Jason and his guest, Christopher Kagan, discuss how people are using (or abusing) their home equity. They also discuss adjustable rate mortgage resets. Danger ahead!
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Jason Hartman: Greetings, Los Angeles, and the rest of Southern California. Happy to be here with you on another edition of Creating Wealth. This show is recorded, so I apologize we cannot take calls today, but I am in studio with a very distinguished guest, Christopher Cagen, who is the Director of Research and Analytics for First American Real Estate Solutions, First American Title, basically, one of the largest title companies in America. And he holds a PhD from UCLA. Go Bruins.
Christopher Kagan: That’s right.
Jason Hartman: And he does some tremendous, tremendous reports on real estate cycles and the mortgage reset issue. We’re going to be hearing some of Chris’ predictions as to where the market is going, what markets to invest in, what markets to be careful of, and we’re also going to talk about adjustable rate mortgage resets. Chris, welcome to the show.
Christopher Kagan: I’m glad to be here.
Jason Hartman: Glad to have you. So America the past several years has been basically using their homes as an ATM machine, that endless supply of home equity money. Are people acting in a responsible way with their equity in terms of financing it through good asset management, or is this just binge borrowing?
Christopher Kagan: Well, there may be some individuals who are doing binge borrowing, but as a nation, it’s responsible asset management. The Flow of Funds statement of the Federal Reserve from 2000 to 2005 shows that the percentage of homeowner equity has been very constant, going from only 58 to 56 percent. So as a nation, people are managing their household money quite responsibly.
Jason Hartman: It sounds like it. So the debt isn’t too high. Everybody always says Americans, they spend too much, they spend their equity, they spend their savings, compare them to other countries in terms of savings rates, but that’s really just not that big an issue, huh?
Christopher Kagan: Well, the national savings rate is low and I wish it were higher, but as far as managing their household money, I will tell you it’s always the spectacular cases that get the attention. There are people who have borrowed too much, but that’s not true of the nation as a whole.
Jason Hartman: Excellent, excellent. Now, when you look at the percentage of equity, basically we’re looking at an overall sort of nationwide loan to value ratio in other words.
Christopher Kagan: That’s right.
Jason Hartman: So that equity can disappear, though, in some markets where it’s more sensitive to the market fluctuations and we’ll talk about that after the break a little more. What about that as a concern?
Christopher Kagan: Well, that depends on what market you’re in. All real estate is a local consideration, so there are some markets where things move up a few percent every year and they are quite safe. There are some markets where things went up very fast, very quick, and then you want to take a look at what’s happening locally in that market.
Jason Hartman: And that’s really cyclic versus the linear markets that we’ll get to after the break. Excellent observation there. I really like that. How is it, Chris, when you compare owner occupants and investors and the way they finance their real estate and sort of manage their equity, what are the differences there?
Christopher Kagan: Well, nationally, they actually, surprisingly, manage their money about the same. The equity percentages are not too different. In certain local markets, there are many speculators and so on, so locally, in a particular situation, it can be different. It can be dominated by non-owner occupants. But for the most part, on a national basis, the investors manage their money about the same as the owners.
Jason Hartman: So really have good equity and overall, a good amount of situation in terms of equity versus risk and loan.
Christopher Kagan: On a national basis, yes.
Jason Hartman: Yeah, excellent. What about negative equity versus positive equity? You show in one of your reports a distribution chart in terms of homeowner equity. Can you tell us a little bit about that?
Christopher Kagan: Well, you see, negative equity means you owe more on the property than it is worth in the market, which means that if a person had to sell or refinance today, they would have to bring up money. The overwhelming majority of people in the nation are in a positive equity situation. It means they have money and if they sold their house today, they could take money out. They would get money. There are some people that are in negative equity.
Jason Hartman: That’s a very dangerous position to be in. In some cases, if they’re not managing cash flow correctly, if it’s an investment property, for example, or if their payments are too high and they can’t afford them because they really have no chance to refi or anything like that. But when you look at different markets, we look at sort of the heartland markets, as you’ve mentioned to me before, versus the coastal markets on the East and West Coast. Who is in a better equity position?
Christopher Kagan: Well, right now, the coastal markets tend to be in the better equity position, primarily because they’ve had prices double or more in the last five years. The question will be could there possibly be a dip in reaction to that. The heartland markets, on the other hand, it’s just a question of risk and gain. They’ve been going up slowly. They build equity more slowly, but on the other hand, they’re less prone to risk.
Jason Hartman: So how much risk do they really have? If they have large percentages of equity on the two coasts and we see a downturn in those markets – and we’ll get your prediction on that here shortly – is there a larger risk on the heartland type markets in terms of this mortgage payment reset issue?
Christopher Kagan: I would say mortgage payment reset, which is what happens when an adjustable mortgage gets its payments changed and generally gets them raised, that is almost not an issue at all in the heartland because they have relatively few of that kind of loans and the equity has built slowly and it’s very stable. That’s why there’s a great deal of interest right now in buying and investing in these heartland markets.
Jason Hartman: I absolutely agree with you. We’ve noticed that, too, when we look around the country and sort of do our very informal research, which ours is sort of finger on the pulse on the street type research. Yours is much more analytical and empirical with really big data groups. But the yuppie sort of markets, the high-end markets where there’s a lot of wealth, a lot more instant gratification mindset there that we’ve noticed. Would you agree with that?
Christopher Kagan: Well, very much. With the kind of strong 20 percent per year or more gains that have been happening in the past, a lot of money has been made I think over the last five years, and particularly, 2004, 2005, but I think that those markets are turning back to a normal state of single-digit growth, or in some cases, flattening prices and there’s a great deal of interest right now in places that haven’t been noticed in the past, like Texas, Tennessee, North Carolina, where you can get houses for less than $200,000.00.
Jason Hartman: Yeah, I agree with you completely, and that’s what we’re really helping our clients do is reposition their equity. Take it out of the risky markets and put it into the markets that are linear in nature, that chug along, and they do nicely, and we also believe many of those markets are counter-cyclical to the California market.
Christopher Kagan: Well, that’s right. And the other thing is that they have not come near the point where affordability becomes an issue. I mean here in California, you may have a $700,000.00 house, which is a just a basic –
Jason Hartman: Condo, you mean.
Christopher Kagan: Or condo. Depends on where. Or whereas people, if they want to retire, you can cash out and get $500,000.00 tax free, buy the same property for $200,000.00 in a beautiful place where people say hi in the restaurants and say hi on the streets and you get half a million dollars tax free. A lot of interest in Texas with the energy economy. There’s a lot of money there and yet they have not maxed out the affordability, so you have lots of building and lots of money coming in, in particular, Dallas, Austin, and just about everywhere in Texas.
Jason Hartman: I agree with you completely. And so why is it – let’s just go back, Chris, to that adjustable versus fixed rate mentality that causes a borrower to choose a certain type of mortgage. I’ve always wondered why is it in the sort of the yuppie-ish, high-end markets, why are people so in to instant gratification where they like those adjustable low payments now, but they always seem to sell the future for that privilege.
Christopher Kagan: Well, when prices are going up 20 – 25 percent every year, it’s perfectly all right. In an adjustable situation, when the interest rates are low, as they have been for the last few years, and prices are going up, it’s very smart to take a low payment at the beginning and then you get your $100,000.00 appreciation every year and you’re a genius. The problem is when interest rates start to rise and prices start to slow down or smooth out, as they’re now doing, right now, the great industry and the great move that people are making is to go from adjustable into fixed, lock in their gains, and remove that uncertainty and have a fixed payment.
Jason Hartman: Yeah, I understand that definitely. Now, there’s been a big increase in popularity of adjustable rate loans recently in the last five or six years and interest-only loans, and I’ve always been boggled because we actually prefer interest-only loans as long as they’re fixed rate. We like to build principle and the equity in the property just through appreciation. Let’s let the market do that for us and improve cash flow with interest-only fixed-rate loans. Why is it that the media lumps these together? They always seem to say high-risk adjustable rate and high-risk interest-only loans. Any insight on to that?
Christopher Kagan: Well, because to them, anything that is not a standard fully advertised fixed is an exotic concoction. The interest-only question isn’t that big of a deal to me because for the first five years or seven years or whatever of any loan, it’s almost all interest anyway, so the change in payments is minimal. The big question is whether you have a teaser loan that will have a strong reset or whether you will have a market rate adjustable or a fixed. Interest only is not that important of a variable.
Jason Hartman: Good point. We’ve got to take a break right now. We will be back with Dr. Christopher Cagen in just a moment. Stay with us.
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Jason Hartman: Welcome back. Glad you’re here with us. We’re still with Dr. Christopher Cagen and we are talking about market cycles. We were just talking about the mortgage reset issue and, Chris, you had a couple of comments you wanted to just wrap up on the teaser rate issue, I believe.
Christopher Kagan: That’s right. The big issue is to make sure that you understand what you are signing. There’s a time and a place for introductory teaser rates of 1 percent, but remember you have to ask yourself what will the rate be two or three years down the road. What is my payment and what is my situation? Understanding is a powerful tool for buyers and borrowers.
Jason Hartman: Absolutely. So the future will come and those payments will adjust, so be careful, and let the buyer beware. Let’s talk about market cycles and market position. Some people say in life, timing is everything. In real estate, timing matters quite a bit. What do you think the future holds for the Southern California real estate market?
Christopher Kagan: Well, I think in Southern California and in particular, Los Angeles and Orange Counties, what we’re going to have and what we’re having now is the transition to a normal market, which is very surprising to people after the kind of extreme bull market they’ve had in the last five or six years, where we’re now having buyers actually negotiating with sellers.
Jason Hartman: What a concept.
Christopher Kagan: Wow and making deals and people looking around instead of grabbing the first thing they saw. I think this is just the normal turning of the seasons. I think, in particular, with interest rates going up and we could have a cycle dip, but it will not be a crash, and this is not a bubble in Los Angeles and Orange Counties.
Jason Hartman: Excellent. So tell us what a cycle dip means. During the break, you were sharing with me that – we were debating whether the ’90s, ’90 to ’97 in Southern California, was a crash or not.
Christopher Kagan: It was not.
Jason Hartman: And so you said it never went down more than 5 percent per year.
Christopher Kagan: That’s right. In Los Angeles County, for instance, as a county, it never went down more than 5 percent per year, spread over four or five years. Local areas, individual properties, can be better or worse than that and that was in a situation with Aerospace layoffs and an earthquake and riots and all the things that happened.
Jason Hartman: And an Orange County bankruptcy.
Christopher Kagan: And an Orange County bankruptcy in 1994. We are not as dependent on one single industry as we were then and certainly in Los Angeles and Orange Counties, they don’t overbuild. They build slowly and that helps to keep the prices firm. So any dip that might come will not be as serious as the 1990s, in particular, as inflation returns, as it goes 5, 6, 7, 8 percent wherever it’s going, that will put a floor under any bear market or cycle dip that might come as hard assets and real property have their value increased relative to paper dollars.
Jason Hartman: Absolutely. Real estate has been, traditionally, a great hedge against inflation and certainly a much better investment than fiat money.
Christopher Kagan: That’s right. My father bought his home in Palo Alto for $14,000.00 and he bought a second home in Los Altos Hills with an acre around it for $28,000.00. I will admit that wasn’t last year, but you can imagine what those properties are worth now.
Jason Hartman: Unbelievable, yeah. Don’t wait to buy real estate. Buy real estate and then wait, I always say. So in terms of that dip that’s possible in Southern California, or maybe you’re really speaking to the whole California market or at least the coastal markets –
Christopher Kagan: Coastal markets.
Jason Hartman: Yeah, in general, we could see 15 – 20 percent over a few years in decline possibly?
Christopher Kagan: Over a few years, but remember that if that happens, it just takes you back to 2004, which was not a disastrous situation.
Jason Hartman: Right, right, but a lot of people have sort of expected that their equity’s going to stay with them forever, so they’ve got to be careful of that. Manage cash flow properly. Don’t be forced to sell at the wrong time. That’s what we always say.
Christopher Kagan: Understand what you’re doing. Understand what you’re signing and then go for it.
Jason Hartman: Absolutely. Okay, so we talked about the California issue. What about other markets around the country? You’re the first person that made me see, about a year, year and a half ago, the concept of cyclic and linear markets. What do you mean by that?
Christopher Kagan: Well, there are some places where there’s lots of land basically and prices will go up 5 or 6 percent every year, more or less smoothly, if you’re in Kansas or Oklahoma, for example. On the other hand, there’s other markets. Those are linear markets. It goes up like a line. Yet there are other markets, in particular, like San Francisco, Manhattan, Newport Beach.
Jason Hartman: Boston.
Christopher Kagan: Honolulu.
Jason Hartman: Miami.
Christopher Kagan: Where there’s not much more land and so, if people are interested in this area and there’s money and times are good, prices have to go up. You have price cycles. So prices go up and down in waves in the cyclic markets.
Jason Hartman: Okay, so the $64,000.00 question here is where do you want to invest, a cyclic or a linear market?
Christopher Kagan: At this point, I would invest in the linear markets because the cyclic markets, the coastal markets, have had an incredible price run-up in the last few years and my friends, you’re not going to get 25 percent every year forever because that’s just not going to happen. So there’s a lot of interest right now in linear markets because prices haven’t gone up that much and they haven’t tested the affordability of the people who live in those areas. I talked to a fellow in Nashville, who lamented the fact that homes were now getting close to $200,000.00.
Jason Hartman: Oh, my gosh.
Christopher Kagan: Well, here in California, that doesn’t even get you in the door.
Jason Hartman: Right.
Christopher Kagan: So it’s cheaper than that in most parts of Dallas, San Antonio, the Carolinas. So a lot of people are thinking about retiring there or investing there or buying second home properties because it’s so reasonable and prices have gone up slowly, so there’s very little downside risk and the great possibility of upside.
Jason Hartman: I agree with you completely. You mentioned linear markets are markets that have a lot of land. Why is that? Why does the land supply make the market linear versus the limited land supplies make it more cyclic?
Christopher Kagan: Well, it’s real simple. If you’re on the Plains and you want to build new homes, all you do is go to the edge of town and build some new homes and there’s lots more land out there where that came from. But if you are in Honolulu, Hawaii, or Manhattan Island, the land has been taken for a long time, so if you want to build something, chances are you’ve got to go to some place where it’s already built and you’re going to have to pay more for it.
Jason Hartman: Or you’ve got to build up, up, up.
Christopher Kagan: Or you’ve got to build up, up, up and anyway, all of that makes the prices go up, up in a cycle much more than when there’s lots of land all around you.
Jason Hartman: See that’s very interesting that you say that and I agree with you. The only sort of variable to this that has really become an issue in the last three or four years is the cost of construction. I mean you talk to anyone who’s in the building business, whether they build office, home, whatever, industrial, it doesn’t matter, the cost of all of these raw materials has just gone through the roof because of China and India.
Christopher Kagan: No question about it. Cement, copper, almost all commodities, high demand. Where there’s high demand for something, it puts the price of that thing up.
Jason Hartman: So how does that play into it? Could that make some of these more linear markets in the Carolinas, Georgia, Northern Florida – not the overpriced Southern Florida – Texas, Utah – now is Utah – we like Utah a lot. We’ve been very bullish on Salt Lake City for a while now. Is that a linear or cyclic?
Christopher Kagan: That has been linear rather than cyclic. A lot of these markets, for instance, Phoenix was going on about its business for many years and then it had 46 percent price run in 2005, and not it’s settling down. So linear markets can have a run and then settle down. I’m especially interested in those that haven’t had one yet.
Jason Hartman: Yeah, right, I agree. So how does the construction cost issue play into these linear markets? Do you think it could make them more cyclic? In other words, could they experience a bigger upswing even though they have the big land supply, but these raw materials are getting so darn expensive? If you buy it now, you’ve locked in your cost. You lock in fixed-rate, long-term mortgages and just wait. That’s kind of my philosophy.
Christopher Kagan: Well, I think that’s the right thing to do is to buy in a linear market, prefer a fixed-rate loan as you’re saying, lock in your costs, and take your time and wait and enjoy your returns.
Jason Hartman: Yeah, absolutely. So what else do you want to tell us about linear versus cyclic markets? You calculate like the size of the swing. How do you refer to that?
Christopher Kagan: Well, the cycle size, if you will, if you’re in these coastal markets, these cycles have their sizes, which they can have their waves of 20 or 30 percent up and down, which goes over several years. But then inflation will act to pull prices up and the long-term trend, because they’re not making any more land in the coastal areas, that acts to pull prices up. So the long-term trend, after the cycle has its up and has its down, the long-term trend is about 6 percent per year or if you have inflation, about 3 percent more than inflation. So that’s why prices will double every 12 years or so.
California had, in the 1970s, six years in a row of more than 20 percent, an even stronger market than we’ve had lately, 29 percent one year for the whole state and those were the inflationary 1970s. So if you think we’re going back to an inflationary period comparable to the 1970s, real estate will be supported by that.
Jason Hartman: Excellent. So tell us about that metric you just mentioned. I wasn’t aware of that. Generally, real estate, does it sort of perform about 3 percent better than inflation? Is that right?
Christopher Kagan: That’s right. It does. The biggest reason is because, first of all, you have improved per capita income, you have higher population, and you have the finite supply of land in the metropolitan areas. So after you smooth it out over 15 years or 20 years, it tends to do about, depending on where you are, 2 – 4 percent better than inflation. And there’s not many investments that do that.
Jason Hartman: Wow and as we talked about during the break, I really feel and I think you concur with me that inflation is really a little bit higher than the CPI might lead us to believe.
Christopher Kagan: Well, if you’ve gone to a store lately or if you’ve put gas in your car lately, I think you’ll agree with that.
Jason Hartman: Yeah, I agree with you. Great. Well, good stuff. Anything you just want to say in closing to wrap up?
Christopher Kagan: I would just say buy wisely for the long term and enjoy your life.
Jason Hartman: Absolutely. Thanks for joining us. This is Jason Hartman with Dr. Christopher Cagen. We’ll see you next time.
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Duration: 35 minutes
