Market Outlook 3.12.11

Here is my response to a great question from an investor who belongs to a discussion group a mentor makes available to me:

Investor
Wouldn’t rising interest only further damage housing market….and drive demand for rentals…in short run? Two ways to get in…purchase apt building or apt reits…thoughts?

Response
But for the Mid East situation, rates have already been on a tear. They were up 1% in ONE month last month before settling back down. A buyer, with 30yr fixed rate financing and 20% down, who wants to keep their budget fixed when looking for a $500k home, can only afford a $445k home when the rates go from the low 4’s to the low 5’s. That’s 11%. And that’s just the purchase market.

As I’ve been warning for 2 years now, the refi market will adjust severely as fully indexed rates on 3, 5, and 7yr i/o’s (interest-only) loans reset, and as rates get back to the teaser rate… by the tune of 40% payment shock. This is a number that will make current valuations unsustainable, especially in light of the fact that over 90% of US consumers today make less in real terms than they did five years ago, when they locked into their short-term financing. We are only about 30% of the way through the re-sets, and about 50% of these have the option to press snooze for another 5 years when converting to their i/o option. This means that each year, for the next 7 or so years, roughly 10% (half of the loans resetting annully) of 90% of everybody who refi’d or bought a home in the last 5 or so years (90% opted for short term rate locks on i/o loans), will likely be added to this “payment shocked” category. And this is if rates stop at 5.25%… and why would they?

So yes, I am confident it will not only damage the purchase market and valuations, but also cause many existing homeowners to face the foreclosure spiral. I do like apartment rentals for this reason but they are hard to finance and even harder to find. So the REIT option may be the way to go indeed. The only thing to look out for is that their rental income may not go up from here even as demand goes up. They will have fewer vacancies maybe, but I was surprised to note how rental prices have been coming down along with home prices, rather than surge. It seems that renters have less income to work with and will keep seeking lower end homes until they can find one they can afford. Unlike many of today’s homeowners, they actually have to move out if they can’t pay up. And I am also in agreement with David’s call to finding those REITs that limit their focus to this vertical.

Lastly, I also like low end single family residences (not tied to potentially fragile HOA’s), which will be the future home of many soon to be displaced homeowners. I even like the low end of mid-priced homes, even despite this forecast of lower valuations over the next 2-5 years… because today’s 5% rates are soon going to feel like tomorrow’s free money, and eventually our inflation and diluted currency will make these values roar back to life.

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