Real Estate | Knowledge@Wharton Today

The 20% Down Payment Dilemma: Can Borrowers Afford It?

Posted on May 8, 2012

Despite rock-bottom mortgage rates — around 4% for a 30-year, fixed-rate loan — potential homebuyers are faced with a dilemma: How will they come up with the 20% down payment many lenders now require in order to secure a mortgage? Although the Federal Housing Administration, Veterans Affairs and the U.S. Department of Agriculture offer loans with lower down payments, a recent Knowledge@Wharton story notes that lenders, spooked by regulatory changes and their own recent experiences with defaults, have changed the stakes. Long gone, it seems, are the days when borrowers could get into homes without having to save a considerable amount. Will buyers be able to meet this demand in a poor economy? And what’s the likelihood that lower down payments will return? Wharton real estate professor Todd Sinai weighs in below:

KnowledgeToday: Is it realistic to think that borrowers can come up with 20% in today’s economy?

Todd Sinai: Thirty years ago, a 20% down payment was the norm. Where did borrowers come up with that down payment? They saved, and their parents chipped in. Both tactics are more difficult nowadays. The return to saving is much lower than it has been historically, making it more difficult to accrue a down payment. And, given the recent turmoil in the financial markets, parents are less likely to feel financially comfortable enough to contribute to their children’s down payments. For these reasons, it will take borrowers longer to accrue their down payments than it did in the past, slowing the transition to first-time home buying. Borrowers will also compensate by buying a less expensive first home, reducing the amount of down payment they need to come up with. But it is unrealistic to think that borrowers cannot come up with 20% down payments. If that is what it takes to buy a house, they will do it, however slowly.

KnowledgeToday: Do you believe this is the market model going forward, or is it likely to change anytime soon?

Sinai: I don’t think anyone ever went wrong betting on bankers lending money! Lower down payments will surely return. There is a demand for high LTV [loan-to-value ratio] loans [for credit-worthy] borrowers who simply have not been able to amass enough equity for a 20% down payment but who have the incomes to support the debt service. That demand is especially strong because the return to saving is so low — making it hard to accumulate a down payment — and the cost of borrowing is so cheap. Even if lenders charged a sizeable risk premium for high LTV loans, the absolute cost of borrowing would still be historically low. I expect that lenders will grow ever more comfortable with the risk of lending in the wedge between 80% and 90% LTV and will be happy with the yields they are able to obtain.

The open question is: How long it will take for higher LTV loans to become widespread again, and how far down the credit-quality distribution will those loans be made? They already are available for good borrowers in stable housing markets. Hopefully, lenders will have enough discipline that high LTV loans do not become as widespread as they were in the mid-to-late 2000s, though.

KnowledgeToday: What kinds of changes do you think could most help the ailing housing market?

Sinai: If the demand for housing grows, house prices will rebound. And the bottom line is that demand for housing — for a roof over your head and space for your family — is dependent on employment and income. So the surest way to recovery in the housing market is economic growth and a stable job market. A rebounding economy will first be reflected in the rental housing market — people are still skittish about the permanence of buying a home — and we are already seeing that growth in apartment rents in many cities. Eventually, those renters will become home buyers. Even though the owner-occupied housing market is being handicapped by frictions in the lending market and some reluctance on the part of households to buying, enough growth in the underlying demand for places to live will improve the owner-occupied market nonetheless. And that improvement consequently would mitigate the hurdles of liquidity and buyer skittishness.

That approach begs the question of what policies could improve economic growth — and whether growth is possible in the absence of an improving housing market. By contrast, the policies that have been proposed to jump-start the owner-occupied housing market and clear up households’ balance sheets — for example, allowing for refinancing of under-water mortgages — aim to bootstrap the economy by improving the housing market, which will lead to greater economic growth, which in turn would better the housing market even more.

Should a policy start with the chicken — the economy — or the egg — the housing market? In practice, they are not mutually exclusive. Policies aimed at promoting employment and income growth and policies aimed at the housing market are complementary, and the choice of policy should be guided more by “bang for the buck” rather than by whether it works through the housing market or the broader economy. However, given the long time horizon of housing investments, any housing policy or fiscal stimulus should be permanent rather than temporary.

Featured Professors: Todd Sinai

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Déjà Vu for Latin America’s House Hunters?

Posted on January 13, 2012

Bucking a global trend as house sales slide in countless other countries, home ownership is increasing across Latin America. For the region’s growing middle class, the mood is indeed bullish as many Latin Americans eagerly plow savings and borrowed capital into the housing market.

Banks and other lenders are now offering financing on terms that even lower-income buyers can afford. From Bogota to Brasilia, Latin American governments are stimulating home buying by subsidizing property prices and mortgage rates paid by low-income buyers. First-time low-income home buyers in Colombia, for example, are paying 7% interest on a fixed-rate, 15-year mortgage, or five percentage points less than the going market rate.

But some real estate experts say prices are rising too much and too quickly in some housing markets, and some parts of the region could face dangerous bubbles similar to those in the U.S., China and various parts of Europe. Marja Hoek-Smit, adjunct real estate professor and director of Wharton’s International Housing Finance Program, cites Brazil as a housing market that could be vulnerable to a correction if the economy were to weaken. “The mortgage sector in Brazil is heavily subsidized on the bank deposit side and the lending side, and therefore the housing sector is more prone to see price escalation, particularly in areas where supply cannot keep up with demand because of land and labor shortages,” she says. “If house prices come down, or there is stress on the repayment ability of borrowers, this could expose the banks and the government that guarantees the portfolios to credit risk.”

For now, the panorama in most Latin American housing markets is positive. Bogota in particular is seeing a frenzy of construction activity. A total of 4,000 houses and condominiums will be sold this year in Pereira, a town of 450,000 in western Colombia’s coffee-growing region, double the units sold in 2006, notes Julio Cesar Cardona, an economist with the city’s largest homebuilding trade association.

It’s a similar story in other parts of Colombia. According to the government, property developers sold 152,000 new houses and condominiums in 2010, up 30% from 2009. Through July 2011, new unit sales nationwide were up 19% over the first seven months of last year. Sales could accelerate in the coming months in light of the 80% year-on-year growth in construction permits granted, and some experts predict a 10% rise in house prices in the country.

But can the surge continue? Colombia suffered a housing bubble in the late 1990s that burst when interest rates shot up. The government was forced to intervene, and essentially forgave payment on up to one-third of mortgages, a social policy decision aimed at avoiding a mass wave of evictions.

Local experts insist mortgage lenders have learned their lesson and have imposed tougher underwriting standards. Buyers typically put up 30% down payments of the purchase price, making them less likely to speculate or walk away from an investment if times turn tough. What’s more, the majority of loans are now fixed rate, so borrowers are less likely to be caught out by inflation.

Many real estate experts also see little chance of the kind of widespread housing market crash in Latin America as witnessed in the U.S. It’s partly because there is still huge pent-up demand for housing in a number of Latin American countries, and mortgage lending represents only 3.5% of GDP in Colombia. Even in Chile, arguably Latin America’s most mature market, it’s around 20%, far lower than in many developed countries.

Concerns exist, however, and many revolve around low supply and weak infrastructure. Experts cite those limitations as the reasons for a 50% rise in housing prices and a 20% decline in unit sales over the first half of 2011 in some parts of Sao Paulo, the continent’s largest city. Traffic jams, in particular, have inflated the value of well-located apartments and houses to astronomical levels. The Brazilian megalopolis, which still lacks a ring road around the urban core, illustrates what the World Bank’s chief economist for Latin America, Augusto de la Torre, describes as the hemisphere’s “structural speed limits to growth.”

Demand for housing across Brazil has been stirred by heavy government subsidies, both with below market mortgage interest rates and price discounts, as part of a goal set by President Dilma Rousseff of building two million new housing units since 2009. But housing supplies have not kept up with the demand that the discounts have helped to create, causing prices to rise to what some describe as bubble levels and raising concerns that it could burst.

Featured Professors: Marja Hoek-Smit

Also posted in Law and Public Policy | Tagged housing market, Latin America, real estate | 1 Comment

India’s Private Equity Market Is Back

Posted on May 4, 2011

Foreign investment flows to India are on the rise as part of the general movement of capital towards emerging markets, the world’s growth engines of the future. And private equity (PE) is one area clearly picking up in India largely thanks to outside money, according to panel members at the recent Wharton India Economic Forum.

Although India’s overall economy barely suffered, PE investment in India took a big hit during financial crisis because of the blow that PE absorbed globally. Some 80% of PE funds in India come from foreign funds. As PE funds have bounced back over the last year with the world economy, many investors are focusing more on emerging markets with the greatest growth potential, such as India and Brazil.

While acknowledging solid potential gains for PE investors, participants on a panel titled “Private Equity: Investing in India – Getting Higher Returns” urged caution, most notably around governance, income tax and general regulatory issues, which remain huge challenges in India. Panelists also noted that India offers a fragmented PE market, often involving family owned businesses and minority stakes, and with little to no opportunities for leveraged buy-outs.

Mukund Krishnaswami, a founding partner of Lighthouse Funds, a PE company that manages $150 million in India, also warned investors to be “careful of betting big” on the things everybody wants to bet on. “The things you hear are hot today are not going to be hot in three to four years. What matters is what is in demand three, four or five years” in the future. “PE is about getting out” and so the question is, “can you return money to investors? The drivers today may not be the drivers in 2015.”

Krishnaswami recommends that investors be “opportunistic and cast a wide net.” Rather than focusing on one industry, PE firms should be generalists that try to take advantage of mega trends. For example, India is noted for its young population and huge trend towards urbanization. “But what does that mean for investors?” Not everyone is moving into the biggest cities. Instead, people from the country tend to move to tier 4-sized cities, and those in tier 4 cities tend to move to tier 3 cities, etc. “That is the shift,” Krishnaswami said. The trick is to know how consumer needs and aspirations differ at each level and to direct investments in a more nuanced way. Part of making successful PE investments in India will be “understanding what is the micro trend below the macro trend.”

Nevertheless, the maco trend in real estate looks like a good bet, said Gulbir Madan, founder and chairman of Brahma Management. “The big story is the domestic demand story.” There is a “huge demand for residential real estate that is just getting organized.” Anything with good management should do well, he added. More generally, investors should be prepared for “a long-term commitment.” Expect a “lock up of at least 10 years — everything takes longer than it should, and so investors must be extremely patient.”

Madan and other panelists also cautioned that pricing in the PE market generally in India has recovered from the financial crisis and is again on the high side.