Boulder Falls 19 Percent, Denver Drops 10 Percent
Is now the time to buy in Greeley?
Location Inc., a Massachusetts-based risk analysis firm launched by Andrew Schiller – that is, the man who accurately predicted the last real estate bust – revealed new real estate predictions for the Front Range. According to recent models, Boulder will plunge by 19 percent as soon as 2022, while Greeley should be a standout holding its value. How accurate are these predictions? Should you panic?
BACKGROUND ON FORECAST
In April 2017, Location Inc., warned 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. The company has now updated its forecasts on a better-than-expected economy which has caused the prediction to change substantially.
THE NEW FORECAST
Location Inc., is now calling for a 9.9-percent decline in northern Front Range home prices during the next five years and Boulder is anticipated to declining 19 percent, with the price peak regionally coming in the second quarter of 2021.
Schiller went further with his prediction:
How accurate is this forecast?
HOW IS THE PREDICTION PREPARED?
One of the most significant inputs to his model is the ratio of income to house price. On the surface, it is impossible for prices to rise much faster than income.
Historically record-low interest rates have allowed people to buy more, but as rates have risen, buying power has eroded as incomes haven’t kept pace with rising home prices.
IS INCOME THE BEST METRIC?
There is no doubt of a correlation between home prices and incomes in many markets, but the correlation is now a bit murkier.
For example, Boulder’s median home price is $1 million. To afford such a home (assume you put 20 percent down at a 5 percent rate, the payment is $4,300/month on an $800,000 loan).
The median salary would need to be north of $175,000. For borrowers making this salary, the definition of income gets a bit more confusing. For example, people in this salary bracket typically have more deductions (donations, childcare, house, losses, etc.) so their actual income is different from their taxable income. Someone may have a taxable income of $175,000, but actual income substantially higher. So, income doesn’t work as the primary metric in Boulder or the Denver metro area, where almost 13 percent of households have incomes of more than $150,000.
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 seemed inexpensive compared to New York City or San Francisco.
Net migration has helped, but is this the real reason 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 into the cycle.
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. I am doubtful this will continue to be the case, as there is already a significant disconnect between prices and income and yet no crash has happened in Boulder or the Denver metro area.
Here are some better metrics to predict declines than simply income:
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 higher the likelihood of a borrower having negative equity.
For example, someone who puts down 20 percent, is considerably less likely to default than someone who puts down 5 percent. A person who puts 5 percent down is quickly underwater when prices drop 10 percent as predicted above. Areas that have more subprime loans are at a much greater risk than others, regardless of income. Many of the less expensive areas have higher leveraged borrowers.
In Boulder, it is almost impossible to get a jumbo loan for 100 percent of the purchase price as government loans cap out at $578,000 in Boulder, and private banks require much great down payments.
On the flip side, in Greeley, with a median home price of $313,000, more buyers are using subprime government low down payment loans, like FHAs that allows less than 5 percent down. According to the federal reserve bank of Minneapolis cash-strapped borrowers are more than seven times as likely to default as borrowers with a strong likelihood to pay. If a borrower is putting in a low or zero down payment, he or she falls into this category. As we saw in the last cycle, low down payment borrowers defaulted at considerably higher rates than borrowers who put 20 percent down.
Supply and demand is critical to any accurate price model. The Boulder-Denver metro, and most of the Front Range is supply constrained. 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 a 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 is supply constrained due to open space, topography and National Forests.
IS A CRASH COMING?
Although I’m doubtful real estate prices in the Denver metro and 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 percent, making payments more expensive. It is interesting that Shiller’s new model predicts a Boulder decline of 19 percent; Boulder has low leverage, basically zero supply and high demand due to well-paying companies in the area, such as Google.
Clearly there is an issue with Location Inc.’s predictions
Although the metro area has heightened prices, there is still a considerable lack of supply and the area remains in high demand due to strong economic growth. Denver and 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 Front Range prices will moderate and could fall 10 percent 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 suggesting Boulder will drop 19 percent 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 and 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 correction.
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.