Bay Area Mortgage Defaults Holding Steady at High Levels

Bay Area mortgage default rates have fallen from the peak levels recorded in 2009, but seem to have stabilized at relatively high levels.

During the third quarter of 2010, there were 483 default notices recorded in San Francisco, and 12,690 recorded in the nine-county Bay Area. Those figures are more than six times higher than the corresponding figures from the third quarter of 2005.

The recent stability in default activity is at least partially due to forbearance on the part of lenders, who have been under political pressure to help homeowners avoid foreclosure. (Remember, we're not talking about actual defaults, but rather about notices of default, which must be recorded by lenders.) A substantial part of the stability, however, is probably due to the stabilization of Bay Area home prices.

I've talked about the relationship between price declines and default rates in earlier postings, for instance, this one. (The key point is that being underwater on your mortgage makes it tempting to surrender your home to foreclosure.) Now that prices seem to have stabilized, the number of underwater homeowners should begin to fall, mainly due to foreclosures and short sales. That should shortly translate into lower default rates.

Homeowners Are Still Badly Stretched

I said in my last post that homeowners are financially stretched. Indeed, even after three years of economy-wide debt reduction – unprecedented in modern history – households are still carrying financial burdens that would have seemed astronomical before the housing boom. Take a look at the chart, below, which shows the ratio of aggregate household debt to aggregate household income.

Until 1999, household debt had never exceeded 80% of household income. When the housing boom began, however, mortgage debt expanded dramatically, driving the debt-to-income ratio as high as 116% in 2007. The ratio has fallen since then (mainly because of mortgage defaults), but is still more than 30 percentage points higher than at any time before the boom.

Another way to look at debt burdens is to compare debt servicing costs to household incomes. (The chart above uses the total amount of debt rather than the cost of servicing that debt.) Mortgage rates are at 50-year lows, so it’s possible that homeowners can carry substantially higher levels of debt without greater difficulty.

Take a look at the chart, below, which shows the ‘Financial Obligations Ratio’ for homeowners.

The Financial Obligations Ratio is the ratio of aggregate housing costs (including property tax and insurance) to aggregate disposable income. Although not as far out of line compared to historical levels as the debt-to-income ratio, the financial obligations ratio is still higher than at any time before the housing boom, including the peak of 1980’s housing cycle.

Mortgage rates are likely to remain low until a sustainable economic recovery is underway. They're bound to rise eventually, however, driving the financial obligations ratio higher and increasing the pressure on home prices just as the economy begins to recover. All things considered, I’d say that the housing market is likely to remain in the doldrums for years to come.

Note: The ratios shown in the charts are based on aggregate figures, and are only indirectly representative of the debt burdens of typical households. The debt-to-income ratio for a typical first-time homeowner would have been far higher than 116% at any point during the thirty year period shown in the charts.

Too Many Homeowners?

One of the most remarkable facts about the housing bubble was the large number of renters who became homeowners. Take a look at the chart, below, which shows the nationwide homeownership rate.

The data comes from the Census Bureau, which defines the homeownership rate as the percentage of households that are owner-occupied.

The homeownership rate began increasing rapidly in 1995 and reached an all time high of 69.0% in 2004. The peak value was almost five percentage points higher than the pre-bubble average (64.3%), and more than three percentage points higher than the previous record (65.8%). The homeownership rate has declined steadily since the bursting of the housing bubble but the current rate (66.9%) is still more than two percentage points higher than the pre-bubble average.

We can't rule out secular changes that might be driving long-term increases in the rate of homeownership (although it's clear that the rapid increase between 1995 and 2004 was not attributable to long-term factors). Perhaps the aging population is causing a secular rise in the rate of homeownership. If so, then perhaps the rate will settle down at a level that's higher than the pre-bubble average. Considering the state of the economy and the over-stretched finances of US homeowners, however, I think we'll be lucky if the homeownership rate doesn't fall substantially below 64.3% during the next few years.

San Francisco Apartment Valuations Are Still Falling

San Francisco apartment building valuations have been falling since 2007. Take a look at the chart, below, which shows the median price-per-unit for 5-15 unit buildings.

The median price-per-unit actually rose in 2010, and is only about 10% lower than in 2007. How is that consistent with my assertion that valuations have been falling?

Despite the downturn, rents have remained fairly strong in San Francisco. Take a look at the chart, below, which shows the median rent-per-unit for 5-15 unit buildings.

San Francisco rents actually have been trending upward since the depths of the financial crisis, and appear to be in line with the long-term trend. As a result, if you compare apartment prices to apartment rents, you get something like the chart below, which shows the median 'gross rent multiple' for San Francisco apartment buildings.

The gross rent multiple (GRM) is the ratio between the building price and the gross annual rent. It's analogous to the price/earnings (P/E) ratio for a stock. If the GRM is falling (as it has been since at least 2007), that means that buyers are paying less for every dollar of rent that they expect to obtain from the building. That's what I mean when I say that valuations are falling. (Interestingly, the number of transactions began falling well before there was a noticeable decline in valuations. The same phenomenon occurred in the market for single family homes and condos, as I pointed out here.)

There are many possible explanations for the observed decline in GRM multiples. Ultimately, they all can be attributed to diminished optimism about the future of San Francisco real estate.

San Francisco Lot Prices Still Falling

San Francisco lot prices peaked in 2006 and have been falling since then. The median sale price through the first nine months of 2010 is more than 60% lower than the 2006 peak.

The chart shows the median sale price for all lots that are listed in the MLS and that have 1,500-4,500 square feet. Most of them are residential lots. Unfortunately, many listings do not include zoning information so I simply included all lots.

Land prices are highly sensitive to home prices. Why? Building costs don't change much from year to year. If the price of a home rises by $100,000, the price of the vacant lot next door is likely to rise by the same $100,000 increment. On a percentage basis, the increase in the lot price will be much larger than the increase in the home price. That's why lot prices have fallen more than 60% while home prices have fallen only 10%-20%.

Keep in mind, too, that most lots are priced under the assumption that they will be developed with multiple units. That's why the median lot price has fallen by roughly $500,000 while the median home price has fallen by only around $150,000.

Office Rents Back to 2006 Levels

Here's another quick snapshot of the business climate in San Francisco. Asking rents for office space have fallen 24% from the recent 2008 peak.

The chart comes from Loopnet; you can find more like it here. Ideally, the chart would extend back another ten years to encompass the dotcom boom period. I don't have a free source of commercial property data, however, so I have to settle for odds and ends like this chart.

Judging from the chart, the office market stabilized early this year, at a level that hardly seems catastrophic -- asking rents have returned roughly to the same level as in 2006, when there wasn't even a whiff of financial crisis. That observation is particularly surprising in light of the fact that San Francisco unemployment was running in the low 4%-range during 2006, and is now close to 10%.

Bay Area Housing Permits Near 30-Year Low

Permits for construction of new Bay Area housing units hit a 30-year low in 2009. Activity has rebounded since then, but 2010 is still on track to be the second-worst year for Bay Area housing construction since at least 1980.

I annualized the July year-to-date figures to get an estimate (roughly 7,000 units) for calendar 2010. That's less than half of the 30-year average of around 19,000 units. Although I didn't show it in the chart, the pattern of permit activity is nearly identical in each of the three main metropolitan areas of the Bay Area, i.e., Oakland, San Francisco, and San Jose.