I recently receive a Denver Metro Association of realtor’s newsletter touting: “People have been flocking…
Location Inc, founded by Andrew Schiller (he accurately predicted the last real estate bust), came out with new real estate predictions for the Northern Colorado Front Range. According to recent models, Boulder will plunge by 19% by 2022 while Greeley should be a standout holding its value the best. How accurate are these predictions? Should you panic? Has anything fundamentally changed since the last crisis?
Background on Forecast:
In April 2017, Location Inc. warned that homes prices along the Front Range were going to peak in the fourth quarter of 2019 and decline 20 percent over a five-year window. Location Inc has now updated their forecasts on a better than expected economy which has caused their forecast to change substantially.
The new forecast
Location is now calling for a 9.9-percent decline in northern Front Range home prices over the next five years and Boulder declining 19%, with the price peak regionally coming in the second quarter of 2021. But Andrew Schiller went further on with the prediction: “ Stay away from Boulder, expect to take a hit on prices of around 10 percent in Fort Collins and metro Denver, and if appreciation matters, buy in Greeley.” How accurate is this forecast? How is it derived? Should you take the advice to buy Greeley? Should you be worried if you own or are looking to buy in Boulder?
How is the prediction derived?
One of the largest inputs in his model to predict future real estate values is the ratio of income to house price. On the surface, it is impossible for prices to rise substantially faster than income. Historically record low interest rates have allowed people to buy more house, but as rates have risen, buying power has been eroded as incomes haven’t kept pace with rising home prices.
Is income the best metric?
There is no doubt a correlation between house price and income in many markets, but the correlation is now a bit murkier. For example, Boulder’s median home price is 1 million+. To afford a million-dollar home (assume you put 20% down at a 5% rate, the payment is 4300/month on an $800k loan). The median salary would need to be north of 175k. For borrowers making 175k+ a year the definition of income gets very murky. For example, people in this salary bracket typically have more deductions (donations, childcare, house, losses, etc…) so their actual income is drastically different than their taxable income. For example, someone might have a taxable income of 175k but actual income substantially higher. So to use income as a predictor of affordability as you get into higher earners doesn’t work as the primary metric in Boulder or the Denver metro area where almost 13% of households have incomes over 150k.
Migration delayed the inevitable
Income and affordability have been out of synch for a while. Why haven’t home prices declined already? According to Schiller, migration has delayed the inevitable “reckoning” of the real estate market. As people moved from more expensive markets, the front range of Colorado is “inexpensive” compared to New York or San Francisco. Net migration has helped but is this the real reason why we haven’t seen price declines or is it that income is understated in the model? I don’t think this is the only explanation of why a correction hasn’t occurred thus far. Is the ratio of income to home prices really the best metric for predicting future real estate values?
Income to house price:
Income to house price historically has been a good metric. Will this metric hold up in future cycles? I am doubtful as there is already a huge disconnect between prices and income and yet no crash has happened in Boulder or the Denver metro area. There are much better metrics to predict declines than simply income.
- Leverage: If there is going to be a crash leverage will no doubt be the prime culprit. The higher the leverage, the higher the risk of default. In every economic cycle it has been proven that more leverage exacerbates risk. The higher the leverage, the increase in probability of a borrower having “negative equity”. For example, someone who puts down 20% is considerably less likely to default than someone who puts down 5%. A person that puts 5% down is quickly underwater when prices drop 10% as predicted above. Areas that have more subprime loans are at much greater risk than others regardless of income. Many of the less expensive areas have higher leveraged borrowers. For example, in Boulder, it is almost impossible to get a jumbo loan for 100% of the purchase price as government loans cap out at 578k in Boulder and private banks require much great down payments. On the flip side in Greeley, with a median home price of 313k, substantially more buyers are using subprime government low down payment loans like an FHA loan that allows less than 5% down. According to the federal reserve bank of Minneapolis cash strapped borrowers are more than 7 time as likely to default as borrower’s with strong ability to pay. If a borrower is putting in a low or no down payment, they fall into this category. We saw in the last cycle that low down payment borrowers defaulted at considerably higher rates than borrowers that put 20% + down.
- Supply/Demand: Supply and demand is critical to any accurate price model. The Boulder, Denver metro, and most of the front range is supply constrained. For example, there is little if any new development in Boulder as national forest and open space has consumed much of the remaining land. There are also very restrictive land use regulations in Boulder that further restrict supply. This lack of supply and strong demand has led to the sharp increase in prices. Greeley on the other hand has ample room to continue growing and considerably less restrictive land use policies. The supply in Weld county will temper prices and create a risk of oversupply when the economy turns whereas Boulder will continue to have basically zero supply. Most of the Front range/Denver metro area are supply constrained due to open space, topography, and national forests.
Is a crash coming?
Although I’m doubtful that real estate prices in the Denver metro/Northern Front range will fall off a cliff, there will be some price declines soon. A recession is bound to happen as interest rates have spiked above 5% making payments more expensive. It is interesting that Shiller’s new model predicts a Boulder decline of 19%; Boulder has low leverage, basically zero supply, and a thriving demand due to well-paying companies in the area like Google. Clearly there is an issue with Location Inc’s predictions
Although the Denver/Northern front range has increased in price, there is still a considerable lack of supply and the area remains in high demand due to strong economic growth. Denver/Boulder did considerably better than most real estate markets in the last recession and will likely continue the trend in the next recession.
My prediction is that in the Denver/Northern Front range prices will moderate and could fall 10% or so as prices reset to the new normal with rising rates and slower national economic growth. I think areas like Greeley will fall more than areas like Boulder due to the leverage and supply/demand constraints. Boulder is a unique market and the study is flawed in thinking that Boulder will drop 19% because of income to home price ratios. I’m not ready to buy into the “sky is falling” mentality of Location Inc.’s recent prediction nor should you. Solid markets like Denver and Boulder with limited supply, high incomes, low leverage, and continued demand will fare fine in the next recession. These are the areas you want to own as they will not only lose less value than other areas, but also come back quicker during the next economic upswing.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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