California Forecast For 2013: More Of The Same Save The "Black Swan"

We would like to share Sean O'Toole's 2013 forecast for the California Real Estate Market.  Let us know what you think.

In 2012, we saw the continuation of a housing recovery in California, with solid sales volumes and price increases throughout much of the state. More importantly, short sales, loan modifications, price increases, and even foreclosures helped many get out from being underwater on their homes. Many say this recovery is artificial.  We disagree.  While there is no question government intervention played a major role, it appears unlikely that intervention will end anytime soon.  We believe, therefore, the recovery is likely to persist—save the possibility of some sort of a “black swan” event.

The biggest change in 2012 was the dramatic decline in foreclosure sales and, as a result, bank-owned properties (REOs). The “foreclosure wave” that many predicted has yet to materialize in California. Instead, over the past 12 months, notices of default plunged by 48.9 percent year-over-year, foreclosure sales fell 27.7 percent y-o-y and REO inventories declined 34.9 percent y-o-y. While we correctly predicted there would be no foreclosure wave, this decline was steeper and sooner than we expected.

For 2013, we largely expect more of the same. Demand will remain strong thanks to Federal Reserve manipulated low interest rates and affordability. Housing supply will remain constrained, largely due to government foreclosure intervention.  As a result, prices will rise, though likely at a slower pace. Unlike 2012, however, we expect sales volume to decline due to further decreases in supply.

‍Demand will remain relatively strong, despite structural issues

• The Federal Reserve is clearly committed to monetary-stimulus programs that will keep mortgage interest rates at or near record lows. Low interest rates have and will continue to positively impact demand.

• In many parts of California, rents remain higher than house payments, despite recent price increases.  High rents make housing attractive to buyers and investors. This positive impact on demand, however, may be offset by further price increases.

• Early foreclosure “victims” may now qualify again for a mortgage and choose to return to homeownership. This new set of buyers will increase demand for scarce inventory.

A few factors may constrain housing demand

• Homeowners with equity are not moving up at the rate they did during and before the credit bubble; instead they’re hunkering down.

• Nearly a quarter of all homeowners are underwater, owing more than their homes are worth. While these homeowners may be able to short sell, they are typically unable to repurchase and are forced to rent instead.

• Mortgage lending standards remain tight. Given that most mortgages are still government-backed and that the government-backed entities are still struggling with losses blamed on loose lending standards, we don’t expect mortgage lending standards to ease anytime soon.

Supply will remain tight, with the inventory of homes for sale at record lows

• Government intervention will continue to play a huge role in the foreclosure market. The National Mortgage Settlement Program, the Home Affordable Modification Program (HAMP), and the California Homeowner Bill of Rights legislation that goes into effect on January 1, 2013, will all continue to put downward pressure on foreclosures and foreclosure inventory. Foreclosures have been a significant source of supply since 2008.  These continued declines will hurt sales volume in 2013, likely dropping foreclosure supply to half the level seen in 2012.

• Similar to the impact on demand, the hunkering down of homeowners with equity, and the inability of underwater homeowners to sell, except through short sales, will negatively impact supply.

• Short sales will likely increase in 2013. We believe this is the sole bright spot for housing supply. Banks ultimately want to clean up non-performing assets, and short sales give banks clear benefits over foreclosing including: faster disposition, better recovery of value, less political opposition, and reduced risk of homeowner lawsuits. That said, short sales are at risk, as the tax exemption established under the Mortgage Forgiveness Debt Relief Act of 2007 is set to expire at the end of this year. This tax exemption allows mortgage debt forgiven by a lender in a short sale, loan modification, or foreclosure to be exempt from federal taxation. We see a low risk that the Act will expire and we believe Congress will extend it for another year. Still, short sellers and their Realtors should push to close currently pending deals before year-end, just to be safe.

Housing prices will rise, but increases will be constrained

• Continued demand, combined with the continued constraint of supply, should result in prices continuing to rise throughout 2013, though likely more moderately than in 2012.

• The increase in home prices will continue to be constrained by appraisals. As bidding wars push prices beyond those supported by recent sales, getting purchase prices to appraise will continue to be a challenge. In 2012, many buyers had the resources to bring cash to the table to overcome this issue. Not all buyers have this ability, which will make this market especially difficult for first-time buyers.

• The increase in home prices will also be constrained by affordability and return on investment (ROI). The key driver to rapidly rising prices in 2012 was the fact that in many areas, house payments, even after taxes and insurance, were lower than rents. This also led to very strong demand for rentals by investors seeking, and finding, high returns on their investment. Demand from these buyers has been the critical driver behind price increases to date, but as prices rise, affordability and returns drop.

Other factors in 2013

• We believe more households will become renters in 2013, through short sales and foreclosures, than will become homeowners. This will continue the strong demand for rentals, and continue to push rents higher throughout much of California.

• Trustee sale investors will continue to see strong competition at the steps. However, as prices continue to rise, they may see the large rental buyers move away from the auctions, and perhaps even California, as they seek better returns elsewhere. This lessening of competition may help offset declines in foreclosure volume for the traditional trustee sale investor, who focuses on restoring foreclosures for homebuyers.

• The FHA’s anti-flipping waiver was extended through December 31, 2014.  We actually believe it would have been better to let the waiver expire to discourage flipping, and instead exempt trustee sale and sheriff sale purchases, which are non-market transactions and require a professional purchaser to flip the property in order to make it available to most homebuyers.

• As the end of 2012 approaches, debate over the mortgage interest deduction is intensifying. We believe the debate is mainly political posturing.  Many Congress members have second homes in Washington and benefit more than most from the mortgage interest deduction. We highly doubt our elected leaders will vote against their self-interest, and when push comes to shove, they will vote to keep the deduction. We also think it would not be smart to do it now. That said, we do think the mortgage interest deduction benefits banks, at the expense of homeowners, by encouraging debt rather than real ownership.

• We expect taxes to rise in 2013, more for some than others. In addition to the unknown tax increases associated with the expiring Bush tax cuts, the Affordable Care Act will impose an estimated $260 billion in new taxes in 2013, and the passing of Proposition 30 will significantly increase taxes for higher-income earners in California. Higher taxes take money away from consumers, constraining job growth and possibly keeping a lid on demand for housing. With higher-income earners clearly being targeted, the most affluent neighborhoods are likely to be the hardest hit.

The risk of a black swan should not be overlooked. The term “black swan” comes from the book Fooled by Randomness by Nassim Taleb. The idea is that rare unexpected events are actually the norm and should be expected. Today we face a number of risks that no one, including ourselves, expects to happen. We summarize some of these here because we believe Mr. Taleb is correct; we should always prepare for the unexpected.

• While we hope the so-called “fiscal cliff” will be resolved before the start of 2013, the issue creates real uncertainty heading into next year. If Congress fails to act within the next couple of weeks, taxes will increase by an estimated $500 to $700 billion, almost certainly sending the U.S. economy into recession. Most expect some sort of compromise, even if it is just pushing the issue into the future. Regardless of the outcome, we are concerned U.S. economic growth in 2013 will remain tepid.  We believe much of the current controversy is more about political gamesmanship than any real attempt to resolve budget and deficit issues.  Both parties are angling to make sure their rivals take the blame for what may lie ahead.

• The Middle East remains highly volatile. A crisis there could send fuel prices skyrocketing. Any U.S. involvement would result in higher spending and deficits the country can ill afford. The resulting harm to the economy from a Middle East crisis, including the possibility of higher interest rates, would not be favorable to housing.

• The Eurozone debt crisis continues to make headlines. In this interconnected world, it would be unwise to think that further problems in the Eurozone could not impact us here.

• Something else, even more unexpected than those we’ve outlined above.

Despite the risks – government intervention, higher taxes, and the other issues that keep us up at night – we remain relatively bullish on the housing market for 2013. We have little doubt that fewer people will be underwater by the end of the year, and that housing will have proven a relatively safer investment than entrusting your money elsewhere.

And no, there will still not be a wave of foreclosures.

© 2012 ForeclosureRadar