1. 2003: Mortgage rates were too low during this period. Due to the lower rates, buyers were able to borrow much greater amounts than they could a year or two earlier, leading to a spike in buyer purchasing power. Sellers in tandem with their agents consciously recognized the increase in the mortgage amounts borrowers qualified to borrow, and began demanding the higher prices that the buyers could now pay for their property. The financial accelerator of excess loans was driving up the price of the collateral – the homes. [For more information on the financial accelerator, see May 2010 first tuesday article, Cleaning up after the ruptured housing bubble.]
2. 2004 and beginning of 2005: Fixed-rate mortgage (FRM) rates flattened, causing buyer purchasing power to stabilize, but by now property prices were rising. To compensate for this mixed condition, lenders, homebuyers and speculators resorted to adjustable rate mortgages (ARMs). ARMs allowed lenders to mask the amount of future payments with low qualifying up-front rates.
3. End of 2005: Sales volume reached its peak while listing prices continued to rise. Option ARMs and Alt-As, also called liar loans, became common so buyers could meet the prices, displaying the contrast between short-term consumer financing and long-term real estate financing.
4. 2006: Sales prices peaked. Home prices began their decline from their artificially inflated status, as homebuyers and their agents began setting prices by applying factors related to the real world: the replacement cost of land and improvements, and the rent-to-price ratio of the income approach for setting value. As prices declined, speculators temporarily disappeared from the market.
5. 2009: The rise in buyer purchasing power seen in 2009 produced the classic “dead cat bounce” inherent in all recessionary drops. Due to the Great Recession and current financial crisis, mortgage rates were dramatically lowered by the lender of last resort – the Federal Reserve (the Fed). This activity by the Fed provided all the mortgage financing needed by those buyers with down payments of as little as 3.5%. Unfortunately, reduced rates and downpayment amounts attracted not only homebuyers as intended, but troublesome speculators and flippers. All this created a momentous environment that drove prices of low-tier housing up again to unsustainable levels. The FHA has since contributed to this mini-frenzy by eliminating the 90-day holding period preventing speculators from sandwiching themselves into a resale for a quick turnover of title for a profit – all at the expense of the seller and the homebuyer.

The importance of buyer purchasing power to agents today

The study of past trends in buyer purchasing power is instructive for those agents taking a look at the current direction of prices in the real estate market. In turn, they will counsel and advise their buyers and sellers with their observations and opinions. The mortgage rate, as must be understood, absolutely controls the amount a buyer (with a set down payment) could have paid for a house one year earlier compared to the amount that same buyer can pay today – both based on 31% of his gross income.

In a transaction contingent on funding from a mortgage, the buyer’s gross income acts as a fulcrum upon which sellers and lenders seesaw up and down in response to changes in mortgage rates. If mortgage rates decrease, lenders lend buyers more money thus controlling movement in the seesaw. In response, sellers on their side of the seesaw weigh in with increased ability to demand a higher price from potential buyers for the same home. However, when rates rise, lenders lend less to the same buyers, and only lend an amount that the buyer can amortize at the higher rates with 31% of his income — effectively pulling money from the seller in a shift of wealth to the lender which, in effect, forces a drop in the price of the seller’s home, implicitly adjusting the market price to the amount of funds buyers can borrow and savings held for down payment.

To demonstrate the difference of the amount of money that can be borrowed at different rates, consider a buyer whose 31% gross annual income ($58,000) allows him to make a monthly payment of $1,500. That monthly payment qualifies him for the following loan amounts at fixed rates (FRM) of:

As shown, if the interest rate fluctuates so much as a half-a-percentage point, the difference in the amount a buyer will be lent is in the thousands. Since all buyers are subject to the same relative reduction in their mortgages on an increase in rates, they collectively can pay less for property due solely on the rise in mortgage rates. Thus, sellers as a whole must axiomatically accept a lesser price if they are to sell at the same sales pace that existed before the rate hike.

Further, other factors weigh in to change the dynamics of this formula. Sellers, by nature, are susceptible to the age-old real estate phenomenon of sticky prices during recessionary periods. Sellers generally are uninformed about pricing properties in the real estate market, but do grasp the concept that they should get more for their property than the neighbor did down the street. This ignorance coupled with their desire to net the most amount of money on a sale leads to a seller’s delayed response in lowering the price of his property to keep pace with the market during times of rising interest rates. As a result, when mortgage rates rise, the real estate market moves toward a standstill and the sellers and their listing agents fail to understand why. [For more information on sticky prices and their effect on the real estate market, see December 2009 first tuesday article The flat line recovery: a side-effect of sticky housing prices.]

Consider a buyer who is interested in acquiring a particular home. Previously the buyer had qualified to borrow sufficient funds to pay the seller’s price. However, mortgage rates have risen and he is now unable to borrow the same amount of money. Unsurprisingly, the property he was able to buy just a few months ago is now out of reach due to the seller’s newly-demanded listing price. The buyer now qualifies to purchase the property, but at a lower price. However, as is usually the case, he is not interested in purchasing a lesser property than the one he once was qualified to buy. Buyers will rarely downgrade. If they saw a home they liked, and had previously qualified for a mortgage large enough to purchase that home, they tend not to purchase a lower-grade home – they will wait until prices or interest rates drop.

Buyers not yet in their retirement years will not lower their standard of living. If a buyer’s job does not change and his annual income does not increase beyond the rate of inflation, as typically is the case during recessionary periods, his position in terms of what he wants to purchase does not change. This is the antithesis of generic affordability indexes, which attempt to classify buyers based on median incomes and median home pricing – neither of which applies to any one person or property.

When the amount of available financing diminishes due to higher interest rates, buyers will simply stop looking and stop making offers, unless sellers lower their prices to meet market conditions forced on them by rate changes (which they quickly meet when rates drop). Buyers will wait until either the sellers drop their prices or interest rates decline to allow them to purchase the level of housing they originally were qualified to buy. The agent’s initial solution for keeping the sales volume from dropping is to change the seller’s pricing to accommodate the change in mortgage rates.

Again, the buyer’s position is static, as the maximum price he can pay for a property is dictated by 31% of his gross income, and the lender’s mortgage rate is controlled by the bond market. Therefore who has to give? Buyers won’t, lenders can’t, so sellers must if their intention is to sell at the “going price.” The seller must adjust his price or exit the market.

The different breeds of sellers

Sellers tend to come in one of three categories:

• The first are the “Must sell now!” sellers. This type of seller needs to sell as soon as possible, is willing to pay standard broker fees and will list the property at the price his agent says will move the property in 30 to 60 days. The “Must sell now!” seller tends to be very cooperative with agents and usually does not fall victim to the sticky-prices bug.
• The bulk of sellers fall into the “Center of the bell curve” seller. This seller may fuss with his agent about broker fees and will try to get “what his neighbor got” for his house or more, but agrees he will eventually accept an offer at less than his listing price.
• Finally there are the “My way or the highway” sellers, who may make up 20% of the listings at any one time. This seller is looking to get his price. He will make sure he gets the same amount or more than his neighbor got regardless of the ability of buyers to pay – and he has no need to sell until he gets the price he wants. This seller tends not to cooperate with his agent since he does not need to sell. So the agent, who by the very nature of his job wants his client to sell, finds himself wasting time with an illusory seller who can wait until he “scores” by finding the buyer who pays the price he demands or the listing expires.

Agents ought to consider what kind of seller they are working for. Currently, there are few “Center of the bell curve” sellers, and even fewer “My way or the highway” sellers. The vast majority of those trying to sell during a recessionary period are those who have to – the “Must sell now!” sellers. Using the historical information before us, it is the agent’s responsibility to encourage and push their sellers (and buyers) to move in the market’s direction.

Sellers do not know what price they can realistically get for their property. Instead, they are hypnotized by a money illusion that the price of their property never decreases. They also do not realize that buyers will not settle for a lower standard of living. So when a buyer can no longer qualify for the loan amount previously available to him due to mortgage rate increases, he will typically not seek a property of lesser value.

By understanding the trends in mortgage rates and the purchasing power of a buyer’s gross income, and realizing where the fulcrum (the buyer’s gross income) currently sits between the lender’s rates and the seller’s price, agents can intelligently advise their necessitous seller not to sit idly by, unable to locate a buyer because of unrealistic pricing.