Doug Duncan Joins Bruce Norris on the Real Estate Radio Show #351

Norris Bruce

Bruce Norris is an active investor, hard money lender, and real estate educator with over 30 years experience. Bruce has been involved in over 2,000 real estate transactions as a buyer, seller, builder and money partner.

Norris Bruce
October 11, 2013
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On Friday, October 18, The Norris Group proudly presents its 6th annual black tie event I Survived Real Estate. An incredible line-up of industry experts joins Bruce Norris to discuss perplexing industry trends, head-scratching legislation, and opportunities emerging for real estate professionals. Proceeds for the event benefit Make a Wish and St. Jude’s Children’s Research Hospital. This event would not be possible without the generous help of the following platinum partners: PropertyRadar and Sean O’Toole, HousingWire, the Apartment Owners Association, the San Diego Creative Real Estate Investors Association and President Bill Tan, Investors Workshops, InvestClub for Women and Iris Veneracion and Bobi Alexander, San Jose Real Estate Investors Association and Geraldine Barry, MVT Productions, Wilson Investment Properties, RODA Construction, and White House Catering. For event information and tickets, visit www.isurvivedrealestate.com.

Bruce Norris is joined this week by Doug Duncan. Doug is Fannie Mae’s Vice President and Chief Economist. He is responsible for managing Fannie Mae’s strategy division, economics, and mortgage market analysis groups. In this leadership role, Duncan provides all economic housing and mortgage market forecasts and analysis. He also serves as the company’s thought leader and is a spokesman on economic and mortgage market issues.

Bruce asked Doug how he would describe the housing market a year ago and how it would be different today. Doug said a year ago there were signs that we were making the turn, but there is still some uncertainty about it. Today we would say housing is definitely on a different path, and that path is one toward recovery. However, we are not at recovery. Directionally we are going in the correct direction, but it is not yet robust. The recent discussion about house price increases showed that they have all been driven by surprise factors, and there is yet to be solid evidence of growth and organic demand. In particular, it represents a risk to a robust growth if we in fact see the change in the interest rate profile to be one where rates will be rising.

Bruce asked Doug what his definition of robust would be. Apparently it is not just price increases since we have had these. Doug said the first thing we commented on in this regard was they beloved the longer-term level of construction should be in the business. This is the primary contribution to GDP growth from housing. This should be at something close to 1.7 million units annually when you combine multifamily and single-family manufactured housing. The forecast for this year is about 950,000, which is a long ways from being back to normal levels.

A builder would love to build 1.7 million, so Bruce wondered why they are not. Do they think it is not profitable? Doug said it is more logistical. When you think of the depths of the crisis when we got down to building around 600,000 units at the bottom. This was at the period when a lot of builders were struggling to stay in business, releasing and selling land options to generate cash to stay in business. A lot of times they have to go back and reacquire the land, and afterwards they have to permit the land. Next they have to find labor to build on that land and have materials with which the labor can work.

Construction workers have seen the largest decline in employment of any employment group in the economy. A lot have been sitting around for four years presumably hoping that construction will start again, but they have probably moved off to different jobs. The builder community has to rebuild the labor supply either by encouraging some of those people to come back to construction by changing wage rates or trading new people. All of this takes time, and there is not an economic interest given what we have seen with price increases. It just takes time to accomplish some of those logistical challenges.

In California, Bruce looks at the sub-division creation as the barometer for a builder’s confidence in the future. Right now in Riverside County, it has an economic base that Riverside does very well when construction is occurring. We are still down 95% in lot creation even though we have had a 30% price increase. It does not seem like the builders are willing to create new sub-divisions, but rather build on existing ones. Building on the existing ones gets them past some of those early hurdles where they probably have permitting in place so that they can act faster. This way they can take advantage of the opportunity, and presumably they are trying to build out of the back side for the parts of the process that take longer.

Someone once asked Doug’s father, who worked on a farm, if someone were to make some kind of change would things be better. His response to that was the first thing that has to happen if you are going to get a harvest of corn in the fall is the tractor has to start in the spring. To some degree this is what is going on in the market here. Doug is very right about this on the supply side. In California, in over two years we have gone from around 6 ½ months’ supply to some places being under two months of supply. The question is where the inventory would come from to glut the market. Six and a half months of supply down to two months took us on a journey of one pretty healthy price increase. Bruce looks at two months of supply and ask where all of the houses going to show up from now.

Doug said there are at least two or three things to consider. One is construction, which he says is going to be slow. A second one is there are probably households who believe they owe more on their house than what it is worth. They may or may not have taken into account the price increases to determine whether or not they could actually offer their property. Price appreciation has brought them out from under water. There is also a significant number of loans still in serious delinquency; and the longer it takes to work those through a short sale or foreclosure, the more of a constraint it is as well. You have at least these hurdles in addition to the construction fees. Doug said they have been surveying consumers now for over three years. One of the questions they ask is if it is a good time to sell a house. For the first two years of the survey this stayed flat at 10%. Usually five out of eight people who buy a house have to sell one first.

Starting in 2012 they saw things picking up to 20%, so at that point they said housing was on a firm footing. The trend line was right and would be sustained, but this did not mean it was robust. This figure the last couple of months has been bouncing back and forth between 35% and 40% of people thinking it is time to sell a house. We have made substantive process, but there is still less than 50% of people in the market who think it is a good time to sell a house. This may or may not be keeping them from offering their properties as well, even if they are not underwater.

Bruce asked Doug if he has done any research similar to what someone who stays current for five years of being underwater and then finally gets some equity. Bruce said to him they would seem to be the least likely to want to go from ownership to renter. Bruce wondered if Doug had asked any of these people if they cannot wait to get rid of their home and pay rent somewhere. Have they really proven that they want to own through thick and thin and stay an owner? Doug said they have not asked this question specifically, but he would infer from the combination of responses related to this that they are likely to want to remain an owner. However, they may want to move to a different property to own. For example, they may have been a constrained move-up buyer. They would actually reappear simultaneously on both the supply and demand side in the market if they were now out from underwater and ready to transact. Most likely they will move toward a rental. Bruce asked where the inventory is going to come from since we are hamstrung by builders not doing as much as they normally do. We have people who are underwater or barely above water who probably will not sell yet.

Bruce asked what Doug meant by “organic growth” when referring to the demand side. Doug said people who have gotten jobs or gotten better jobs are in a position to want to become homeowners or become move-up buyers. With first-time buyers, we have seen little to no growth in real incomes subsequent to the recession. We have seen no real income growth at the household level since the end of the recession. Job growth has been weak with the recent unemployment rate coming down from people leaving the labor force. All of these are factors that come out of the demand side of the equation. One nuance we do not understand yet is whether the job growth that we have seen is disproportionately a greater share of part-time jobs, and those do not have the financial strength that full-time jobs would have as a one who wants to become a first-time homebuyer.

Population and demographics is really in the long-run with what drives housing. We still see household formation at well below levels that it should be at given where we are at with demographics. We are still short of the 1.2 to 1.3 million households that should be forming under normal circumstances. This is because of economic reasons, possibly because with the habits of the echo boomer generation they wait longer to form permanent marriage type unions. The question is if we are about ready to play catch-up. Doug said this is the hope since we do have the highest share of 16-34 year olds living at home with their parents than we have ever had. All of that should be a part of the unfolding of the demand curve, but until we see a significant jump in income growth it is hard to figure out how this will happen. You also have to have the capability growth at the same time. If we were to see strong job growth and rises in low income, then this number would unfold fairly rapidly. However, this has just not been that kind of expansion.

Bruce asked if you really need the wage growth because you had such a real cost of housing go down due to the all-time interest rates being low. Bruce asked if this trumps the need for a raise. Doug said there is no questions that affordability has improved partly by policy, or the intentional drop down of interest rates through monetary policy. You also saw house prices fall substantially, so young households do recognize that this is a good time to buy a house. This number has been very strong. It is not that they are not interested, but this is the group that sees housing as an investment. They are also saying that they want to be sure they have their finances in shape to buy the house and maintain it once it is purchased. They are exercising what Doug would say is a question about getting their financial household in shape prior to making that commitment. Doug has seen the cost of not doing this.

If Bruce asked this question to a 2004/2005 participant, he wondered if the answer would be very different from the 2013 buyer. Doug said it would since the 2004/2005 household would have focused on things like tax advantages, capital gains, treatments, appreciation, wondering if you will get into the market. You had a lot of financial answers, whereas today you have a lot of qualitative answers.

Bruce asked if it is human nature that this will shift once again when homes increase. Doug said it certainly can happen, and this is definitely a possibility. Hopefully memories will be a little bit longer than that, but it is doubtful. If you live in California, one of the interesting things that they have been talking to folks about is that the last time there was a significant rate spike in a short time period, one of the responses that occurred in the housing sector was a spike in adjustable rate mortgage usage. Year-over-year California has been the highest market share of adjustable rate mortgages. The rules have changed now so that underwriting an adjustable rate mortgage requires that it be underwritten at the maximum rate that it can be reset to in the first five years of its life. This is essentially what fixed rates are at today, so as a result we have not seen the spike in adjustables that we saw in the 1999/2000 and 1994/1995 experiences. Doug said they were wondering how this would impact markets that are typically heavily-armed markets.

As prices go up, the mentality of the buyer changes. They go from being conservative and just wanting to make their payments to wanting to own two or three properties. Bruce jokingly asked if lenders drink the same kool-aid and if Doug sees this progressing at some point to where lenders start creating programs that are more aggressive if they are privately funded and not necessarily connected to Fannie, Freddie, and FHA. If they are a regulated depository institution, Doug said he doubts you would see that response because regulators are going to be on that risk-taking. Doug believes the reason we have not seen more of an expansion of credit is because if you look at the overlays that lenders are putting out there today, he views them as being as much a response to regulatory risk as they are to credit qualifications. We will not know for a while since, for one, not all the rules have been written. We will not know how well the changes in regulatory structure will constrain the ability of those institutions to take on more risk.

Bruce was thinking a lot of business came from refis over the last five years, then the next five years that might decline. Debra Still of Pulte Mortgage said it has already declined by about 70%. The thing that is different about this downturn is that it is the after effect of the specific policies set that were intended to lower the average rate in the outstanding mortgage portfolio. When that policy is removed, then there has to be some adjustment period to get back to what has been the level of market-based activity, and this will take some time. It may also drive some consolidation among lenders, especially since there are a significant portion of lenders who are heavily populated in the refinance space. If they did not look forward on how they were going to adjust their cost structure in a purchase market, then they may as well leave the business.

Bruce asked what percentage of the market Fannie and Freddie have combined. Doug said we don’t know for sure how many dollars banks are putting in their own portfolio that we do not see. If you throw FHA in there, it is certainly the three of them who are in the 90% range. Right now it seems like everybody is doing well as far as the recent crop of loans going back to around three years. Bruce asked if this would be one profitable group of loans that were created. Doug said absolutely and the default on these loans was very low. It is a very clean book of business and the underwriting is substantially stronger than in the bubble period. Bruce asked if the emphasis is still on downsizing to ultimately make a big change away from that type of financing.

Doug said part of the policy environment was for the regulator to work through and increase guaranteed fees and underwriting criteria to find the point at which private capital would find it profitable to supplant the business that the GSEs are doing. This is a reasonable thing to think about and a contributor to why the proficiency books are so good. At the same time, we have not seen much involvement of private capital, depending on how you define it. You could define it as either lenders who would come in and make loans or securities not being involved with the GSEs. Doug said he would have to believe that part of this is simply because they have not reformed us. If you issue a permanent label security that is somewhere near the fringes of the business that either of the GSEs does, then the reform of the secondary market is such that it actually turns out to carry into a story bond. Those story bonds have adverse pricing relative to the broader, more liquid markets. It is likely to be the case that some exhibitions are sitting on the sidelines waiting to find out what the final rules are before they put their capital at risk. Doug believes part of it is the need to move on and reform the GSEs.

FHA just announced a change in policy as far as one year after a bankruptcy, foreclosure, or short sale that they will make a loan. This would seem to be a positive thing for demand, and at the same time we are talking about reducing the loan limits. Bruce wondered if any of these things is important to the markets doing well. Doug said it would have an impact on the number of people who might qualify for credit going forward. If they were also to lower the loan limits, that would also raise the question of whether private capital would step in and at what price it would step into the area where the FHA was previously dominant. This is another area where we may see some advancement.

There are still a lot of people waiting for that shadow inventory to show up. Bruce wondered if we are waiting in vain. Doug said he had just looked at some data that showed the time to take a loan in all the way from initiation of a foreclosure to the completion of it is about 900 days. Unless they are going to hire a whole bunch of judges, he is not sure how you would accelerate this. That aspect of the market will just gradually trickle in, which the market understands. When they are thinking about the construction and full supply curve, that is counted as a factor. Unless something substantive comes along in the administrative or legal process that accelerates it, we just view that as a gradual contributor on the supply side with no big rush to the market. This would unsettle prices significantly.

The Norris Group would like to thank its gold sponsors for supporting I Survived Real Estate 2013: Adrenaline Athletics, California Property Solvers, Coldwell Banker Town and Country, Claudia Buys Houses, Elite Auctions, FIBI (For Investors By Investors), In a Day Development, Inland Empire Investors Forum, Inland Valley Association of Realtors, Investor Experts Inc, Keystone CPA, Las Brisas Escrow, Leivas Associates, Mike Cantu, Northern California Real Estate Investors Association, Northern San Diego Real Estate Investors Association, Orange County Real Estate Investors Association, Orange County Investment Club FIBI, Personal Real Estate Magazine, Pilot Limo, Primary Residential Mortgage, Realty 411 Magazine, Rick and LeaAnne Rossiter, Southwest Riverside County Association of Realtors, Sonoca Corporation, Spinnaker Loans, uDirect IRA, Tony Alvarez, and Westin South Coast Plaza.

See www.isurvivedrealestate.com for more on the event and all of our sponsors.