Friday, April 5, 2019

THE DANGERS OF BOOTSTRAPPING

As April arrives and we hit peak selling season, the overall state of the Denver housing market is still relatively healthy.  Our local economy is strong and robust and our demography remains positive... but after several years of booming prices, it's my contention that values are flattening and the market is reaching a point where many first-time buyers are simply priced out.

This has ramifications, because demand "from the bottom up" has been the driver that has created the equity boom that has created the wealth effect which has made Denver one of the most economically vibrant cities in all of America. 

For as long as I have been in real estate (which is now going on 25 years), I have described market demand as a pyramid, which simply means there are always more buyers and more demand at the bottom of the market... and because of this, there is almost always built-in price protection for entry-level buyers because demand exceeds supply.

That premise - that demand is always most strong at the entry level - is now being tested.  

I measure demand in terms of "absorption rate", which is defined as how many months it would take, at the current pace of sales, to sell every home on the market, assuming there was no new inventory coming online. 

The real estate industry has long posited the axiom that six months of inventory reflects a balanced market, favoring neither buyers nor sellers.  

I personally feel that the real number for equilibrium is more like four months, because the way real estate is transacted in the digital era is very different than they way homes sold 15 years ago.  It used to be that open houses, sign calls, newspaper ads and postcard mailers were how people found out about homes.  Selling a home was like marinating a steak - it took time and results often came slowly.

In the digital age, everything happens quickly.  A new listing hits the market, and within minutes smart phones are pinging all over Denver.  Listing activity is front-loaded to the first few weekends a home is on the market, and if you can't sell a home within a few weeks, you have a problem.

The thought that six months of inventory reflects a balanced market is totally dated convention, but then much of the legacy thinking in our industry is aged and flawed.

For context, here are current absorption rates for all prices brackets I track in Denver:

$0 to $250k:  1.82 months of inventory
$250k to $400k:  0.76 months of inventory
$400k to $600k:  1.42 months of inventory
$600k to $1M:  2.21 months of inventory
$1M and up:  3.82 months of inventory

But back to the original premise... from the time I began selling real estate in Denver in 2006 until the end of 2016, we without fail had the quickest absorption rates in the sub-$250k price category.

Predictably, as you worked your way up the pricing ladder... the $250k - $400k range was the next tightest market segment... followed by the $400k - $600k range... followed by the $600k - $1M range... followed by homes priced at a million dollars and up, which often sit on the market (even in good times) for many months before selling.

More buyers at the bottom, fewer buyers at the top, the demand pyramid made perfect sense.

Starting in November of 2016, however, we saw a change.

At this point, homes in the $250k - $400k range actually began selling faster than the sub-$250k range, and the reason for this is that while the move-up buyers were flush with equity, the incoming crop of entry-level buyers was finding it harder and harder to both qualify and come up with down payment money.

While demand for homes at all price levels has remained strong during our housing boom, the stress on first-time buyers hit another last milestone last February (2018), when for the first time in all the years I have been tracking numbers demand was actually stronger in the $400k - $600k range that the sub-$250k entry level.

Increasingly, it has become apparent that the housing party in Denver is mostly reserved now for those who already have significant equity, which is the kind of elitist market dynamic I left when I departed California at the end of 2005.

Put another way, if you've owned a home since 2011, you're flush with equity and living a much more secure financial life than the younger people coming into our market today.

And for that generation of owners who won the housing lottery simply by taking action at the right time... they have significantly more options and opportunities than those recent college graduates coming out of school with $100k in student loans looking at median home prices pushing $500k.

That's one of the reasons Colorado Springs (historically much more affordable than Denver) is now ranked as the #1 housing market in American for 2019 by Trulia, and why Denver no longer appears on that Top 20 list.  

So while the established owners are able to use their equity toward down payments on larger move up homes, emboldened by their own balance sheets and the feel-good headlines we've grown accustomed to... the first-time buyers in our market have been falling further and further behind, or giving up on the dream of home ownership altogether.

The issue here, as I see it, is that push in our market has always come from the bottom up.  And now that housing is out of reach for many would-be first timers, you simply don't have the farm system in place to keep driving prices higher as you work your way up the pricing scale.  

The word I have used to describe our market, repeatedly, over the past nine months or so is "fragile".  When interest rates suddenly spiked into the 5's last fall, it hit our market hard and fast.  The types of homes that had sold in the spring in one weekend with multiple offers suddenly began sitting 15, 30, 45 days before any offer would materialize.

And without the frenzied bidding wars that characterized the spring market... sellers started seeing offers that were less than full price.  And then buyers (the nerve!) started asking for repairs.  And you started running into more valuation issues with appraisers.  And by the end of the year, there was grounds for reasonable doubt about whether you would see any appreciation in 2019 at all.  

The good news, at least from our standpoint, is that all of our political dysfunction and drama in Washington has caused interest rates to drop back down in to the low to mid 4's - for now - which significantly helps affordability and breathes life back into our market.

But active inventory is still up 36% from a year ago.  More homes which go under contract are coming back on the market than I have seen in many years.  Buyers' remorse is a real thing, and the "get a home at all costs" mentality that drove the market from 2012 - 2017 is transitioning into a mindset that is much more cautious and deliberative in nature.  

If you pay attention to other markets which have boomed in recent years (Seattle, San Francisco, San Diego, Austin, etc)... you see a steady thread of headlines.  Inventory is up and prices are flattening, not because people don't desire houses in high-cost markets.  They simply can't afford them any more. 

And that means you should be adjusting your thinking accordingly. 

I have become much more conservative with my buyer clients in 2019, to the chagrin of my managing broker and to the detriment of my bottom line.  I'm not interested in people bootstrapping their way to minimum down payments with monthly mortgages $300 to $600 higher than rents.  Why does that make sense, especially if prices are flattening?

If your reputation is the currency of your business, you always think in the long term, even when it costs you money.  My commitment has always been to the "happily ever after", and not the quick buck so many others are chasing.  

Owning a home is an expensive proposition.  Roofs age, furnaces quit, sewer lines break and exteriors need painting.  For most people, it's still worth it.

But if you don't have reserves... if you are fully dependent on two incomes... if you're not prepared for the unpleasant financial surprises that sometimes come with home ownership... you need to be thinking long and hard in a grown-up way about whether or not it really makes sense to commit to this market right now.  

If you have cash, equity, plenty of reserves and a good, stable job... by all means, buying is almost always logical and a financially-sound decision.  

But I spend a lot of my time these days having lengthy conversations with young people who seem intent on bootstrapping it, and for those who are not receiving solid advice, I worry that an uncomfortable percentage of today's bootstrappers may be tomorrow's short sales.