Entry-level housing in California carries a very high cost, and there is little hope this will improve any time soon. In fact, the problem will likely get worse before people get fed up and do something about it.

When house prices move up rapidly and significantly as they have in California on numerous occasions, even the highest wage earners can’t afford a significant portion of the housing stock with what they can borrow and what they save from their large incomes. Prices get so elevated because previous owners sell their homes and use the equity that accumulated through the appreciation windfall to bid up prices on more desirable properties. As a consequence even the highest wage earners can’t start out in a property as nice as they would like: they must climb the property ladder.

How the property ladder works

In the real world, most first-time homebuyers use an FHA loan and buy a low-cost property. The reason for this is simple: it takes too long to save 20% for a down payment on a conventional loan. First-time homebuyers use FHA loans because the 3.5% down payment is within reach. Further, once these buyers are in a property, they simply wait five or ten years for loan amortization and wage-based appreciation to magically give them 20% to 30% equity in a property to use on their move-up purchase.

Once the owner has enough equity to get a closing check large enough to fund a 20% down payment on a move-up property, they go shopping. Since this is usually quite some time after buying their FHA financed property, it’s likely the household’s wage earners are making more money. They take their larger family income and their 20% down payment and buy a more expensive move-up property.

The broken property ladder

For the property ladder to work, home prices and wages must rise steadily and borrowing costs must remain stable, or better yet, mortgage rates should fall gently. If any one of these features is missing, the property ladder becomes unstable.

During the housing bubble, prices rose very rapidly, but rather than enrich an entire generation of homeowners, lenders allowed them to borrow and spend their equity, so while house prices doubled during the bubble, aggregate home equity actually declined. This left an entire generation of homeowners over-indebted and trapped in their starter homes. This lack of move-up equity and lingering problems with underwater borrowers explains the unusually low levels of for-sale housing inventory.

Today’s entry-level homebuyers in Coastal California must pay upwards of $600,000 in nicer areas. With as large as that number is, the number is financeable by many entry-level buyers with high family incomes. If the previous generation would have only paid $450,000, those owners would have $150,000 in equity they could use to move up to a $750,000 home, and the property ladder would function.

However, that’s not how much the previous generation paid. Many entry-level buyers from 10 years ago paid $650,000 to $750,000 with their option ARM loans with teaser rates. Any while many of those buyers lost their homes to foreclosure, many more obtained loan modifications, so rather than $450,000 or less in debt on their starter home, they still have $650,000 or more in debt, and they can’t sell.

Since the owners stuck in entry level homes carry too much debt, they aren’t listing and selling their homes, and they can’t make a move-up trade. Housing analysts concoct many plausible reasons for the lack of for-sale inventory, but the real reason is the excessive debt still carried by the previous generation of homebuyers.

The problem with a lack of inventory is most acute at the entry level because an entire generation of entry-level buyers is stuck. And since they can’t sell until they get enough to cover their debt, and since most won’t sell until they have enough left over to make a move-up trade, entry-level housing is scarce and hopelessly overpriced, particularly in California.

Amy Thomas, May 18, 2016

First-time homebuyers in the Bay Area need to pay between 69% and 110% of their total household income to support a 30-year fixed rate mortgage (FRM) for a starter home, according to a new report by Trulia. Conventional wisdom concerning a balanced economy holds this allocation for shelter ought to be closer to 30% for both tenants and buyers.

It isn’t just that it “ought to be,” most lenders won’t extend loans to borrowers with debt-to-income ratios exceeding 31%, so whenever the amount required is greater than that, many people are priced out — and no affordability products toxic loans are available to help.

Not surprisingly, the report on starter home affordability across the U.S. indicates nine out of the ten worst metropolitan areas for first-time homebuyers are here in California. The report reveals the sharp rise in income needed to purchase a starter home from Q1 2012 to Q1 2016. The nine California cities with the steepest increases are: Oakland, which requires 29% more income today than in 2012;

Los Angeles, which requires 28.2% more income;

San Jose, which requires 26.6% more income;

San Francisco, which requires 24.7 more income;

Sacramento, which requires 23.3% more income;

Orange County, which requires 22.6% more income;

Ventura County, which requires 19.8% more income;

San Diego, which requires 18.1% more income; and

Riverside, which requires 16.8% more income. The only non-California city to weasel into the top ten worst spikes is Miami, Florida with a 19.2% increase in income needed over 2012. …

The problem in California is a chronic lack of supply. When supply is not sufficient to meet demand, the highest wage earners compete with each other, and the lower levels of income get priced out. Affordable housing subsidies don’t help because they merely merely provide housing to one family at the expense of another family that has a higher income and more savings, an unjust outcome.

Why starter homes matter Though the concept of “affordability” is inherently flawed as it is muddied by its reliance on the abstraction of median pricing, these broader conclusions are indicative of a growing problem. Starter homes have a critical role in the transition into homeownership. First-time buyers purchase starter homes with the intention of building up equity and later trading up to an ideal family home they will occupy for a prolonged period of time. Without an initial toehold to leverage themselves into the future ownership of an ideal property, the ownership catalyst for the future of housing is missing from the equation. The increase in price and decrease in inventory — which according to Trulia is down to a scant 158 starter homes for sale in San Francisco — is partially the result of mid-tier homeowners trading down. The average mid-tier home price across California increased 8% from January 2015. This increase pushed mid-tier homeowners down to purchase low-tier homes, those commonly defined as starter homes. In turn, low-tier prices increased 11% from January 2015. Homeowners who elsewhere are among the high-earning set are settling for these simpler homes, leaving mere scraps (at best) for first-time buyers scavenging the market.

That is a good description of the problem. It also illustrates why adding supply is the only solution.

Top five methods of housing market sabotage

Sometimes to find the best solution to a problem, examining how the problem could be made worse reveals options and perils that might otherwise go unnoticed. Unfortunately, upon close examination of the housing market, the path to destruction may disguise itself as the path to recovery.

To sabotage the housing market, remove homeowner equity and raise borrowing costs. The result is a disappearance of entry-level housing, a collapse of the move-up market, and very low sales.

To stop the orderly progression up the property ladder, it’s imperative to decrease equity and reduce mortgage balances. If potential homebuyers don’t have sufficient home equity, or if they can’t borrow enough money to complete a move-up trade, the entire chain of move-ups grinds to a halt, and home sales will plummet. So what are the best ways to accomplish this?

Inflate a bubble that bursts, and trap an entire generation in their starter homes with no equity. Turn off subsequent generations on the entire idea of owning because of the high cost of bailing out the previous generation. Remove most equity from the system with unlimited mortgage equity withdrawal. Remove supply from the MLS to limit the options of those buyers willing to pay the high prices required to bail out previous buyers and the banks. Raise mortgage rates to lower aggregate loan balances to prevent wage growth from causing home price appreciation.

Generation X has little or no equity thanks to the housing bust and rampant mortgage equity withdrawal, so they can’t make a move-up. Millennials don’t want to play the game, so they are choosing to rent instead leaving the entry-level market in shambles. Between the two, we have home ownership rates at 48-year lows, a dearth of housing supply, inflated house prices, and little hope of improvement in the short term due to an impending rise in mortgage rates.

In other words, to sabotage the housing market, we simply need to stay the course.

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