In this episode of the REconomy podcast from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain how the vast majority of potential home buyers reach the decision to buy a home and what that means for the housing market and homeownership rate moving forward.
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“So this slow-moving, very positive demographic story is going to continue for a number of years, predicated against those continued low rates, maybe not as low as they were at the beginning of this year, but we're not expecting rates to be 6-7-8 percent anytime soon, either. All those millennials that have delayed marriage and having children in favor of their education, which by the way means they're going to have more income, which means they'll be able to afford more home in this low-rate environment, is going to push demand for homeownership and the homeownership rate is likely to rise over the coming years.” – Mark Fleming, chief economist at First American
Odeta: Hello, and welcome back to another episode of the REconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hi, Mark, we're tackling a pretty big question today, wouldn't you say?
Mark: That's right, Odeta. I think we talk about all kinds of different things on our podcasts and our blog. But, we often have neglected to talk about the most basic thing of all, which is the biggest financial decision that someone usually makes, how they make the decision to become a homeowner. So Odeta, what's your discount rate?
Odeta: You know, I'm in the process of calculating that in my life right now. But, before we dive into that, and before we even dive into what drives the decision to become a homeowner, I'm curious about the history of homeownership. I mean, has it always been a main tenet of the American Dream?
Mark: Yes, our favorite, walks down memory lane. We like to do those, and we should do this one. This one actually starts back in the early 1900s, prior to the Great Depression. We didn't even have a 30-year fixed-rate mortgage, rather mortgages had balloon payments. They were much more structured and shorter, and they had to be paid off much more quickly. It really created effectively a much more expensive process of borrowing money in order to finance buying a home. And of course, what do we find? There's a much lower homeownership rate. But after the Great Depression, and banks stopped lending, you know, there's a big flurry of activity in the New Deal era with a homeowners corporation in 1933. The Federal Housing Administration (FHA) was born in the early 1930s. And Fannie Mae came to bear in the late 1930s. Then, what really what drove it was the GI Bill, which basically subsidized returning soldiers from World War II to become homeowners and large amounts of the suburbs were built. All the GIs returning meant a lot of people became homeowners in the 1950s. In fact, the homeownership rate went above 50% for the first time. My favorite decade of the 1980s was pretty boring, because the homeownership rate really didn't move around very much until again, the late 1990s, when we really started to drive the homeownership rate further up with, shall we say, financial innovation in the housing finance market.
Odeta: So okay, we're going to the 1990s, and the 1990s are my era. So, I'm happy to talk about it. And as you mentioned, we had a pickup in the late 1990s in the homeownership rate, and then obviously, the housing boom and the subsequent decline. But I think what's important to note is that that decline was not all driven by the crisis, a big part of the decline was demographically driven. And let's just break down the homeownership rate to see what we really mean by that. The homeownership rate is pretty simple. It's just the number of owned households divided by the total number of rented and owned households. So actually, prior to the Great Recession, we saw big growth in owned household formation at the expense of rental formation. And then, in the aftermath of the Great Recession, we saw a whole bunch of rental household formation. So why was that? Well, that's your millennial generation, yours truly, they were graduating from college, they were leaving their parents’ home, leaving their dormitories, and they were doing what their generational predecessors did before them. And that's rent first. So we saw this huge boom in rental household formation from about 2005 to 2015. So we increase that denominator, going back to the math, which brought down that homeownership rate. Then, starting in 2016, we kind of saw this start to reverse. We're seeing the homeownership rate increase because we're seeing a lot more owned household formation. That's your older millennials, aging into homeownership. There's a long run demographic demand shifting away from renting to homeowning. And that's really again, being driven by millennials aging into homeownership. And then, in the most recent years, accelerated by historically low mortgage rates. But that kind of gets us a little bit to the heart of the discussion today. What drives a decision to become a homeowner?
Mark: Wait a second. Did you just say that the homeownership rate declined not because of fewer homeowners, but because of more renters.
Odeta: After the Great Recession, because there were more renters. Exactly.
Mark: And now what do all those renters want to do? That millennial who we thought would never ever want to become a homeowner now wants to become a homeowner? What's driving that decision? How do you make that choice? Well, our research basically shows it’s pretty simple. First, you have lifestyle changes, things like getting married, having children, growing up, if you will, from being that renting 20-something year old, going out to bars and doing whatever you like every weekend, and settling down and having family. That dynamic changes the decision first to desire homeownership. And then separately from that, once you've made what we call that tenure choice decision for homeownership, you will decide how much you can afford to buy.
Odeta: Wait a minute, wait a minute. Are you saying that people aren't calculating the net-present value with after-tax cash flows being discounted by the homebuyers required rate of return? Are you saying that I'm doing this whole tenure choice thing completely wrong?
Mark: Odeta. What's your discount rate?
Mark: Yeah, the net-present value calculation. Does anybody know what…oh, yes, economists like you. And I know what a net -resent value calculation is. But even economists like you and I, sometimes act economically, irrationally, shall we say. And so that process, there's actually research papers that have been written that sort of say, this process of determination of homeownership as a function of the net-present value calculation, comparing renting to home owning, blah, blah, blah….No, first I decide I want to become a homeowner, then I just go figure out how much I can afford to buy.
Odeta: Exactly. And again, we're starting to see these older millennials who are doing just that, getting married, having kids and starting to buy their first home, even moving out to the suburbs to get a little bit more space, get a backyard, get the school district and we're seeing exactly that. They're just doing it a little bit later in life, right. Millennials are staying in school, they are one of the highest educated generational group. They're staying in school longer. They're obviously pushing their tenure choice decision a little bit further along. And so, rather than making the decision to buy a home in their mid-20s, they're doing it in their early 30s. And so certainly, we're starting to see the impact of those older millennials buy homes.
Mark: So, once they've made this decision, this lifestyle decision, I want to become a homeowner, I want to buy that first home. The next step is financial, what can I afford to buy? What monthly payment can I afford, right? I suppose at that point, if you're an economist, like maybe you've done this, Odeta. Have you? This is where you would now calculate your net-present value and figure out what your discount rate is. I'm still trying to get you to say what you think that discount rate of yours is.
Odeta: I know you are.
Mark: But most people don't do that. And they start to really just back into it. First of all, I need to basically make sure that whatever my monthly budget or salary or income that I have goes to renting or buying shelter. Roughly 1/3 of that is a good rough measure. 33% is sort of this debt-to-income ratio, you want to spend a third of your pre-tax pay, which roughly turns into about a half of your post-tax pay on a mortgage payment. And then, well, you're not quite done yet. Because, yes, your credit score or credit worthiness matters. But presuming your credit worthy, and you know how much you can put in a monthly payment, you then take that amazing interest rate, and back into how much does that mean in terms of a loan amount, given the income that you're willing to spend. And that's what we refer to as your purchasing power for the loan at a certain down payment. And voila, you now know given your income, given prevailing mortgage rates, how much you can afford to buy.
Odeta: And those potential home buyers have really been benefiting from mortgage rates below 3%, earlier this year, and now just hovering above 3%, which to put in historical context, which we've done before, this historical average is about 7% to 8% mortgage rates. So, 3% is pretty darn good, especially when you consider the first part of our conversation, which is you've already decided to buy a home. And so you've made that lifestyle, calculated personal lifestyle decision. And now you're trying to figure out what you can afford to buy. And with rates still being in the 3% range, we expect to see continued demand.
Mark: I'm just harkening back to the last podcast where we talked about the multipliers, if you really want a real rough way of figuring things out. Remember, we talked about how many times your income and it used to be the adage of three or four, but with rates where they are right now it's as high as seven or eight. Multiply your income times six or seven or eight, and voila, that's your loan payment again, this is because, as you say, we have the benefit of low interest rates.
Odeta: Absolutely. And then the other thing to consider, that I think a lot of potential home buyers are considering when they're buying that home is, why is it part of the American Dream? Well, part of it is because of the wealth-building component of owning a home. We did some analysis awhile back looking at just how good of an investment a home is. And it is one of the best long-term investments a person can make. The median homeowner has 40 times the household wealth of a renter. What I would give to be a homeowner right now in the current rapidly rising house price appreciation environment. But, alas, I am not. I’m still in the market, calculating that discount rate. So again, potential home buyers are thinking about the wealth-building component of buying a home. So, with all of this said, what are we anticipating for the future of homeownership?
Mark: Well, one of the great things about being a housing economist is, as you've pointed out, throughout this podcast, a lot of it is actually a demographic story, and not an economic story, with the millennial generation aging in very large numbers to their home buying years, or making that tenure choice decision. As for forecasting the future, economists generally are not that good at forecasting the future. But there is one thing I can solidly forecast next year, we'll all be a year older. And next year, more millennials will be one year older and, therefore, more likely to be wanting to buying a home. So this slow-moving, very positive demographic story is going to continue for a number of years, predicated against those continued low rates, maybe not as low as they were at the beginning of this year, but we're not expecting rates to be 6-7-8 percent anytime soon, either. All those millennials that have delayed marriage and having children in favor of their education, which by the way means they're going to have more income, which means they'll be able to afford more home in this low-rate environment, is going to push demand for homeownership and the homeownership rate is likely to rise over the coming years.
Odeta: It sounds like you're saying millennial demand for homeownership is poised to continue to fuel our roaring 20s of homeownership demand, if you will. The issue of course being, will there be anything for them to buy? But, that's a topic for a different day. Thank you for joining us on this episode of the REconomy podcast, be sure to subscribe on Apple, Google, Spotify, or your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, follow us on Twitter @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.