These policies not only encouraged homeownership, but bribed homeowners to purchase more, and larger, properties than they should have, and in unnecessarily remote locations. Most of all, government tax subsidies encouraged homebuyers to borrow more than they could afford to repay, as the family shelter came to be seen as an investment, and owners collectively built up a massive amount of highly leveraged toxic debt. [For more information about the mortgage tax deduction, see the March 2011 first tuesday article, The home mortgage tax deduction: inducing debt and stifling mobility; for more on tax credits for homeownership, see the December 2009 first tuesday article, Homebuyer tax credit part 2: return of the subsidy.]

Over the past two decades, the unquestioned government position has been “homeownership for all!” With that stance in mind, the policies of the the Department of Housing and Urban Devlopment (HUD), Federal Housing Administration (FHA), Freddie Mac and Fannie Mae were altered to qualify large additional segments of the population as homebuyers and make homes more available through seemingly cheaper mortgages.

Lenders doing it their way, the culprits

Meanwhile, regulations on lenders fell to the wayside as Congress allowed tax code loopholes that applied only to owner-occupied housing. Interest rates on mortgage loans dropped dramatically and continuously, from 18% at the end of the 1980s to approximately 5% in the mid-2000s.

In the absence of government regulation and enforcement to limit risks to society, the financial crisis was allowed to gestate on Wall Street for 30 years, until it abruptly plunged the private mortgage markets into a condition of total rigor mortis in 2007. From 2007 until early 2010, the only signs of monetary life came from the Federal Reserve (the Fed).

The Fed, the nation’s lender of last resort, directly funded all home mortgages in the first years of the recession via the bond market and the U.S. Treasury. In 2008, the Treasury acquired and recapitalized Freddie Mac and Fannie Mae for $140 billion — a price tag which continues to rise with the ongoing costs of bad mortgage loans.

The economic policies which led to the housing bubble will not be repeated in the near future. Government efforts now turn from pumping up housing to organic growth in small businesses and jobs to support the economy in the long term. Current zero-bounded interest rates have already demonstrated that bargain-price mortgage financing will not be enough to rebuild the inflated homeownership levels that took place in the 1990s and early 2000s. [For more on the effect (or lack thereof) of low rates, see the first tuesday Market Chart, Buyer purchasing power.]

The victims: ongoing defaults and foreclosures

The driving force behind the continuing loss of homeownership is negative equity. Some 2.5 million California homeowners have mortgage balances which far exceed the value of the properties securing the loans. A loan-to-value ratio (LTV) of over 125% leads to an imperative for strategic default. [For more on strategic default, see the July 2011 article, Strategic default smarts.]

These deliberate and considered defaults will continue to increase well into 2015 as homeowners become better informed of (and less satisfied with) their options.

Downward pressure on home prices will continue for a couple of years, preventing negative equity owners from finding escape through price inflation. Government mandates for mortgage principal cramdowns would end the trauma. However, continued demands at all political levels for European-style fiscal austerity and personal sacrifice keep getting in the way of proper fiscal governance and job creation. [For more information on the government’s continued reluctance to back cramdowns, see the February 2012 first tuesday article, Cramdowns shot down: another missed opportunity.]

Bad lending practices and a changing job-skills market has left many unemployed and led directly to an ownership apocalypse. The crisis continues to manifest itself in a slowly abating flow of foreclosure sales statewide. California will experience a minimum of 400,000 more foreclosures before the rate of default returns to normal, probably sometime in 2016. [For more on foreclosures in California, see the first tuesday Market Chart, CA NODs and trustee’s deeds.]

Exacerbating the problem of low home sales is the trepidation felt by potential homebuyers, who are made nervous by their perception of the market for mortgage financing. Mortgages remain available, and on excellent terms, for those who make the effort to seek them out. Unfortunately, potential homebuyers, uninformed by their agents, see only tight credit and cautious lenders (lender apprehension to lend increased somewhat in 2011). [For more on the current availability of loans on good terms, see the first tuesday Market Chart, FHA, PMI, or neither?]

Until agents learn to navigate the world of lenders and begin getting their clients pre-approved by multiple lenders as a standard business practice, homebuyer hesitation will remain a significant factor depressing home sales volume. This lull will continue until the quantity of foreclosures drops to a normal level. High-tier homebuyers will be the first to do well in the recovery, as many of them know better than agents how to deal with lenders. [For an appropriate worksheet to compare lender pre-approvals, see the June 2010 first tuesday Form of the month: June 2010 forms.]

In lieu of homeownership, potential homebuyers will take advantage of their only other option: renting. Often they will occupy detached SFRs, currently the playground for ownership among many industrious buy-to-let investors.

The rental activity of would-be homeowners forced to be tenants will be one of the driving forces increasing rental occupancy rates for the short term. City councils, however, will not likely permit the construction of high-rise, high density multi-family units required to keep rents stable. Without proper zoning, rents will increase enough to cause a shift in housing preference to homeownership of SFRs. Then it will be back to suburban sprawl all over again. [For more on the problem dissonance between homebuyer confidence and sales reality, see the first tuesday article, Homebuyers feel ready and willing to buy, but not financially able.]

Current homeowners not exempt

The drama will not end with Wall Street’s already-nascent recovery, since it is an economic fact of life that California’s 2.5 million negative equity homeowners who presently occupy their properties can no longer really be called “owners”. A homeowner who lacks equity in his residence has effectively been denied all the economic benefits of property ownership, and is reduced to the de facto status of a tenant. [For more on the ownership status of negative equity homeowners, see the Federal Reserve staff report The Homeownership Gap, by Andrew Haughwout of the Federal Reserve Bank of New York.]

A homeowner with a positive equity stake in his property benefits from any future increase in the property’s value. Also, any principal reductions by amortization or other principal payoff of the loan, or property improvements, are directly added to that homeowner’s existing wealth.

None of this is the case in negative equity situations. All the financial benefits of ownership go directly to the lender. The owner, on the other hand, is left making overpriced monthly payments to his “landlord,” the lender, frequently at twice the rental rate for the home, with no financial advantage until the LTV hits 94%. The majority of negative equity homeowners who stay the course, foregoing strategic default, will likely have to wait 2025 before they escape their debt and begin to achieve their potential standard of living.

With this in mind, the California homeownership rate depicted on Chart 1 is actually an inflated number since negative equity homeowners are simply not economic homeowners; they do not experience any of the homeownership incentives enjoyed by a homeowner in a positive equity position, with the exception of their raw possession.

The Fed estimates that the national homeownership rate (presently 67% and dropping fast) would be 25% to 45% lower if the rate of homeownership were changed to exclude the massive population of negative equity homeowners (2.5 million of whom are in California) who are not (except under legal phraseology) owners. In fact, “prisoners” might be a better term. [For more on the confining power of negative equity, see the January 2012 first tuesday article, Migratory lockdown: underwater homeowners confined.]

Empty units do not indicate lack of tenants

Logic dictates that any large decrease in California homeownership, such as the one currently underway, should lead to a correspondingly large increase in demand for rental housing. After all, displaced former owners have to live somewhere. After a long period of low renter activity, demand for rentals is now on the increase, and will remain high until rents have risen to squeeze out the less affluent in the area. Expect demands for rent control, especially from the older and wealthier districts such as Contra Costa, Alameda, west Los Angeles and Orange counties.

Builders of multi-family units have come to the same conclusion: they are now building new apartments, in the expectation that new renters will arrive to occupy them. 25,595 apartment/condo starts took place in 2011, up 32% from 2010.

first tuesday forecasts that apartment construction will continue to increase in 2012, and will jump dramatically from 2013-2016, when new jobs begin to be created and the public regains its confidence. California lost 1.5 million jobs in the years immediately following December 2007, and those jobs will be returning, along with one million additional jobs needed to support the three million people that will have been added to the population between 2007 and the time it takes to recover jobs lost.

As the growing occupancy-aged population combines with the nascent job-market recovery, the potential demand we see will be realized, producing a sharp rebound in the builders’ market for apartments. For the moment, however, rental housing is not scarce, particularly in the inland communities. No reason exists to expect any overall scarcity within two or three years. [For more information on current and future apartment/condo construction, as well as SFR construction, see first tuesday’s Market Chart, [CA single- and multi-familyhousing starts.]

Apartments rise

Until recently, the rental vacancy rate appeared intractably high. Chart 2 shows that the vacancy rate at the end of 2011 was still significantly higher than in the period 1998-2004. However, this high rate of vacancies may be misleading. Apartment rents fell during the years immediately following the Great Recession, and apartment vacancies rose, not because people did not need apartments, but because a temporary confluence of factors aligned to make apartments less popular. Among these factors:

• tenants of single apartments moved in with each other in multi-bedroom units or SFRs, consolidating their housing in order to reduce costs;
• families turned to vacated SFRs and condos, which were available for rent at low rates thanks to a seemingly complete absence of homebuyers;
• reverse immigration (emigration) became more and more common, as workers moved away from areas where the unskilled construction and labor-intensive jobs had disappeared, leaving more space available for other lower-income residents; and
• “marketability mismatch”, in which the vast majority of rental units were simply marketed at prices too high by “holdout landlords”, who refused to make their properties available to the members of the population who most needed rental housing. Rent control added to this fever.

All of these recession-induced factors are largely temporary, and are even now becoming less important. Today, apartments have largely emerged from the foreclosure phase, and rents are moving upwards, presenting good “forward-looking” investments for builders. The new housing they construct will be targeted toward the demographic most likely to benefit from good quality mid-tier and high-tier rentals. Vacant SFRs will cover most of the demands of the low-tier housing segment.

Until the new housing supply is fully created, signs indicate the existence of an unseen problem of supply and demand, caused by the pricing and location of available rentals. The highest rental demand is in urban coastal areas, a situation not likely to change. However, foreclosures (and thus vacancies) have been focused on suburban areas. Apartments in outlying communities are experiencing reduced demand (and rents), not only due to tenants’ preference for urban areas, but also because foreclosures will place more homes in suburban areas on the market for rent to former homeowners.

Meanwhile, city centers are dominated by unsellable multi-story condominium developments. At present, such developments are rented by the builders acting as landlords. Monthly rental payments are 50% of the unit’s potential cost to a homebuyer for monthly mortgage payments, HOA fees and lost opportunities for the down payment, if the builders, investors and owner-occupants could ever close a sales escrow.

These rental condos exist only until they are returned to the homebuyer’s market. They remain beyond the price range many of their renters can qualify to purchase. Landlords also engage in their own screening of tenants, and may reject those with poor credit histories or apparent financial problems (other than a foreclosure), keeping many rentals reserved for the wealthier. Again, zoning for greater density and height of buildings is the solution, and intelligent politicians will take the opportunity offered by this slow recovery to create jobs and improve housing through rezoning.

Rentals are thus available, but not at the locations or prices necessary to make them a viable option for most renters. California is not exactly a low-income state, but housing is still required for the many laborers who support California’s rather affluent society. These maids, gardeners, cooks, nannies and other workers need shelter, and will often prefer renting to buying if rentals are available at rates within the range of their income and near to places of employment.

Even more important in the short term, the population of the low-wage earners has been augmented by the masses of the unemployed. They, too, will need temporary housing in good locations available within their reduced ability to buy or rent.

The government’s role and limitations

If the private sector fails to anticipate and meet the need for low-income rental housing, it will be at least partially up to the government to encourage the development of low-income rental housing where it is needed most. California has done a remarkable job in this, so far. Continued support for low-income housing may necessitate even more change in local government policy, which has in the past been directed primarily towards promoting single-family homeownership, not rentals.

In fact, several government incentives and subsidies already exist for this purpose on both state and federal levels. These include the federal “Section 8” Housing Choice Voucher Program and the state Renter Assistance Program. The most significant federal programs like the Low Income Housing Tax Credit for syndicators and builders, which formerly received a great deal of mortgage investment from Fannie Mae and Freddie Mac, have struggled in the current crisis.

The most effective state programs are the already-extant California government subsidies to encourage builders to increase rental construction, which should be more than sufficient to produce an adequate supply of housing for the labor force once builders regain the ability to borrow money for their construction. Tax credits are bountifully available for syndicators and builders of low-income apartments, which they re-package and sell to investors.

The fact remains that, in spite of potential future rental issues, the supply of apartments is not currently a problem. The market has no shortage of available units, but their supply is diminishing, leading to an eventual rise in rents unless construction rises. Profits at some point will become excessive, and builders of apartments will find a way to get in on that action. As has been said many times: excess profits bring ruinous competition. Thus, any government efforts to artificially increase the development of new rental property would be premature.

More important to many renters will be the government’s measures taken to make current rentals available to low-income earners and the unemployed. Such government measures will involve conflicts with landlords, and sometimes with local governments as well. Local governments often attempt to exclude rental housing, especially low-priced rental housing, from middle- and upper-income suburban enclaves.

These local governments have no political will to help their communities become well-rounded and thus indirectly foster the emergence of surburbia’s classic “Not In My Back Yard” (NIMBY) mentality. Federal and state enforcement of fair housing laws, and policies that prohibit landlords from rejecting voucher-holders and low-income individuals as tenants, are simple fixes that will do much to promote multi-family housing across demographics.

Direct subsidies, like those provided under Section 8, may sometimes elicit knee-jerk refusals or complaints from landlords. However, landlords tend to calm down during tough economic times when they discover that the government’s money spends just as well as the tenant’s portion of the rent, and arrives just as regularly. Government financing for Section 8 landlord upgrades to improvements only sweeten the deal.

Indirect incentives for rental housing also exist, including the tantalizing 27.5 year depreciation schedule for residential rental property, the liberal expense deductions for landlords who make improvements to their properties and the fact that tenants filing their federal taxes are not required to report rent payments made to landlords.

Are rentals a passing trend, or a permanent change?

The economy’s woeful state will be sufficient to keep homeownership depressed for the immediate future. Those who do buy a home will now purchase without influence from the bias towards homeownership which formerly stimulated the market. Agents, friends, and family members who once enthusiastically touted the myth that it is better to own than rent have been temporarily silenced. Home purchases will be based on forthright sellers, careful research and hard numbers delivered by agents, not the bandwagon effect of momentum purchasing.

Homeownership is thus on the decline at the moment, and has already declined further than most of the public suspects. It will be a decade or so before current and former homeowners, who are or have been the victims of negative equity or foreclosure, will be ready to put their families and their fortunes back into homeownership.

A long time remains before homeownership levels hit bottom in California, and homeownership will not begin any measureable resurgence from that bottom level until at least 2018. In this decade, rental property will become the new standard; the only alternative to traditional homeownership (with the possible exceptions of homelessness, motorhomes, boats and cars).

Less risky than traditional homeownership, renting is poised to fill the gap left by foreclosure for families who will need to relocate. Many families hit with foreclosure are now unable to qualify for a purchase-assist mortgage to buy another home, and many more are simply disillusioned with the financial facts of homeownership. Once burned, they are hesitant to put themselves back into what they now perceive as a combustible situation.

But are rentals the wave of the future, or will the population and the government return to pushing single-family homeownership when pocketbooks and anxieties finish recovering from the worst of the recession’s pain? The answers will not be determined by current or former homeowners, but by the large new generation of potential homebuyers in Generation Y (Gen Y) who are just beginning to come of age.

The population of potential first-time homebuyers, traditionally aged 25-34, last peaked with the Baby Boomer generation in the early 1990s. After diminishing in size since the early-2000s, Gen Y is growing larger once again, and will reach its apex in 2018. When Gen Y (the sons and daughters of the Boomers) decide whether to buy or to rent, it will determine the direction of the real estate market for this decade. first tuesday predicts they will be more likely rent than past generations.

The recent recession and concurrent financial crisis have given an edge to rentals for the moment, but a number of other factors combine to give rentals the upper hand with the mobile and fast-paced Gen Y. [For more on the influence of first time homebuyers in the market, see first tuesday’s Market Chart First-time homebuyers and new housing.]

Even in the absence of the economic crisis that has wiped out their parents’ savings, demographic and cultural trends currently point towards increased urbanization among the young. New homebuyers, concerned with energy conservation and low-impact living, are increasingly inclined to live near their urban workplaces, abandoning gas-guzzling and time-consuming commutes from suburban neighborhoods. The younger generation is also waiting longer to get married, postponing (sometimes indefinitely) the time when a large home will be necessary to raise a family.[For more on the increase in solo homeowners, see the February 2012 first tuesday article, Single households on the rise.]

Meanwhile, the population, especially the female population, is becoming better educated and more globally-aware than their Boomer parents. Throughout the nation, the economy is transitioning from an industrial economy that produces marketable goods to a service-based economy that provides information and research. This transition is focused on urban centers, and those who succeed will be the ones who ably put themselves where professional and cultural opportunities are created.

Gen Y is thus (generally) not much interested in the rural or suburban lifestyle, especially now that they have seen traditional homeownership transformed into something similar to imprisonment for many of their parents. Urban life is more social, more cultured, and features better paying jobs and improved professional opportunities. In the light of the real estate crash, urban life is beginning to look more economically feasible as well.

In the immediate future, first tuesday forecasts that the population will become increasingly centered in the cities, where jobs, culture and personal conveniences are ready at hand. California, which has always had a homeownership rate roughly 10% lower than the nation as a whole, will be especially susceptible to this trend.

In times of serious job losses, creative people, the naturally optimistic movers of society, need to be especially able to relocate to the newest opportunities. Homeownership – in which the costs of selling one home and purchasing, financing, and moving to another typically amount to 15% of the price of the property sold – simply does not accommodate frequent moves.

For a mobile, contemporary and more youthful population like California’s, rentals will more often be the natural choice. [For more on the rapidly increasing appeal of urban living, see first tuesday’s June article, The plight of California to be solved by… cities?; for more on the homeowner’s choice between buying and renting, see the June 2010 first tuesday article, Renting vs. buying: the GRM.]