest rates around 4% for four years in a row. In that sense values are propped up and inflated. Now we need to see a market that is more driven by wage growth and the economy instead of historically low interest rates and low inventory. It’s an interesting point in the market right now. Lenders could begin to loosen standards and/or get more creative with financing to help buyers afford higher prices (thus inflating the market). Lenders have lots of power right now (as the Fed does).
For any onlookers, I did a screencast this morning to talk through some of the trends in the market in 2005 in Sacramento County. When the “bubble” popped ten years ago, one of the byproducts was a VERY clear increase in inventory (as well as price reductions and such). It’s a good idea to study the market so we can be informed and have more to talk about as this conversation emerges. https://youtu.be/JNOcyg7Wtek
Thanks for your response Ryan. We are in complete agreement with regard to the lenders having a lot of power right now as well as the impact of FHA buyers who do not have much skin in the game. But the current low mortgage rates, in the 4% range, are reflection of a weak underlying economy. I simply do not see how interest rates can go significantly higher from this point unless there is a substantial pickup in the economy. If that should occur we could get significant wage growth which would in turn offset the higher interest rates.
Agreed, Tom. Interest rates were intentionally lowered when the recession hit, and here we are now. It’s going to be interesting to see how it all plays out. Hopefully it’s not like that scene from Indiana Jones where he tries to place the bag of sand on the altar where the golden idol rests. It would be nice if the economy could fill the void that low rates have met….. I’m not sure that analogy works well, but that was a good movie. 🙂