2017 in Review: A Gradually Strengthening Economy Meets Higher Construction Costs

At this same time a year ago, I wrote about an economy that was improving enough that the Federal Reserve was about to raise interest rates for the second time since 2006, followed by up to three more hikes in 2017.  However, there has also been a consequence of this growth in the form of higher costs for land, labor and materials, making it challenging for builders to build the types of affordable housing at a time when new home starts are predicted to jump sharply in 2018.

U.S. GDP growth – which averaged about two percent in both 2015 and 2016 and was just 1.2 percent in 1Q 2017 ---- surged to three percent in the second and third quarters, due mostly to increased consumer spending, inventory investments, exports and federal government outlays.  Current forecasts are suggesting this rate of growth to improve even further to 3.3 percent in the final quarter of 2017.

Job growth, which rose by 261,000 in October, averaged 169,000 per month through the first ten months of 2017 (down 12.2 percent from the same period of 2016), and would likely have been higher without the negative impacts from a particularly harsh hurricane season.  Had job growth stayed on track with the average through August, job growth through October would have been closer to 185,000 jobs per month.  Moreover, October’s official unemployment rate of 4.1 percent is the lowest reported since December 2000.

Not surprisingly, consumer confidence from both The Conference Board and the University of Michigan surveys has risen to the highest levels since the early 2000s, boosted in large part by the strengthening job market.  In turn, wages have come under increasing pressure, with average hourly earnings up 2.2 percent for the 12 months ending in October.

Still, because the Federal Reserve-preferred PCE price index rose by just 1.6 percent per year through September, it’s not clear just how many interest rate increases we’ll see in 2018.  Complicating matters further are higher inflation indicators from both the Producer Price Index and Consumer Price Index, which rose by 2.6 and 2.2 percent per year through September, respectively.

Certainly one area in which we’ve seen higher inflation is in the cost for building a new single-family home, which as of September 2017 was up by 5.2 percent year-on-year and 29.2 percent over the previous five years.  Combine that increase with tight supply in most markets, and the result has been a decline in home affordability.

As of 3Q 2017, the NAHB/Wells Fargo Housing Opportunity Index fell to 58.3 percent, for the lowest rate since the same quarter of 2008, and down sharply from the last peak of 77.5 in 1Q 2012.  Since 3Q 2008, median national home prices tracked by the same report rose by 26 percent.

Single-family new home sales, which dipped in July and August, rebounded by nearly 19 percent in September to 667,000 per year, and were up 17 percent year-over-year.  So far in 2017, new home sales have averaged 609,000 per month, up nine percent from the same period of 2016.    At current sales rates, existing inventory would take 5.0 months to sell, down slightly from 5.1 a year ago.

For existing homes, lack of inventory at the lower end of the market and rising prices have recently stunted sales, with September’s pace down 1.5 percent from a year ago and the share of first-time buyers declining to 29 percent from 34 percent.

Although September’s inventory did rise slightly to 1.90 million homes – or a timeline of 4.2 months at current sales rates -- it has fallen year-over-year for 28 consecutive months. While pending home sales in September were flat from August, they were still down 3.5 percent from a year ago, and have fallen on an annual basis in five of the past six months.

Thankfully, there does seem to relief on the horizon.  Looking ahead to 2018, FreddieMac is predicting home builders to take up much of this slack in overall housing inventory.  Annualized housing starts, which averaged 1.19 million for the first nine months of 2017, are forecast to rise by another nine percent to 1.33 million in 2018, with total single-family home sales rising by about two percent to 6.30 million units even as mortgage rates trend slowly upward.

As for potential consequences of tax reform on the housing market, given the high level of push-back from multiple interest groups, and with the Senate and House versions still far apart as of mid-November, that analysis must wait for another day.

The (Slow) Housing Recovery: Tighter mortgage financing is to blame

I’ll never forget the time I was visiting a new home sales office near Los Angeles in the height of the boom years.  The agent was attempting to explain to the potential buyer how an Option ARM could help them qualify for a higher loan balance that could easily be refinanced into a standard 30-year fixed rate program down the road.  As the alarm bells started going off in my head, I decided to re-visit the first model rather than risk challenging the agent’s presumptuous thinking.  It was at that point that I was pretty sure our industry was firmly in bubble territory.

Fast forward to 2014, and we now have the opposite problem of not enough credit due to often overly stringent underwriters who prefer to approve only the best candidates with near-perfect credit scores and reliable W-2 income.  In fact, the problem has become acute enough that the Mortgage Bankers Association recently revised their 2014 forecast downwards due to “a combination of rising rates and regulatory implementation, specifically the new Qualified Mortgage Rule.”  The new forecast predicts annual refinancings this year to be down 60 percent from 2013 (largely due to higher interest rates) but purchase originations to still rise by 3.8 percent.  During the fourth quarter of 2013, the mortgage businesses for Wells Fargo and JPMorgan Chase were reportedly down by 60 and 55 percent from a year ago, respectively.

As noted in my column last month, the reasons for the tighter credit are two-fold:  an incomplete Dodd-Frank Act which means regulations are unclear, and new Qualified Mortgage Rules which went into effect on January 10^th.  Qualified mortgages are those which are no longer than 30 years, charge fees and points no more than three percent of the loan amount and don’t include any negative amortization or interest-only programs.  For adjustable rate loans, underwriters now must take into consideration the potential maximum rate and payment amount over the life of the loan instead of approving based on the teaser rate alone.  This would seem to disproportionately impact younger buyers who were previously willing to take a gamble that their paychecks would improve along with their careers, thus making higher monthly payments in the future feasible.

Also now largely shut out of the mortgage market are the newly self-employed, as evidenced by nationally syndicated housing columnist Lew Sichelman’s disappointing experience to refinance a rental property despite a credit score of 760 and an LTV of 70 percent.  With less than two years of history of 1099 income, Lew’s equity in several other properties simply wasn’t relevant under today’s underwriting criteria.

There may, however, be a signs of a thaw in this somewhat frozen market.  Many eyes are now on former congressman Melvin L. Watt as director of the Federal Housing Finance Agency, which oversees both Fannie Mae and Freddie Mac.  As opposed to Edward DeMarco, the agency’s acting director for the past four years, Mr. Watt has already indicated a clear shift in direction which includes delaying a series of higher loan fees announced in December and putting access to mortgage credit front and center ahead of other goals, especially that of scaling back the federal government’s role in propping up the residential mortgage market.

What this means in the short run is that those buyers without perfect credit and large down payments will not face higher upfront loan fees charged by Fannie and Freddie.  In the long run, there remains a larger policy disagreement on the role of private capital in our nation’s mortgage market, one that would be completely separate without any connection to government.  And yet in a lending environment of mortgage rates below five percent, private capital has stayed on the sidelines because there are too many other competing options which offer higher yields.  Add in the considerable interest rate risk that an investor takes with a traditional 30-year fixed-rate loan and it’s not surprising that lenders continue to be picky.  Eventually, however, lenders which rode the now-declining refinancing wave of 2013 will have to make up that lost business with new loan originations.

To spur lending, three things should happen.  Firstly, Fannie and Freddie will have to expand the range of mortgages they guarantee without lowering standards.  Secondly, the re-emergence of private capital should occur before government fees are raised.  And thirdly, Mr. Watt should ensure that the 30-year fixed-rate loan remains a bedrock of housing finance given its historic role as the best way for homeowners to slowly build wealth without worrying about future interest rate shocks.  

About Those New Qualified Mortgage (QM) Rules...

About 20 years ago, it was fairly common for home builders to have close relationships with outside mortgage lenders.  This was done for two reasons:  to streamline the financing process for their buyers, and to bolster their competitive position by offering various incentives for using these affiliated lenders.  Throughout the 1990s, most large builders figured out that bringing these operations under the corporate umbrella – including in-house title and escrow services -- could make the process even more efficient, while also adding more revenue streams to the bottom line.

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FannieMae to allow renters to remain in foreclosed homes

In an attempt to prevent throwing out renters of foreclosed properties onto the street, FannieMae will act as an interim landlord for nearly 4,000 tenants. FreddieMac is expected to follow suit. From a CNNMoney.com story:

Fannie Mae, the battered mortgage giant, has agreed to act as an interim landlord for thousands of tenants living in foreclosed homes around the country.

Fannie (FNM, Fortune 500) will sign new leases for the approximately 4,000 renters in its foreclosed properties, said spokesman Brian Faith. These tenants would otherwise face eviction, even if they had been paying their rent on time, because of the owners' failure to pay the mortgage on the property.

The policy will go into effect on Jan. 9, Faith said. He said Fannie will observe an existing moratorium on new evictions. Both Fannie and Freddie Mac have agreed to temporarily hold off on evictions...

Freddie Mac (FRE, Fortune 500), the other government-backed mortgage giant, has not announced any changes, but a spokesman hinted that the company is developing a new policy.

"We are working through the operational details to provide something by January," said Freddie spokesman Brad German.

German said it was in his company's best interest not to evict responsible renters.

"If it's an investment property, with multiple units, we'll do our best to keep our tenants in the units, for all the obvious reasons, including that it's easier to sell the unit to another investor," said German...

So why wasn't this rather obvious and common-sense approach implemented months ago? Good question!