Rentals: the future of California real estate?

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California’s homeownership rate at the end of 2013 was 54.3%, down slightly from 54.5% in 2012. Homeownership was at its highest in 2006, at 60.7%. Since then, it has quickly decreased. California homeownership will drop to 53% by 2016 and remain at that level for about a decade as interest rates rise.

The state’s rental vacancy rate decreased from 5.2% in 2012 to 5% in 2013. 

Chart 1

CA annual homeownership rate

Chart last updated 02/06/2014

2013 2006: Peak year of homeownership
1989: 30-year homeownership low
Homeownership Rate

Chart 2

Vacancy rate

Chart last updated 02/06/2014

2013 2012 2011
Vacancy Rate

Data courtesy of the U.S. Census Bureau

California’s current state of homeownership

California’s homeownership rate is historically around 10 percentage points below the national homeownership rate (at 65.2% in Q4 2013). This is due to a combination of factors; including the lesser impact the national policy of pushing the “American Dream” of homeownership has had on more mobile, free-spirited Californians.

California’s rate of homeownership has declined dramatically since the 2008 recession, a full six percentage point drop since its peak year of 2006. If underwater homeowners are excluded from the number of homeowners since they have no equity stake in their properties, the California homeownership rate is more like 40%-45%.

In a non-recession market, homeownership rates drop as interest rates move upward to cool the economy, as reflected in the rate of homeownership during the late 1950s through the early 1980s. Chart 1 displays the generally unacknowledged converse relationship between the average 30-year mortgage rate and the homeownership rate (and home price trends) from early 1980 until 2006, at the beginning of the current drawn-out recovery.

However, due to our bumpy plateau recovery brought on by the financial crisis, after 2007 both mortgage and homeownership rates have dropped in tandem. Today, the homeownership rate is still stabilizing, a correction of the effects of irresponsible lending during the Millennium Boom (not the fault of FHA or Frannie, but Wall Street bond market independence).

Further, the Federal Reserve (the Fed)’s third round of quantitative easing (QE3) will attempt to coax homebuyers out of the woodwork (since Congress has failed to do so) by lowering mortgage rates by continuing to supply money to mortgage lenders at literally zero interest. However, by 2015 the 30-year mortgage rate will again begin to rise, as it did in the ‘60s and ‘70s, and with that move, the homeownership rate will continue to lose strength before it fully stabilizes.

Looking back for a look forward

California’s homeownership rate demonstrated an upward trend from the 1970s until peaking in 2006. This long-term increase and the following crash were due to a variety of economic factors.During the past 30 years, interest rates were in a continual state of decline, reaching their all-time low today. Over the next 25 years or so, interest rates will rise, inhibiting homeownership growth. As demonstrated in Chart 1, the Fed intentionally raises short-term interest rates to induce a business recession when the economy is over performing. The effects usually take hold in two to three years. More precisely, the recession sets in around 12 months after short-term rates rise above long-term rates. This cyclical action has occurred periodically since WWII, until the early 2000s, when the Fed skipped the second phase of this action due to the events of September 11.

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Just as the recession’s magic was removing inefficiencies in the economy, fiscal and monetary moves post-9/11 led directly to the Millennium Boom. In the boom, as aided and abetted by financial deregulation, low-tier home prices were artificially driven to a three-fold high. A new real estate paradigm was prematurely declared in which prices would go up and up forever, in defiance of economic principles. Bond rating agencies, properly induced by Wall Street Bankers, fully endorsed the concept. Of course, this false paradigm came crashing down in 2007, and we have been in recession and recovery mode ever since, the Lesser Depression.

The next time the Fed will likely raise interest rates will be in 2015, once the Fed deems QE3 has accomplished its goal of stabilizing the economy, and the housing market has regained its past vigor (but not past prices).

Buyers need jobs

Looking forward on another plain, the homeownership rate will stabilize when California’s employment level reaches its 2007 pre-recession peak. As of December 2013, California still required an additional 466,600 jobs.  These jobs are currently being regained at an annual pace of roughly 240,000. Thus, the jobs recovery will likely occur around 2016.

It will take a further two-to-three years to reach the percentage of California’s population employed in 2007, since we will experience a nearly 10% population increase from 2007 through 2016. This factor will be to the single family residence (SFR) builders’ delight.

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Distressed property sales decrease the homeownership rate

The quantities of short sales, trustee’s sales and bankruptcies, for so long as they remain abnormally high, will continue to affect the homeownership rate adversely. The reduction of demand by removal of these displaced homeowners is the culprit, not property pricing and mortgage rates which cannot fully offset the headwinds of past homeownership destroyed.

The number of trustee’s sales has decreased since 2010. The number of short sales has only recently begun to decrease in 2013, accounting for 13% of all California resale activity in Q4 2013, down by half from one year prior. As short sales and foreclosures collectively continue at an elevated rate, properties hitting the market are more likely to be held by lenders or gathered by speculators and buy-to-let investors. The homeownership rate will continue to decrease as displaced homeowners involuntarily revert to renting.

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Bankruptcy’s often overlooked tie to homeownership

Apart from the effects of various economic factors, the evolving societal mores of the younger generation (Generation Y (Gen Y)) show an increasing tendency towards renting, rather than owning, one’s shelter.

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The rental alternative

In lieu of homeownership, potential homebuyers will take advantage of their only other option: renting. Often they will occupy detached SFRs, currently the playground for ownership among many industrious buy-to-let investors.

The rental activity of would-be homeowners forced to be tenants will be one of the driving forces increasing rental occupancy rates for the short term. City councils, however, will not likely permit the construction of high-rise, high-density multi-family units required to keep rents stable. Without proper zoning, rents will increase enough to cause a shift in housing preference to homeownership of SFRs. Then it will be back to suburban sprawl all over again.

Empty units do not indicate lack of tenants

Logic dictates that any large decrease in California homeownership, such as the one currently underway, should lead to a correspondingly large increase in demand for rental housing. After all, displaced former owners have to live somewhere. After a long period of low renter activity, demand for rentals is now on the increase, and will remain high until rents have risen to squeeze out the less affluent in the area. Expect demands for rent control, especially from the older and wealthier districts such as Contra Costa, Alameda, west Los Angeles and Orange counties.

Builders of multi-family units have come to the same conclusion: they are now building new apartments, in the expectation that new renters will arrive to occupy them. 41,000 multi-family construction starts took place in 2013, up 30% from 2012.

first tuesday forecasts that apartment construction will continue to increase at the same pace in 2014,-2015. The next peak in multi-family starts is expected in 2018-2019. California lost 1.5 million jobs in the years immediately following December 2007, and those jobs will be returning, along with one million additional jobs needed to support the three million people that will have been added to the population between 2007 and the time it takes to recover jobs lost.

As the growing occupancy-aged population combines with the nascent job-market recovery, the potential demand we see will be realized, producing a sharp rebound in the builders’ market for apartments. For the moment, however, rental housing is not scarce, particularly in the inland communities. No reason exists to expect any overall scarcity within two or three years.

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Are rentals a passing trend, or a permanent change?

A long time remains before homeownership levels hit bottom in California, and homeownership will not begin any measureable resurgence from that bottom level until at least 2018. In this decade, rental property will become the new standard; the only alternative to traditional homeownership (with the rare exceptions of homelessness, motor homes, boats and cars).

Less risky than traditional homeownership, renting is poised to fill the gap left by foreclosure for families who will need to relocate. Many families hit with foreclosure are now unable to qualify for a purchase-assist mortgage to buy another home, and many more are simply disillusioned with the financial facts of homeownership. Once burned, they are hesitant to put themselves back into what they now perceive as a combustible situation.

But are rentals the wave of the future, or will the population and the government return to pushing single family homeownership when pocketbooks and anxieties finish recovering from the worst of the recession’s pain? The answers will not be determined by current or former homeowners, but by the large new generation of potential homebuyers in Gen Y who are just beginning to come of age.

In the immediate future, first tuesday forecasts that the population will become increasingly centered in the cities, where jobs, culture and personal conveniences are ready at hand. California, which has always had a homeownership rate roughly 10% lower than the nation as a whole, will be especially susceptible to this trend.

For a mobile, contemporary and more youthful population like California’s, rentals will more often be the natural choice.

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