Our world is founded and based upon incentives either to do something or not to do something. Today’s real estate market is driven by incentives, organic and non-organic—financial and social. In fact, incentives play a pivotal role in our lives and either drive demand or result in a lack of demand in the world of real estate.
Let’s break down these incentives into these two categories as they pertain to real estate supply and demand:
- Incentives to buy
- Organic and non-organic
- Financial and social
- Incentives not to buy
- Organic and non-organic
- Financial and social
What is an organic incentive? Organic incentives are those that naturally occur in a real estate cycle. A good example of an organic incentive is the relationship between the cost of a mortgage payment and the rental rate in a given area. The closer the comparable payments, or the lesser the spread between them, the greater the incentive to buy. Conversely, the higher the spread between mortgage payment and rental rate, the greater the incentive is NOT to buy but rather to rent.
What is a non-organic incentive? Non-organic incentives are those that are not naturally occurring in a real estate cycle. A good example today is the Fed’s program to buy mortgage-backed securities over the last 13 months. This program was put in place to artificially drive down mortgage rates to stimulate home sales. Typically, the market drives rates in an organic fashion—as investors buy or don’t buy mortgage backed securities, interest rates rise or fall, i.e., organically based upon demand.
What about financial incentives? What financial incentives are out there? Which ones stimulate growth and which ones are holding back growth? Financial incentives can include the amount of down payment required, the kind of documentation needed for loan approval, and the cash reserves that may be needed post-closing. A good example of a financial incentive is the first-time homebuyer tax credit of $8,000. This is a government-created (non-organic) incentive to buy a home, especially if the buyer is sitting on the fence trying to decide if this is the right time to buy. Another example of a financial incentive is the type of down payment required to purchase a home: A program with a lower down payment is a greater incentive because less money out-of-pocket is required for ownership.
What are the social incentives? Back in the late 1990s everyone was either a “day trader” or a “stock expert.” This role was easy and readily accessible, and the media played it up as that which everyone should be doing. Then came the “dot bomb” in 2000, and everyone lost big in the stock market. The same situation happened in real estate investing soon after that. It was the next big thing, and everyone became a “real estate investor.” As a result, we jumped from one bubble market—stocks—into the next—real estate. Owning stocks in the 1990s became socially acceptable and expected. Then in the early 2000s everyone felt the same way about real estate—it was the same song, just a different verse.
Nowadays everyone is much more conscientious about buying or investing in real estate; and, as a result, not everyone is expected to own or invest in real estate. Because of this and a not-too-friendly media, social real estate investing just doesn’t hold the allure it once did. The result of fewer people looking to invest in real estate is less demand and lower prices.
So, what does this mean for our market? What trends are we seeing specifically? The market has split into three distinct pieces, each with its own list of incentives either to buy or not to buy. Here in Central Texas we see distinct markets for homes listed at $300k or less, homes listed between $305k and $439k, and homes listed above $450k. What is the cause of this stratification? You’ve guessed it—incentives!
Homes priced above the $450k mark. There are not many incentives to buy these homes. In fact, there are a plethora of incentives NOT to buy in this price range. The spread between rental rates and mortgage payments is very large; therefore, homes in this price range can easily be rented for up to half of what a mortgage payment would be. Homes in this jumbo price range also require a 20 percent down payment, and the Fed’s program to buy mortgage-backed securities does not apply to jumbo interest rates. In fact, rates on a jumbo loan can be 1½-2 times higher than rates for lower loan amounts. These loans also require higher credit scores and higher liquid reserves. Most buyers in this market have adopted a wait-and-see attitude when it comes to home buying because the incentives NOT to buy outweigh the incentives to buy.
Homes priced between $305k and $439k. In this price range there seems to be an equal number of incentives to buy and not to buy, albeit leaning a little to the not-to-buy. The Fed is buying mortgage-backed securities, which have driven rates to all-time lows. A buyer can put as little as 5 percent down; and, if a buyer is putting at least 20 percent down, the Fed is allowing credit scores as low as 620. This, along with the addition of the existing homebuyer tax credit, has added great incentive to buying in this price range. However, there are still a number of incentives not to buy in this range: The spread between rental rates and mortgage payments is still large. Moreover, tightening guidelines for qualification, risk-based pricing tiers based on credit score, high cost of mortgage insurance, and high credit score requirements for down payments of less than 20 percent have put the incentives not to buy in the lead in this category.
Homes priced at $300k and below. Saving the best for last, what do we see concerning this price range? We see huge incentives to buy, including the almost nonexistent spread between rental rates and mortgage payments. In fact, rental rates in some areas can be higher than the equivalent mortgage payments. Additionally, the majority of buyers in this range are first-time buyers, who qualify for the $8,000 tax credit; and interest rates are at historic lows. Two of the greatest incentives in this price range relate to the loan programs available. Buyers can utilize either FHA or USDA loan programs. FHA requires only a 3.5 percent down payment and has very low monthly mortgage insurance. USDA requires NO down payment and has NO monthly mortgage insurance. Neither of these programs requires large cash reserves, and buyers find these to be loans for which it is easy to qualify.
As you can see, the incentives to buy definitely increase as the sales prices decrease; and financing seems to be the key incentive determining whether people choose to become buyers or to remain on the sidelines. The government-sponsored non-organic incentives are all scheduled to expire the first part of this year, which will leave only the organic incentives. How will the market respond? We will have to wait and see. Those of you who remain on the sidelines, consider—times will change and so will the incentives. The question is this: When will the incentives to buy outweigh the incentives not to buy?
John McClellan Branch Manager Supreme Lending – Austin