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Rick Jarvis

Part Two – The Market is Too Sensitive (The Federal Reserve)

August 20, 2013 By Rick Jarvis

In Part One, we discussed the impact of the Government Sponsored Enterprises of Fannie Mae, Freddie Mac and (less so) FHA.

  • Part One – Mortgages and the GSE Guidelines
  • Part Two (here) – The Role of the Fed
  • Part Three – Congress, Taxes, Zoning and Building Codes
  • Part Four – The Conclusion

In next installment, the topic of the Federal Reserve’s role will be discussed.  While the complexity of the impact of the GSE’s is pretty hard to cover in a blog post, the impact of the Fed is even more so.  For those purists who read this, understand that the purpose of the article is not to fully explain monetary policy but rather to take a look at some base level impacts of Fed decisions.

Part II, The Fed

iStock_000006204163XSmall
The Federal Reserve expanded its role in the 2008-12 crisis to a level previously unseen in US history.

While the Fed’s primary goal is to create a stable monetary environment whereby long term interest rates are predictable and employment is maximized, they have other powers as well…the most notable of which is the regulation of the banking institutions in the US. By having the ability to influence the demand for money as well as the availability of it, the Fed has an incalcuable impact on the housing market.

During the 2008-12 adjustment, the Fed simultaneously made money incredibly cheap and very easy.  Partially for the reason of propping up failing banks (which would have been a catastrophe had they begun to fail en masse) and partially to spur economic activity, the Fed opened up its proverbial wallet and started tossing around cash like a drunk sailor on shore leave.  While on the one hand they became the nation’s ATM, they also placed restrictions on loaning it out to the end user (for reasons I am not sure I understand.) A good friend of mine in banking told me, back in 2011, that careers in banking were made by NOT making loans, regardless of a deal’s merits. Despite interest rates at historic lows, banks were hamstrung from making loans by regulators from the very entity giving them free money to loan.

The Fed has the ability to not only influence money supply, but how and what it is loaned upon. Their regulatory power gives the Fed the ability to influence how much housing can be produced through policies designed to discourage speculative building. By restricting the production of new supply (which they have undeniably done), they are pushing pricing up…and that may not be the worst thing in the world. The question is whether or not they realize the correct levels at which to relax restrictions. As we stand here in late 2013, the rate of supply of new homes has returned to just over half of the pre-bubble level after production of new homes languished off 70% or more during the darkest days.  By and large, we are still under-supplied.

While the need for the Fed is a real one, homeowners need to understand that the Fed’s mandate is not to protect your home’s value…it is to create long term stability in the interest rate markets and to maximize employment.  Sometimes those goals are aligned, sometimes they are not and sometimes housing gets caught up in the wash.

Part Three Discusses Congress, Taxes and Building Codes

 

 

Part One of ‘The Market is Too Sensitive (Fannie, Freddie and the GSEs)’

August 19, 2013 By Rick Jarvis

This is a 4 part series about how the housing market is far too sensitive to the effects of government.  Each section is below:

  • Part One (here) – Mortgages and the GSE Guidelines
  • Part Two – The Role of the Fed
  • Part Three – Congress, Taxes, Zoning and Building Codes
  • Part Four – The Conclusion
Washington Monument and the Capitol Panoramic Nighttime
Even DC’s most subtle and seemingly minute policy shifts can have a dramatic impact on the housing market.

I know what is said here will ignite feelings (and comments, possibly) that are decidedly anti-this or anti-that…which is not my intent.

As a matter of a fact, if you feel so compelled, please refrain.  This is not the forum.

The intent of the discussion is for those who choose to read this to better understand why and how the housing market is so sensitive to subtle shifts in housing and monetary policy.

Part I – Mortgages and the GSE Guidelines

No discussion about housing can begin anywhere else other than with the money supply.  The Federal Reserve, Fannie Mae, Freddie Mac, FHA (and to a smaller extent, VA) all impact the availability of credit.  Credit (or in the case of housing, mortgages) are the primary instrument by which we purchase our houses.  30 year mortgages in all of their forms (fixed, adjustable, hybrids) and their somewhat dysfunctional relatives (interest only, balloons, contract for deed) are what makes real estate affordable by allowing buyers to purchase with far less than the price of the home.  Leveraging $20,000 into a $400,000 home with a monthly mortgage payment roughly equivalent to the lease payment on a nice apartment is an attractive option…or at least 75 million believe it to be the case.

iStock_000013200637XSmall
Fannie and Freddie’s mortgage backed securities were designed to shift risk and hopefully decrease it, not eliminate it…as many seemed to think prior to 2008.

These loan products are a result of the formation of the GSE’s (GSE is an acronym for Government Sponsored Enterprise.)  Specifically, it is a reference to the entities of Fannie Mae, Freddie Mac and Ginnie Mae, whose charter (basically) allows them to create a secondary market for the mortgages generated by the network of originators throughout the US.  Their involvement shifts the risk of borrower non-payment from the banks who originate the mortgages to the GSE’s and purchasers of the pooled debt (this is also a gross simplification but it suffices for the point of this article.)

The existence of the GSE’s means a bank can originate a loan and, provided it is within established parameters, sell it to Fannie/Freddie, and redeploy the cash to the next borrower (and repeat the process millions of times).  Knowing that Fannie and Freddie stand ready to purchase the debt originated according to their own guidelines, banks have higher incentive to originate only those mortgages which fall within those parameters.  Interest rate pricing is better, leverages are greater and the underwriting scrutiny for borrowers is less stringent.  One only needs to look at commercial loans to see the difference (commercial loans are held on an individual bank’s books and the pricing will be similar to a home which is not backed by a Fannie/Freddie loan.)

The following pricing is as of August 19, 2013:

  • Fannie Mae 30 Yr. Fixed – 4.75% 0 + 0
  • Local Lending Institution – 6.0% 1 + 0, 5 year term, 20 year amortization

The cost of financing for Fannie vs. local lending institution is far higher in both rate and terms.  Given the choice, the market will almost always opt for the Fannie/Freddie backed loan, for obvious reasons.  On a $300,000 mortgage, the Fannie 30 Year payment is  $1,564 while the local bank’s is $2,150…that is a big difference.

So what is the impact?

Understanding the payment difference for being inside the parameters versus outside, you can see how buyers would be affected if a policy shift moved them from in to out.  What if this shift affected millions of potential borrowers?  Adjusting credit score minimums, down payment levels or even how commission income is counted towards qualification can have a drastic impact on the pool of buyers.  Fannie and Freddie (and FHA) constantly tweak many of their underwriting guidelines and correspondingly add and subtract both the number of buyers who qualify as well as the different types of homes which qualify.

One simple example:

  • The VA Jumbo Loan Limit is currently $417,000 in Caroline County but $843,000 in bordering Spotsylvania County…for those who know that marketplace, there is not a 2x difference in home prices.
  • Further, the median home price in Mechanicsville 23116 was $310,000 and in Spotsylvania it was $272,000 yet the same Jumbo loan discrepancy exists.

Can you imagine the impact on the upscale new home builder in Spotsylvania if Jumbo guidelines were changed (as you can argue they should be)?

During the market adjustment, Fannie and Freddie dramatically changed their underwriting.  As they did, they began to not buy loans on the properties (or on the borrowers) that they would have accepted only a scant time before.  The modification in lending practices was supposed to firm up the market by only allowing those who should buy to buy, but it effectively shrank the pool of buyers at a time when the pool needed to be expanded to combat falling prices.  Prices fall when demand weakens and even an incremental governmental policy shift can have a huge impact on the marketplace…especially at such a critical time.

As long as we are dependent on Fannie and Freddie to determine what types of properties and people they will loan on/to, we will be very sensitive to their policy shifts as ultimately, their policies have the greatest ability to impact demand.  Those whose properties are near loan underwriting margins (Jumbo, Condos, Investors, especially) need to be quite mindful of this fact.

Additionally, it absolutely be noted that the involvement of Fannie Mae and Freddie Mac makes housing more affordable.  As the example above of how commercial mortgage pricing differs from commercial pricing clearly shows, Fannie and Freddie DO help make the financing of real estate far more affordable, despite some obvious holes in the system.  Somewhat recently, voices on Capital Hill have begun to question the need for Fannie and Freddie.  As a tremendous amount of taxpayer money was pumped into these entities during the market adjustment, the voices are becoming increasingly louder.

Will Fannie and Freddie be around in 5 or 10 years?  They probably will, albeit in different forms.  I hope that DC understands that homeowner equity is a huge part our nations economic well being.  If the cost of financing were to increase sharply, the value of housing would suffer.  On the heels of the massive levels of lost wealth during 2007-2012, the dissolution of Fannie and Freddie would not be wise without some very viable private alternatives.  As always, the market would adjust, I just hope that policy makers understand the element of timing and the still fragile nature of the recovery.

Part Two can be found here...

Why or When You Buy…Which is Most Important?

July 1, 2013 By Rick Jarvis

For the past 12 months, the voices screaming ‘IT IS TIME TO BUY’ have been at their loudest…and during any 12 month period in the last 5 years, the voices had it pretty much right.  According to Case Shiller (the gospel when it comes to home prices), from April of 2012 to April of 2013, home prices in the 20 City Index rose over 12%.  That is the largest gain in home prices in a 12 month period since 2006, and in my opinion, perhaps the most reasonable gain in the history of home pricing since we moved out our caves.

CS Index April 13
The Case-Shiller Index measures home prices in the largest markets in the US. If you look at the trend line going back into the middle 1990’s to now, you can see that with reasonable appreciation, we are not too far off of trend.

Why do I say this?

Quite simply, we are correcting back to where we should have been in the first place had lending standards never been altered and Wall Street never hijacked the process.  Had we simply continued on the historic 3 – 5% per year appreciation track, we would be right about where we are now.

If you look at the appreciation discussion a bit differently, ask yourself the following question:

Are you better off because of when you bought or because of why you bought?

Imagine this scenario, you have no substantial down payment, a decent but unstable job and serviceable but weak credit.  You walk into Countrywide’s office in the mall and somehow decide that buying a home is a good idea…it is 2003.  By the end of the weekend, you are under contract to buy a newly constructed $485,000 home with 6 bedrooms, his and hers brass bidets, 14′ ceilings on a golf course…and 30 days later, you move in your new home.  By some miracle (the miracle was probably disguised as a job loss, but I digress), you end up selling it in 2007 and renting an apartment downtown.  How much money did you make?  A ton.

Lets say it 2007, you are 27 years old with a graduate degree, a stable job ($85k/year as an managerial consultant) and you have saved up $30k for a down payment.  You shop diligently each weekend for 6 months in numerous neighborhoods.  You decide on a reasonable 3 bedroom home with 1.5 baths in a decent school district.  Your back end DTI is less than 30% (very conservative) and you make an offer, get bid up a bit, and end up under contract and close 45 days later.  In 2012, your company closes down, you lose your job and take a dramatic pay cut on the new one meaning you have to sell and move into an apartment downtown.  How much money did you lose?  A ton.

Lets say it is April 2012 and you land your first job after college.  Your roommate, who works for a commercial contractor, says he will rent a room from you and if you give him 3 months free rent, he will help you paint it.  Your parents, as a gift for your graduation, stake you to a small loan, and you find a 4 bedroom colonial in a decent school district with a HOMEPATH rider on the for sale sign indicating a foreclosed home with incentives for first time buyers to buy.  The home was sold in 2006 for $385,000 and you bought it for $249,000 with a 3.35% 30 year mortgage and about $20,000 all in with closing costs and down payment.  45 days after you move in, the paint is complete, as are the new counter tops and the weeds are gradually being converted back to grass.   You have 2 room mates paying you $500/mo and you make up the difference…maybe $400/mo including taxes.  How much money do you stand to make?  Several tons…

The simple point is, since 2003, WHEN you bought has been far more important to the outcome than WHY, WHAT or WHERE.  This is rapidly changing back to the way it should be where WHY, WHAT and WHERE matter more than WHEN.

As noted earlier, prices went up 12% in the last 12 months and we are still about 20% below the tip top of the market.  However, if you look closely and draw a 3.5-4.5% yearly increase from 1995, do you realize where we are?  We are right about where we should be and I am ok with that.

Housing is not stock and it should not be treated as such.  Housing, while an asset, is the only real appreciating asset that you use on a daily basis.  You do not use your stock certificates as place mats nor do you use your mutual fund prospectus as anything other than a cure for insomnia.  The market gains from ’03-08 were false and driven by underwriting guidelines that were an embarrassment.  Likewise, the subsequent correction from ’08-12 were driven largely by the same idiotic factors (just reversed)…neither of which represented a normal market.

The new market, which will begin sometime in 2014 as the production of new houses catches back up and the Federal Reserve quits buying down our interest rates, will reward the astute buyer and the solid decision makers.  It will reward those who see housing as ‘buy and hold’ and not ‘buy and trade.’  It will reward those with an eye towards design and reward locations ripe with walkable amenities.  The last half of 2013 will prove to be the last 6 month period where it sort of didn’t matter what you bought…just THAT you bought…and the market will make you look like you made a good decision.

So it is a great time to buy and use mortgages to do so as pricing for both is still historically low.

In 6 months, that may no longer be the case.

The Dangers of HGTV

June 29, 2013 By Rick Jarvis

love it
Hillary and David (especially David) say things that I know many real estate pros would love to say in real life…

HGTV is dangerous.

Needless to say, as a real estate lifer in a real estate family, we watch the channel.  When your five year old wants to stay up to see whether or not a couple decides to ‘Love It’ or ‘List It,’ it is an indicator as to how much we watch the channel.  She was able to reel off about seven different shows by name the other day…scary…but that is another conversation for another day.

While HGTV is addictive and it has the ability to suck you in almost as well as a good Law and Order marathon, its ‘watchability’ is not what makes it dangerous.  HGTV is most dangerous because it sets an incorrect expectation in the mind of the market as to the ease at which property can be bought, sold and improved.  While the channel does not profess to be a ‘how to’ on the correct way to buy/sell/flip/finance properties, it does not dissuade us from making the assumption either, and that is truly where the danger lies.

Issue ‘Numero Uno’ is the cost of renovations.  Love It or List It, while one of my absolute favorite shows, is one of the worst offenders.  Sellers regularly have wish lists that include complete kitchen re-do’s, removal of stairs and/or walls, additions, completion of basements and master bath overhauls and with a budget of $35 – 50k.  The large majority of the time, the request list relative to the budget constraint is extremely unrealistic.  Likewise, professional fees (architecture, engineering, interior design) are largely ignored and I have yet to see an episode where the plans sit on someone’s desk at City Hall for an extra 3 weeks for no apparent reason (happens all of the time in real life.)  The simple act of opening up a wall can trigger all sorts of code upgrades, especially in older homes, and one questionable interpretation from a county code inspector can impact the entire plan and/or blow much/all of the budget.

These shows tend to gloss over the costs associated with financing and transferring of real estate.  ‘Congratulations, you have improved your home by $45,000 even though you spent only $30,000’ sounds great but it is not that simple.  If cash was used to pay for the improvements, then that cash cannot be accessed unless the home is sold or refinanced, meaning that the $15k in new equity will either partially (or entirely) eaten up in commissions and/or closing costs/refi fees.  Additionally, if the refi mortgage rate is higher than the current one, then you have managed to up your monthly obligation in order to recapture the cash spent on the renovation.  I also have not touched on the fact that appraisals are a crap shoot in this market and what a home may be worth in the eyes of the bank may differ from what they comparable sales indicate it should be worth.

Another huge issue is how these types of shows depict the buying process.  In almost every show, the buyer looks at several potential properties, also has their team look at it, weighs their decision thoroughly, has plans drawn, sees a demonstration on the work to be done, and then proceeds to buy one of the three homes.  In this market, any home worth buying would have received multiple offers and sold at or above asking price.  The contractor and/or architect who helped draw the plans would be sending the buyer an invoice for their design work, regardless of the outcome, and this would repeat itself over and over until the buyer either quit the process or bought a home without the comfort of completed plans.  Glossing over the time and expense of buying a true ‘fixer upper’ is a huge disservice to the buying public.

Ok, this post is not to say that these shows are not valuable nor is it saying that they have no place…they do.  The concept of before and after is huge and improving a home may still be the best option for many folks.  Opening up a home can have a huge impact on its marketability as well as on day to day life of the occupants.  Getting natural light to interior rooms and the huge impact on space that paint, correctly sized furniture and new fixtures can have on space is hard to describe but easy to show…and these shows do just that.  Illustrating new concepts and design trends is also quite valuable and keeps the viewer closer to the latest trends.  All of these reasons are valid and valuable, they just fall short of the entire story.

If you are entering the market to purchase a home or considering renovation, please do not expect to have an HGTV experience.  Buying a foreclosure, fixer upper or executing a major renovation is extremely hard and should be undertaken with great care.  Make sure that your budget is far less than your reserves and that you do not bite off more than you can chew.  Expect the unexpected and bake in extra time, extra cash and extra headache.  If you do that, then the correct expectation has been set.

But don’t forget to tune in tonight at 8 to see if they are going to ‘Love It or List It.’

Is It a House or Is It “Housing?”

May 14, 2013 By Rick Jarvis

cantor
Congressman Eric Cantor was kind enough to listen to what a panel from the RAR (including yours truly) had to say back in 2011 about the lending policies of Fannie Mae and Freddie Mac.

I live in a HOUSEand you live in a HOUSE, but collectively, we live in HOUSING.

Please explain…

Individually, we buy a house (or condo) that fits our needs and personality.  It can be big or small or it can be blue or beige or tall or short, but it is our house.  It contains our stuff and it contains our memories.  It has pictures on the walls of the people, places and things that are important to us and it creaks and moans when the wind blows…and we know where the water shut off valve is (because of ‘The Incident’ back in 2007.)  We also know that flushing the toilet in the master bath while the washing machine is running means an immediate increase in the shower temperature by about 20 degrees.

Once again, it is our house.

That being said, the US is comprised of millions of houses just like yours and mine.  This collection of millions of homes makes up the market called ‘HOUSING’ and it is what shot to the moon in 2006 and was in free fall in 2008.  The US Housing Market is a complex collection of numerous inputs (supply, demand, credit, Mortgage Insurance, schools, materials, seasonality, type, location, density, demographics, etc.) and it is these factors collectively that drive value.   Despite what HGTV, Pottery Barn and Home Depot would have us believe, it is not our paint colors, furniture placement or lighting selections that truly affect value.

[ Inventory levels have plummeted since 2008 while pending inventory is trending upwards.  More stats here ]

Currently (spring of 2013), we are in the throws of another massive correction…but this time to the positive.  The correction that we are currently experiencing is a re-correction from the over-correction that occurred from 2008-2011.  During the 5 year period prior to 2008, prices rose at an unsustainable pace due mostly due to a lending process that was flawed.  The severity of the correction was due, in large part, from the UN-availability of credit once the market adjusted.  The overall leverage in the marketplace in 2008 was unprecedented, especially when compared to historic trends, and when values began to fall, the debt levels exacerbated the correction on a level unseen in most of our lifetimes.  The implosion of the market either caused (or was caused by, depending on who is asked) the implosion of Wall Street and the fallout in the credit market was global.

The lesson in all of this is that the HOUSING MARKET determines the value of homes and not Realtors, an appraiser, Zillow or the individual homeowner’s selections.  Without a doubt, the most important inputs to the local market are controlled well outside of the region.  While design trends and color palates may affect pricing to some degree, by and large, the swings in value that are significant are driven by MACRO factors.  A paint job will not improve your property values by 10% but a policy shift in DC sure can.  Simply put, when there are more homes than buyers, prices go down and when there are more buyers than homes, prices go up.  Those who are truly shrewd investors understand this and strategize accordingly.

Remember to keep these macro factors in mind when making the decision to purchase.  I see so many buyers fail to understand the overall picture and in doing so may let a home pass over an inspection item or negotiations break down over a few thousand dollars.  In the grand scheme of things, owing property now, at the interest rates currently available is likely to be one of the most intelligent financial decisions you will make.

These extremely favorable market conditions will continue to be for the next 12-24 months as we correct back to trend.  Keep an eye on the inventory levels and interest rates.  When the graphs look like they did in 2003-5, we are back to a stable and (relatively) predictable market.

The re-correction is not over but it is in mid-process and the days to purchase an large asset at a discount are ending sometime in the foreseeable future.   Serious consideration should be given to the opportunity to enter, re-enter or adjust one’s housing situation as these market conditions are fleeting.

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