The Looming Real Estate Crisis

With mortgage rates at their lowest in decades, folks are cashing out at 10 times the rate they did just five years ago. And the methods used to get people into houses are getting more aggressive. Rising interest rates make houses less affordable, and thus depress their prices. Homeowners who find themselves overextended may be heading for trouble.

By Bill Mann (TMF Otter)

July 16, 2003

Che Guevara I'm not. Yet, apparently I'm some sort of revolutionary. At least, my mortgage banker seems suspicious.

That's right, I recently refinanced my house. I know -- hardly the antics of one who's tired of working for The Man and not going to take it anymore, but that's another story.

(Shameless, yet wholly sincere, plug: I used LendingTree (Nasdaq: TREE), linking directly from our Mortgage Center on the Fool site. It was a great experience -- fast, easy, and cheap.)

My discussion with my mortgage officer went something like this:

"OK, Mr. Mann, the appraisal for your house came back, and it's appreciated substantially since you bought the place. Have you decided how much you want to refinance for?"

"Yep, I'm refinancing the amount of my existing mortgage."

"Really? You don't want to cash out? Take advantage of the equity built up?"

"Nope. And I want the 30-year fixed rate."

"I'd suggest you look at the adjustable rate mortgages we have -- your payments would be substantially lower."

"And what happens at the end of the fixed period?" I knew full well what happens at the end of the fixed period.

"Your rates adjust upward or downward to reflect the current rate at that time."

"Uh-huh. And what's the chance of that being downward? I know you can't predict, but guess."

"Seeing as we're in the lowest interest rate environment in decades, not very good. But in the meantime, you'll save a ton of money."

"No. 30-year fixed, with no cash out will be fine."

This guy was very nice, and competent. He'd also apparently not come across too many people who didn't (a) jump at the lowest rate possible, and (b) take out some of that built up equity. Numbers from Fannie Mae (NYSE: FNM) back me up on the latter.  Throughout the 1990s the aggregate amount taken out of home equity in "cash out refinancings" varied annually between $25 billion and $50 billion; in the past two years homeowners cashed out nearly $400 billion, with another $120 billion estimated for 2003.

To put those numbers in perspective, it's estimated that over 10 years, the much-ballyhooed and -maligned Bush tax cuts will amount to $670 billion. My point: Cash-out refinancing has provided a massive amount of stimulus over the past three years.

Washington Mutual (NYSE: WM) estimates that fully a quarter to a third of all loans originated in 2002 contained some variable-rate provision. Again, these have the benefit of offering lower rates now, but transfer a great deal of interest rate and market risk from the bank to the homeowner, especially in a low-rate environment like today's.

Snake eyes
What are the odds that the residential real estate market writ large goes into a tailspin? This country has enjoyed a period of near uninterrupted growth in land values going back to the turn of the century. But history offers no precedence for the levels of debt taken on by individuals relative to their incomes. We've also not seen until quite recently the advent of a) 30 year mortgages, b) no- to little-money down home purchases, c) a hyper-active national monetary policy, or d) liquidity for the market largely in the hands of two companies -- Fannie Mae and Freddie Mac (NYSE: FRE). Each of these elements has the effect of changing the landscape of the market; taken as a group they make comparisons with historical real estate events downright specious.

In fact, what happens going forward is anyone's guess. I have no special insight into real estate prices in the future. What I do know is that conservatism pays when times get bad. And none of the trends in residential real estate are in any way conservative. Here's what else I know:

1. Lower interest rates push up home prices.   The lower the interest rate, the lower a person's monthly payments. This seems obvious, but it also means that a buyer can afford a much higher list price. Two observations -- first, it is unlikely that mortgage rates drop much farther. Second, the converse must also be true -- higher interest rates make houses less affordable.

2. Housing prices have risen much faster than income levels.  It's an article of faith in the industry that, over the long term, housing prices should rise in lockstep with income levels. Lower interest rates have provided the additional fuel to make up the difference, but this can't continue apace.

3.  Savings rates in the U.S. are awful. How could they not be? We spent the 1990s enjoying rapidly appreciating stock portfolios and homes, and our spending increased 100 basis points faster per year than did our incomes. Now the Federal Reserve has done everything in its power to encourage spending by cutting interest rates down to nothing.

4.  The rapid increase of no-cash down financing products means that only a small drop in housing prices will turn a larger portion of the existing mortgage base upside down.  Once upon a time 20% downpayments were the norm. Now we have a growing component of the market putting anything from 3% to -3% down to get into houses. These folks have no room for error, and neither do their banks. Should real estate prices drop at all they will be underwater on their loans.

The result is a housing market with little by way of a safety net. Those who accept the additional risk of adjustable rates are taking on even more risk in this environment. Think about it: you accept an ARM that begins adjusting in 5 years. Should interest rates rise, reducing the affordability of housing, you will be left with a grim choice: You can either sell the house and be out of pocket the negative equity, or pay a substantially higher rate, and payment, which you may not be able to afford, especially if you stretched too far to get in the house in the first place.

This is a bleak picture, and it's one that may unfold because the Federal Reserve has played with interest rates so much. But with rates so low, it's likely that the refinancing, homebuilding, and purchasing markets will remain frothy. We would recommend that you retain a conservative approach to buying your new house.

1. Don't "buy as much as you can afford." This is one of the old truisms of home ownership. When we bought our house we qualified for a loan twice as big as the one we took. Our mortgage broker explained that he's seen a degrading in standards over the last few years. Buy a house with a payment you're sure you can afford.

2.  If you refinance, check your reasons before you cash out. There are good reasons to take equity out of a house: capital expenditures, starting a new company, or a good investment opportunity. But if you're taking money out just to have more to spend, then don't. The "house to blouse" phenomenon of the last two years means people are taking on substantially higher risk for the sake of keeping up a higher standard of living. Bad plan.

3. Rates are low, low, low.  Lock 'em in.  ARMs have their places. Do not use one, though, simply to buy more house than you could afford on a fixed note. Just because your payments are low now doesn't mean they'll stay that way.

While it may come back from the ledge, the real estate market is sporting a huge amount of risk. Don't add to it by being aggressive. If the crisis comes and housing prices deflate even a little, you'll want to be as insulated as possible.

Fool on! Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann anxiously awaits the "Behind the Music" episode on The Wiggles. He owns none of the companies mentioned in this article. The Motley Fool has a disclosure policy.