The housing market boomed in response, and then, as we all know, it exploded and fell in on itself. At the same time, Wall Street’s collapse took away the financial basis for the illusory wealth that homeowners had come to depend upon. There had been no sufficient value in their property to support the price they had paid or the debt they had taken on.

In the absence of the government intervention needed to limit risks to society, the financial crisis birthed by Wall Street plunged the private mortgage markets into a condition of total rigor mortis. The only signs of life from 2008 until early 2010 came from the Federal Reserve, which as the nation’s lender of last resort directly funded all home mortgages via the bond market, and from the US Treasury, which acquired and recapitalized Freddie, Fannie and Ginnie. The financial repercussions of Wall Street’s unregulated excesses will be felt on home sales even beyond 2018; the next anticipated high point in cyclical real estate sales volume, and of course prices.

The massive decline in homeownership is not just a symptom of the past recession; it is the inevitable result of overly aggressive government policies.

Bad lending practices, current job stagnation and the lack of available employment have thus led to an ownership apocalypse; a crisis which continues to manifest itself in an unabated flow of foreclosure sales statewide in spite of the recovery now underway. The state will experience a minimum of 400,000 more foreclosures before the rate of default returns to normal, probably sometime in 2014. Many have already lost the homes that the government’s housing policy encouraged them to buy, and many more losses due to ill-advised purchases by tenants are taking place daily. [For more on foreclosures in California, see the first tuesday Market Chart, CA NODs and Trustee’s Deeds.]

Exacerbating the problem further is the trepidation felt by potential buyers, 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 buyers, uninformed by their agents, see only tight credit and cautious lenders (lender apprehension to loan has only increased going into 2011).

Until agents themselves 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 to be the case until the quantity of foreclosures drops to more normal levels. [See first tuesday Form 320]

In lieu of ownership, potential buyers will take advantage of their only other option: renting, often in detached single family residences (SFRs), which are currently the target of many buy-to-let investors. The rental activity of would-be homeowners as tenants will be one of the driving factors increasing rental occupancy rates in the upcoming years, although it has yet to exert any upward influence upon the economy. [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 the 2,500,000 California homeowners with negative equities who presently occupy their property can no longer really be called “owners” — especially in California. As reviewed in The Homeownership Gap staff report written by Andrew Haughwout of the Federal Reserve Bank of New York, 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.

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 are directly added to that homeowner’s existing wealth.

This is not the case in negative equity situations, however, since all these financial benefits go directly to the lender until the loan-to-mortgage (LTV) ratio drops to below 94%. The owner, on the other hand, is left making overpriced monthly payments to his “landlord,” the lender, frequently at twice the rental rate of the home, with no financial advantage until the LTV hits 94%.

The New York Fed’s report concludes that the homeownership rate depicted on the chart above is actually an inflated number, especially in California, 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 66.9% and dropping fast) would be 25% to 45% lower if the rate of ownership were changed to exclude the massive population of negative equity homeowners (2,500,000 of whom are in California) who are not (except under legal phraseology) owners.

Even now, in the recovery years following the Great Recession, former homeowners, would-be homeowners, and even current homeowners with negative equity continue to act as implicit renters since their economic status, based on the future benefits they will receive from the property, is that of a tenant. Many of them are now renting or living with friends or family members. An eventual return to economic prosperity (meaning a job) will allow them to move into their own apartment units, increasing the demand for rental property in desirable locations near schools, jobs, and urban centers.

These renters will not buy homes, even if they are able, until they sense that the time is right for them to purchase. More importantly, many of them may find that they like renting, with the freedom from the bondage of mortgage payments, the increased ability to move as work opportunities move, and the possibility of living “where the action is” in the inner cities. A large number of those who adapt to the renter lifestyle may never return to homeownership at all — especially if they lost a home in this recession as nearly one million families will have before foreclosure levels return to historic norms. Suburban communities have their work cut out for them to hold on to their population numbers.

Empty units do not indicate lack of tenants

Logic indicates 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 as shelter is a necessity for all. Thus far, however, demand for apartments has not remained constant, and is dropping in most locations.

Data on the construction of multi-family units leads to the same conclusion: builders are not building significant numbers of new apartments; they know that not enough renters exist to occupy them.

first tuesday forecasts that there will be no significant increase in apartment construction until beyond 2012 when new jobs have been created to recover the 1.5 million lost after December 2007 in California. 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, and no reason exists to expect any 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-Family Housing Starts]

The picture painted by the mass of empty houses and empty apartments may be misleading however, argues a recent article from the Federal Reserve Bank of Atlanta. Apartment pricing is falling, and apartment vacancies rising, not because people do not need apartments, but because a temporary confluence of factors has aligned to make apartments less popular. Among these factors:

• tenants of single apartments are moving in with each other in two or more bedroom units or SFRs; consolidating their housing in order to reduce costs;
• families are turning to vacated single family residences (SFRs) and condos, which are available for rent at low rates thanks to a seemingly complete absence of homebuyers, but not investors;
• reverse immigration (emigration) has become more and more common, as workers move away from areas where the construction and labor-intensive jobs have disappeared, leaving more space available for other lower-income residents; and
• “marketability mismatch”, in which the vast majority of rental units are simply marketed at prices too high by “holdout landlords”, who refuse to make their properties available to the members of the population who most need rental housing.

All of these recession-induced factors are largely temporary. At some point between now and 2013, apartments will have gone through their foreclosure phase and will become once again a good “forward looking” investment for builders. The new housing they then construct will be targeted toward the demographic most likely to benefit from good quality, lower- to mid-tier rentals.

Until the new housing supply is 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 areas, a situation not likely to change, but 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, which at present are often rented by landlords at monthly payments of 50% the unit’s potential cost to a buyer for monthly mortgage payments and HOA fees, 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, and they remain beyond the price range many 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 more wealthy.

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 make up the backbone of California 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.

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

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. This may necessitate a change in some government policy, which has in the past been directed almost exclusively towards promoting single-family homeownership with 97% mortgage debt, treating rentals as an undesirable afterthought.

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. Thus far, such incentives have had mixed results. 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. Any further government efforts to encourage the development of new rental property would thus be grossly premature at the moment. The market has no shortage of units, rents are on the decline, and the supply will remain high for the next few years.

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 exclude rental housing, especially low-priced rental housing, from middle- and upper-income suburban areas.

These local governments have no political will to help their communities become well rounded and thus more prosperous populations – the “Not In My Back Yard” (NIMBY) syndrome of suburban mentality. Federal and state enforcement of fair housing law, 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, but 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, and the fact that tenants filing their federal taxes are not required to report rent payments made to landlords.

The bigger picture

The ability of the population to take advantage of rental housing depends most of all upon the population’s financial well being. This well being, in turn, has been harmed by the unstable status of the single-family residential housing market.At present, the federal government’s first priority must be to increase and improve regulation of banks and lending institutions. At the same time, congress and the administrative agencies must take every measure necessary to keep the mortgage bond market viable. Housing values in California have yet to hit bottom, and as they continue to drop, the risk of catastrophic deflation increasing throughout the economy must be met with more stimulus to create jobs, but not more housing when doing so.

The economy’s woeful state will be sufficient to keep homeownership depressed for the foreseeable future. Those who do buy a home will now purchase without influence from the bias towards ownership 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 now been silenced. Home purchases will be based on forthright sellers, careful research and hard numbers delivered by agents, not the bandwagon effect of momentum purchasing.

Are rentals a passing trend, or a permanent change?

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 a house.

A long time remains before ownership levels hit bottom in California, and homeownership will not begin any measureable resurgence from that bottum level until at least 2016. In the upcoming decade, rental property will become the new standard; the only alternative to traditional home ownership (with the possible exceptions of homelessness, mobile homes and cars, and cave dwelling).

Less risky than traditional ownership, rental property 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 facts of homeownership. Having been burned once, they will be hesitant to put themselves back into the fire.

Even the prior homeowners who have the will and means to buy are likely to wait until they are convinced that home prices have reached their bottom, a point that remains somewhere beyond 2013. So it is that many homebuyers who would have scoffed at continuing to rent a few years ago are now saving money by taking advantage of the current renter’s market.

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 (“Generation Y”) that is 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. This homebuying age group is growing larger once again, however, and will reach its apex from 2016 to 2018. When Generation Y (the sons and daughters of the Boomers) decides whether to buy or to rent, it will determine the direction of the real estate market for this decade.

The now ended 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 Generation 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.

Meanwhile, the population, especially the female population, is becoming more educated and more globally-aware than their boomer parents. Throughout the nation, the economy is transitioning from an industrial economy that produces goods for sale 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.

Generation Y is thus (generally) not 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. Home ownership – 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 these moves. For a mobile, contemporary and 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]