All last week, we looked at the Housing Recovery theme, challenging the arguments and assumptions of the Residential Real Estate bulls. Last Monday, we began with Debunking the Housing Recovery Story, looking at the huge overhang of Shadow inventory. On Tuesday, it was a Reality Check on Home Affordability. Wednesday, we looked at valuations in the Problem With Home Prices. And on Thursday, we discussed Foreclosures: A Decade Long Overhang.
Today in part 5, we take a closer look at the Psychology of Renting — the factors that have led to a fear of owning homes, and how his may play out in the Housing recovery.
Way back in 2005, as we were approaching the peak of the Real Estate frenzy, David Leonhardt published an interesting and rather contrarian article, Is It Better to Buy or Rent?. The Pulitzer prize winning business reporter for the New York Times wrote:
“But renting might deserve another look right now. After five years in which rents have barely budged while house prices in New York, Washington, Los Angeles and elsewhere have doubled, renting has become a surprisingly smart option for many people who never would have considered it before.”
That was 2005 — since then, the Real Estate market crashed 35% nationally. Rents have risen dramatically. After under building rental units for a decade or longer, Home builders have been increasing the percentage of multi-unit homes and apartments they are constructing. The Architecture Billings Index has risen. Not owning a home has increasingly become the first choice for many new households.
We have become a Nation of Renters.
Why has this dramatic shift away from the American Dream of home ownership occurred? Some of it is outside of the potential home buyers control — namely, lacking the financial wherewithal of a 20% down payment and/or ability to qualify for a mortgage. But much of it is driven by Psychology — there are very specific fears of ownership that are (at least partially) alleviated by renting:
1. Owning an asset class that is still falling in price;
2. Being stuck with a property you cannot sell;
3. Losing one’s job;
4. Impact of rising Interest Rates on prices;
Despite repeated premature calls of a housing bottom from the likes of savvy investors such as Wilbur Ross and Warren Buffett, we have yet to see prices find much stability. (Premature being the polite word for terribly wrong). What we can legitimately observe is that prices are falling more slowly — but that is not the same as bottoming.
Buyer Psychology plays a huge role in this. When it comes to psychology, we are less concerned with what will actually happen and more focused on potential buyers’ perceptions and concerns of what could happen. That is what drives their behavior.
Falling Prices: Its my opinion that it is very doubtful home prices will fall another 35%; However, buyer psychology is that after a steep drop, the fear of a continuing price slide remains. The prior drop impacts their behavior in such a way that they behave as if a similar fall is likely. We see very similar behavior in equity investors, who after a 50% drop in prices, fear more of the same. Their reaction is to panic and sell out, forming a bottom.
Most people do not want to own an asset class that is still falling in price. The ability to ignore the downside momentum and buy into the fall is beyond many traders — and potential home buyers.
Inability to Sell: If you are a long term owner, the short term price fluctuations are irrelevant. But if you may need to sell your property over the short run — let’s define that as less than 5 years after purchase — there is a possibility that the home will sell for less than the purchase price. For someone who saved for a decade to build up a down payment, that is a situation to be avoided.
Even worse than the dollar hit is the situation of not being able to sell the house at any price. This is a problem severely underwater owners face. There homes are worth less than their mortgages, and they suffer from a form of economic immobility. Without a banks permission to effect a short sale, they are stuck. The data shows that once a home is more than 25% underwater, the possibility of a WalkAway or voluntary default goes up dramatically. The impact of this default on credit ratings is severe.
Job Insecurity: Some of the Rental Nation psychology also comes from a very legitimate fear of losing one’s income. The mass layoffs during the Great Recession and the inability of many people to get another job of comparable salary is a very credible worry. If one were to lose one’s job, a home mortgage and sale becomes a burden. The thought process seems to be its is its easier to find a cheaper rental than go through the full process of selling the home under duress.
Rising Mortgage Rates: The last element in the fear of buying is probably the one that potential buyers are least concerned with; its also the one that has the greatest potential impact on transaction prices: Rising interest rates.
Purchasers of homes are mostly concerned with their monthly costs — the amount they must pay in interest & principle, insurance taxes and maintenance. Interest rates are presently near record lows. The likelihood of an increase over the next decade is a very high probability. Rising rates are not usually a positive factor in terms of homes prices.
Indeed, from the 1970s to 2004, rates were in a secular downtrend. That was very supportive of higher home prices. As rates fall, one can carry the same house at the same monthly cost with a higher purchase price. For most of the past 3 decades, interest policy of the Fed has been an ally of home ownership. Today, it is likely a future headwind.
We have seen more than $6 trillion in owner’s equity destroyed since housing peaked in 2006. Look at the Housing market in Japan — its still a mess, more than 2 decades after its 1989 peak.
The negative implications of buyer psychology are still with us. This is a process, one that will take time to heal. A few years of stable prices, an improving economy, and recognition of the many negatives of renting will eventually bring home ownership back into vogue. But that process is ongoing; it may still not resolve itself for any number of years.
We have made some significant progress — but we are not quite there yet.
Rent vs Buy Calculator (NYT)