Market Values

In the previous two sections, the discussion was more national in scope as we discussed both The Fed and the GSE’s.  Part Three is both national and local in scope as it touches on building codes and the impact of taxes.

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

The Mortgage Interest Deduction (MID), Capital Gains, Tax Abatement, Federal versus State Historic Tax Credits, Dodd-Frank Financial Reform Act, the Downtown Master Plan…all are governmental interjections (City, State and Federal) into the housing marketplace that impact how properties are taxed, built, sold, approved and inspected.

While the impact of the Fed and the GSE impact how properties are purchased, the tax code impacts how they are sold.

The tax code, which is modified pretty regularly, places different rates of taxation on different asset classes with the biggest difference being the definition of long and short term capital gains.  An asset, held for a longer period of time is taxed at a rate lower than ones held for less time…which influences how an owner will behave. Consider the person who renovates homes for a living…purchasing and renovating a home creates the highest amount of income tax possible while renovating it, holding it for a few years and then selling it lowers the rate.  The incentive is to either not buy the home or to minimally renovate it.  Seems a little counter-intuitive to me.

Likewise, income levels also determine how and when an owner may deduct interest paid on a property.  In 1986, when there was a massive overhaul of the tax code, the treatment of passive losses (interest, depreciation) were changed to disallow the sheltering of ordinary income making many real estate investments far less feasible for many high earning individuals.

Why does this matter?

Owning property simply for the purpose of tax reasons is a dangerous game, but much of what we do is influenced by taxes.  As a good friend loves to point out, that which we need less of, tax heavily.  That which we want more of, tax less.  It is a very true statement.

The Federal Government, with the stroke of a pen, can dramatically alter an asset’s performance by simply changing a definition in the tax code. Treating passive income differently than active income had a massive impact on properties for investment properties and that one simple change turned many properties upside down.  And even when the market is given ample notice that a change in the code is coming or a temporary change is nearing its end (Sunset Provision) as the date for the change draws near, more and more are forced to either sell or buy and prices can be affected.  Understand this if you are in the investment arena.

In addition to the impact of taxes, there are numerous levels of interference from a multitude of agencies, many times with conflicting interests, making the process of building and developing harder than it should be.  Each level of regulation placed on any industry causes unintended consequences.

Several ‘Betcha Didn’t Know’ Anecdotes –

• Historic Tax Credits are effectively doubled if you build an apartment building (for rent) as opposed to a condo property (for sale) and thus the 2000+ apartments built Downtown since 2010 with no new condominium development during the same time period
• Dodd-Frank largely prevents a seller from holding financing (and it also eliminated free checking, fyi…)
• FHA will not do a condo loan in a condo project with no rental restrictions. VA will not do a loan in a condo project with ANY rental restrictions
• The Uniform Residential Appraisal Report make no adjustment for green/LEED/other responsible building practices despite the government’s latest mandate to improve building performance ‘by 30%’
• The IRS ruled that contributions into a partnership for Tax Credit purposes are, in fact, taxable (that one absolutely befuddles me)
• The sign ordinance in the City of Richmond is directly at odds with the Department of Historic Resources (in many cases)

Why does this matter?

It matters because each layer of compliance and regulation, while intended for the greater good (I do actually believe that, for what it is worth), simply creates another impact on the market which typically increases the cost of buying, selling or building. Each increase in cost has a corresponding effect on demand and thus, pricing. While mandating a home be 30% more energy efficient sounds great, when a home will not appraise (and thus not be financeable), a builder is far less likely to build it.

Ultimately, an shrewd property investor is acutely aware of the tax code.

Part Four – The Conclusion – May Be Found Here…

 

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

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

 

 

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

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.

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...