We continue our focus on Woodbridge HELOC abusers and Ownership Cost with a discussion on property taxes and Mello Roos.

Irvine Home Address … 13 LONGSHORE 79 Irvine, CA 92614
Resale Home Price …… $560,000

{book1}

Raven hair and ruby lips
sparks fly from her finger tips
Echoed voices in the night
she’s a restless spirit on an endless flight
wooo hooo witchy woman, see how
high she flies
woo hoo witchy woman she got
the moon in her eye
She held me spellbound in the night
dancing shadows and firelight
crazy laughter in another
room and she drove herself to madness
with a silver spoon

Witchy Woman — The Eagles

Today is part 3 in the ongoing series on Ownership Cost:

Ownership Cost: Income, Payments and House Prices

Ownership Cost: Interest Rates and Downpayment Requirements

Ownership Cost: Property Taxes and Mello Roos

Ownership Cost: Homeowners Associations

Ownership Cost: Taxes and Opportunity Costs

Four Major Variables that Determine Market Price

Over the last two days we looked at the four main variables that determine home price:

1. borrower income,
2. allowable debt-to-income ratios,
3. interest rates, and
4. downpayment requirements.

Today we are looking at some of the minor cost inputs that work by influencing the four major ones; property taxes and Mello Roos taxes.

When you qualify for a loan, the difference between what your income can support and the payment you can make to the lender is a number of related expenses that only homeowners must pay; property taxes, special assessments and Mello Roos, insurance and homeowners associations. These expenses (1) reduce your payment to the lender, (2) reduce the amount you can borrow and bid, and thereby (3) reduce the value of real estate. Over the rest of this week, we will look at these costs of ownership.

Property Taxes

Property taxes have long been a source of local government tax revenues. Real property cannot be moved out of a government’s jurisdiction, and values can be estimated by an appraisal, so it is a convenient item to tax. In most states, local governments add up the cost of running the government and divide by the total property value in the jurisdiction to establish a millage tax rate.

California is forced to do things differently by Proposition 13 which effectively limits the appraised value and total tax revenue from real property. Local governments are forced to find revenue from other sources.

Proposition 13 limits the tax rate to 1% of purchase price with a small inflation multiplier allowing yearly increases. In California, the first half of regular secured property tax bills are due November 1st, and delinquent after December 10th; the second half are due February 1st, and delinquent after April 10th each year. If the delinquent date falls on a Saturday, Sunday, or government holiday, then the due date is the following business day.

Often the lender will compel the borrower to include extra money in the monthly payment to cover property taxes, homeowners insurance, and private mortgage insurance, and these bills will be paid by the lender when they come due. If these payments are not escrowed by the lender, then the borrower will need to make these payments. We have had some contentious discussions about impound accounts, and I remain a fan of them. The tiny amount of extra interest you may make saving in your own account is not worth the hassle.

Due to Proposition 13, the property tax bill is very easy to calculate; take one percent of the purchase price. Divide it by twelve to get the monthly cost. We do this in IHB Property Valuation Reports.

Automatic re-assessment for cash-out refinancing

An idea emerged from the aftermath of the housing bubble; limit HELOC abuse by making cash-out refinancing in excess of the original purchase price an event that triggers property tax re-assessment. The effect is to drive up the cost of borrower money and discourage the behavior. It would probably be very effective.

The lenders would cry foul, and in particular there may need to be an exception for reverse mortgages to accommodate seniors (I think reverse mortgages are a bad idea, but forcing retired people to leave their homes is probably worse). Despite the resistance, the legislation if passed would curtail HELOC abuse, but in an economy dependant upon Ponzi Scheme financing, such legislation is unlikely; although, if the budget shortfall gets bad enough, everything will be on the table.

Mello Roos Taxes

In our reports, we classify these as other taxes and assessments because Mello Roos fees are paid through your tax bill. To understand how this became a tax you pay, a brief overview of the Community Facilities District Act is in order (What is Mello Roos?.pdf). From Wikipedia:

A Mello-Roos District is an area where a special property tax on real estate, in addition to the normal property tax, is imposed on those real property owners within a Community Facilities District. These districts seek public financing through the sale of bonds for the purpose of financing public improvements and services.
These services may include streets, water, sewage and drainage,
electricity, infrastructure, schools, parks and police protection to
newly developing areas. The tax paid is used to make the payments of
principal and interest on the bonds.

Mello-Roos is deductible in some cases but not in others.

That is the textbook version, now I will give you mine. Imagine you are a real estate developer, and you have a parcel of land that would be worth $10,000,000 if it had infrastructure installed; unfortunately, you do not have the money to install this infrastructure and wait for the investment to come back to you in land or home sales.

What if you could take out a 30-year mortgage on your infrastructure improvements and borrow the money? Now you can finance the deal and develop the land, but there is still a problem. How do you get the homeowner to pay off the infrastructure mortgage after they buy the house?

The solution elected officials came up with was to create a special tax district so the repayment of the bonds to fund the infrastructure is bumped up the payment priority list. In short, you can’t avoid paying Mello Roos, or the tax man will be after you, and he has the power of foreclosure, though it is seldom used.

For those of you that are homeowners, the next time you write that check for Mello Roos, realize that you are paying down the loan for the infrastructure around you. You didn’t think the developer absorbed those costs, did you? That would cut into profits.

Realistically, Community Facilities Districts do encourage private development by making marginal projects feasible. It keeps development in the hands of private individuals rather than municipalities developing their own roads, streets and utility systems. To the degree you believe these results are desirable, you should support Mello Roos.

Without the ability to develop marginal projects, supply is always lagging behind. The Community Facilities District Act does encourage development to lead into growing markets and blunt the impact of supply shortages. Despite the additional supply this law puts on the market, it has failed to prevent housing bubbles.

Determining Mello Roos

Property taxes and Mello Roos fees are deducted from a borrower’s available income to service cashflow, and thereby it reduces the amount they can finance. In essence, there is already a 30-year mortgage on the property you must pay off — your portion of the Mello Roos — so the purchaser money mortgage must be paid with left-over funds.

Builders and developers both know the impact of Mello Roos, so builders will pay less for lots with high Mello Roos fees because they know they will have to discount the purchase price of the final product in order to qualify any buyers. Developers want the Mello Roos fees to be as high as possible because the higher the fees, the greater the bond revenue developers receive. Builders want the Mello Roos to be as low as possible to give them competitive advantage. The resulting compromise usually puts Mello Roos at between 0.5% and 0.8% of total value.

The good news with Mello Roos is that the fees are fixed. As house prices go up, the Mello Roos fees become less burdensome to later buyers. If the Mello Roos are set at 0.8% of an initial $200,000 sales price, the same figure represents only 0.4% of a $400,000 resale price. Of course, the reverse is also true.

When the Irvine Company first opened Woodbury and Portola Springs, they were priced to the peak and they had maximum Mello Roos. Now that houses are selling for lower price points, the Mello Roos start to become onerous. If the original sale price of a condo was $400,000, and the Mello Roos were 0.8% of value, if the condo resells for $200,000, the Mello Roos now represent 1.6% of the purchase price. That is a stiff property tax bill by California standards.

Does anyone know if the Irvine Company has bought down the bonds on Woodbury or Portola Springs, or are new buyers going to get a huge Mello Roos tax bill and an unsettling surprise?

Irvine Home Address … 13 LONGSHORE 79 Irvine, CA 92614

Resale Home Price … $560,000

Income Requirement ……. $104,246
Downpayment Needed … $112,000

Home Purchase Price … $585,000
Home Purchase Date …. 11/21/2003

Net Gain (Loss) ………. $(58,600)
Percent Change ………. -4.3%
Annual Appreciation … -0.7%

Monthly Mortgage Payment … $2,432
Monthly Cash Outlays ………… $3,180
Monthly Cost of Ownership … $2,390

Redfin Property Details for 13 LONGSHORE 79 Irvine, CA 92614

Beds 2

Baths 2 baths
Size 1,930 sq ft
($290 / sq ft)
Lot Size n/a
Year Built 1983
Days on Market 61
Listing Updated 10/21/2009
MLS Number S586981
Property Type Condominium, Residential
Community Woodbridge
Tract L

According to the listing agent, this listing may be a pre-foreclosure or short sale.

Back on the market!!! Unique luxury townhome located in the ‘South Lake’ area of Woodbridge. Tri-level floor plan featruring 2 bedrooms + FULL DEN located on the water with amazing views! Upgraded kitchen with granite counters, stainless steel appliances, remodeled bathrooms featuring travertine & slate. Huge master suite with large retreat, walk-in closet, finished attic. Inside laundry room on 3rd floor!

featruring?

Today’s featured property was a classic housing bubble workhorse — the owner worked this place for every penny of appreciation available.

• The property was purchased on 11/21/2003 for $585,000. The owner used a $400,000 first mortgage, a $126,500 second mortgage, and a $58,500 downpayment.
• On 2/18/2005 the owner refinanced the first mortgage for $525,000.
• On 7/13/2005 he refinanced for $605,500.
• On 4/19/2006 he refinanced for $720,000.
• On 7/2/2009 he stopped paying his mortgage.
• Total property debt is $720,000.
• Total mortgage equity withdrawal is $193,500.

Foreclosure Record
Recording Date: 07/02/2009
Document Type: Notice of Default
Document #: 2009000349556

Today I have an in-depth look at how borrower income levels impact payments and house prices; plus, I profile an epic HELOC abuser.

Irvine Home Address … 32 Summerwind Irvine, CA 92614
Resale Home Price …… $640,000

{book1}

You always keep me guessin
I never seem to know what you are thinkin
And if a fella looks at you
It’s for sure your little eye will be a-winkin
I get confused, cause I don’t know where I stand
And then you smile, and hold my hand
Love is kinda crazy with a spooky little girl like you
Spooky

If you decide someday to stop this little game that you are playin
I’m gonna tell you all what my heart’s been a-dyin to be sayin
Just like a ghost, you’ve been a-hauntin my dreams
So I’ll propose on Halloween

Spooky — Atlanta Rhythm Section

I revisited my post on Rent Versus Own where I talked about the cost of ownership. Many of the questions people have about our IHB Property Valuation Reports are related to the various cost inputs and how they impact values. Therefore, I want to take each of these costs and talk about them in more detail. In order to do this in a logical flow, I have broken this task into a series of five posts that will be debuting all this week. These posts are:

Ownership Cost: Income, Payments and House Prices

Ownership Cost: Interest Rates and Downpayment Requirements

Ownership Cost: Property Taxes and Mello Roos

Ownership Cost: Homeowners Associations

Ownership Cost: Taxes and Opportunity Costs

I haven’t finished them yet, so we will see if my performance matches my ambitions….

Four Major Variables that Determine Market Price

There are four variables that determine the purchase price of a property:

1. borrower income,
2. allowable debt-to-income ratios,
3. interest rates, and
4. downpayment requirements.

These variables are impacted by some other minor cost inputs which I will be discussing on Wednesday through Friday, but for the most part, the variables above determine market pricing. The first two variables are the focus of today’s post, and the last two are the topics for tomorrow.

Payment is a direct link to borrower gross income. The debt-to-income ratio allowed by a lender applied to the borrower’s monthly income is the maximum allowable monthly housing expense an underwriter will consider. From this amount, a lender will subtract an allowance for taxes and insurance to calculate the total amount of the available housing expense applicable to debt service. Here is where interest rates enter the calculation.

Lenders have complex formulas — which thankfully are distilled into simple spreadsheet commands — that are used to calculate loan balances, payments and other important numbers. If the payment is known (which we calculated above), and you apply an interest rate and amortization schedule, the inputs can be put into a spreadsheet or financial calculator (or it can be laboriously calculated by hand) to come up with a loan amount.

Once the largest loan amount a certain level of borrower income can support is known, adding the downpayment requirement to the loan amount equals the amount a borrower can pay for a house. At that point it is a numbers game. Are there more buyers at these income levels than properties available? If so, then prices stabilize or go up. If there are fewer buyers than available property, then prices go down. As a society are we going to allow banks to be the new housing cartel releasing product only as they get their price? That is where we are headed.

Borrower Income and Wage Inflation

Borrower gross income is the basis of all lending… or is it? With Stated Income (liar loans), income doesn’t matter… When you think about that for a moment, it isn’t a mystery why liar loans went away first; they undermine the foundation of all lending — accurately measuring borrower capacity.

Wage inflation is the slow increase in aggregate wages over time in a given area. Wage inflation is a driver of price inflation because workers will use wage increases to bid up the cost of goods and services they demand. in a housing market, wage growth pushes up prices as follows:

Assume a worker is earning $100,000 and can borrow $400,000 to bid on property in today’s market. In one year, if this worker gets a 3% raise (not this year), he will be making $103,000, and if other terms do not change, he will be able to borrow $412,000. If he has also increased his savings, the amount he can bid on real estate has also increased by 3%.

A property that might sell for $500,000 today can sell for $515,000 in one year and it is no more expensive in terms of its financial impact; debt-to-income, savings impact, time of amortization — the key variables remain the same. This is “normal” home price appreciation.

Prices should mirror incomes

In a normal real estate market, people at each income strata compete with each other for available properties in their price range. If there is a shortage of supply, shoppers learn to settle for less. Rather than a 3/2, someone settles for a 2/2 with a den. A shortage of supply does not necessarily make for higher prices; it can simply result in a lowered standard of living as people take the income they have and compete for what is available.

Assuming supply is sufficient — which in the long term it always is — the most desirable properties will be held by the highest wage earners, and the least desirable properties will be inhabited by the lowest wage earners. That is how markets work. Is there a better way? The median income will control the median property over time, and the median home price should represent the median income applied to conventional financing metrics.

In Irvine, the last reported median income is $91,101. I doubt it has gone up. If you take $91,101 / 12 x 0.31 = $2,353. That is the maximum amount a median wage earning household should be putting toward housing costs. Looks similar to the median rent, doesn’t it? If you calculate the largest loan amount $2,535 can service at 5.1%, you get $433,454 (real loan balances would be lower due to taxes, HOAs and insurance). If you assume this is 80% of a purchase amount (20% down), then the total purchase price would be $541,818 — a number very close to the current Irvine median.

I am not saying we are at a bottom because I do not believe the government props are stable, and there are future supply issues, but I believe payment affordability is the best it has been in years, and it may not improve even if prices fall further.

What would create demand?

Payment affordability is at an all-time high thanks to the Federal Reserve. IMO, this indicator is likely near its peak for the cycle. The Federal Reserve can make the cost of borrowing so low that any price can be made to cashflow.

Markets like Irvine have not crashed as hard as subprime markets, and since prices are still greatly elevated here, a huge increase in affordability brings the ridiculous into reach. In the beaten down subprime markets, affordability is remarkable.

Here is where it gets strange — prices will continue to fall, and interest rates will be allowed to creep upward resulting in lower payment affordability even as prices move lower. The slow erosion of payment affordability is the inflationary push the economy needs to motivate idle cash — like all of us fence sitters.

People who buy now will experience payment affordability at unprecedented levels in many markets. They will endure a slowly sinking ship that reaches low tide in three to five years. Prices will get back to their entry points in 2015 to 2020. If they wait it out or take a minor loss (amortizing loans with downpayments give them flexibility), they still have mobility, and future ARM meltdowns should be averted.

Buyers over the next three to five years will get lower prices, but it will cost them more to get it because payment affordability will decline with higher interest rates. Perhaps prices will fall fast enough to increase payment affordability, but with the shadow inventory remaining in the shadows, there is no reason to believe prices will be dropping 30% until this inventory hits the market.

Payments using conventional financing are now affordable. Will they remain that way?

Allowable Debt-to-Income Ratios

The Allowable Debt-to-Income (DTI) Ratio is a limit lenders determine is the largest percentage of your wage income you can give them before you go into default on the loan. Lenders have been steadily increasing allowable DTIs since the 1970s. They are out to squeeze every available penny out of your life.

Lenders permit these higher DTIs ostensibly to allow customers to bid on more expensive homes. The result is a higher equilibrium price for all properties in a market and a higher percentage of income that the general population is putting toward debt service. Lenders are knowingly putting their customers in a state of perpetual servitude.

Borrowers sacrifice disposable income in order to service a higher DTI — wait! — is there a way to increase disposable income and service a higher DTI? It would be a panacea…. Lenders solved this problem with the Option ARM, and they used it to inflate The Great Housing Bubble.

{book4}

The moment lenders allowed customers to pay debt with increasing debt, it became a Ponzi Scheme, and it was doomed to crash. It is amazing how large it became; hundreds of billions of dollars flowed into these Ponzi Scheme assets. The collapse of the subprime home mortgage Ponzi pyramid was a precipitating factor that lead to the financial meltdown of 2008.

The beauty of the arrangement was the sales pitch; you can get a huge pile of spending money, pay less per month on your mortgage, and whenever you needed more, the California ATM house will magically refill itself with money through home price appreciation. It was self-reinforcing delusion used to hide a Ponzi Scheme beneath.

I can see why the idea is popular with bankers and customers alike; lenders get to write larger loans which put more investor money to work, and borrowers get to borrow and spend like maniacs. Ponzi Schemes work well in the beginning.

In the end, we are left with a large number of people who greatly overborrowed. The overleveraged masses are realizing that they will have to give up the disposable income and lavish lifestyle if they are going to keep their homes. It is the inevitable result of the failure of lenders to resolve the basic dilemma of increased payments with increaseed borrowing. Many people are walking away.

The mortgage market is struggling to find an equilibrium DTI where borrowers do not default. The first round of loan mods back in 2008 tried to use 38%, and it was a dismal failure. The latest round of loan mods is using 31% (like the FHA), and although the success rates are not much better, the current defaults are strategic based on being underwater, not because they cannot afford the payment.

In short, allowable DTIs are going to retreat to stable levels between 28% and 32% before terms stabilize and we begin on the next Ponzi Scheme.

Interest Rates

Tomorrow’s post is part 2 Ownership Cost: Interest Rates and Downpayment Requirements.

Irvine Home Address … 32 Summerwind Irvine, CA 92614

Resale Home Price … $640,000

Income Requirement ……. $119,139
Downpayment Needed … $128,000

Home Purchase Price … $284,000
Home Purchase Date …. 9/9/1994

Net Gain (Loss) ………. $317,600
Percent Change ………. 125.4%
Annual Appreciation … 5.2%

Monthly Mortgage Payment … $2,780
Monthly Cash Outlays ………… $3,620
Monthly Cost of Ownership … $2,720

Redfin Property Details for 32 Summerwind Irvine, CA 92614

Beds 3
Baths 2 full 1 part baths
Size 2,091 sq ft
($306 / sq ft)
Lot Size n/a
Year Built 1981
Days on Market 105
Listing Updated 10/5/2009
MLS Number S581455
Property Type Condominium, Residential
Community Woodbridge
Tract Wc

According to the listing agent, this listing may be a pre-foreclosure or short sale.

Wow,Woodbridge Beauty, Inside The Loop, Close to Lake & Swimming Lagoon. It’s Gorgeous,3 Bedrooms,2 1/2 Bath,Plus Upstairs Bonus Room/Office. 2 Car Direct Access Garage,Remodeled Kitchen and Bathroom,Granite Countertops,Custom Lighting,Beautiful Cabinets,Designer Flooring,Engineered Wood,18’x18′ Porcelain Tile Stainless Steel Fridge Microwave, Window Blinds,Separate Family Room and Living Room with Gas Fireplace With Large Mirror,Master Bedroom Retreat Area,If That Were Not Enough,Enjoy The Enclosed Gardener’s Delight Landscaped and Hardscaped Yard With Covered Patio,Enjoy All That Woodbridge Has To Offer,Lakes,Lagoons,Swimming Pools,Tennis Courts,Walking & Bike Trails,Excellent Schools,It Just Feels Like Home.

Title Case? Why Do People Write In Title Case? You Have To Remember To Press Shift At Each Word, And It Slows You Down. Plus It Is Very Difficult To Read.

TheListingAgentDoesn’tLikeSpacesEither.

• This property was purchased on 9/9/2004 for $284,000. The owners used a $213,000 first mortgage and a $71,000 downpayment. The 2000 purchase amount was part of a divorce settlement and does not reflect the price of the property at the time. After the split, our remaining owner began sipping kool aid.
• On 6/18/2001 he opened his first HELOC for $20,000.
• On 10/10/2003 he refinanced the first mortgage for $341,000.
• On 10/10/2003 he opened a HELOC for $99,000.
• On 10/28/2005 he refinanced the first mortgage for $600,000.
• On 11/4/2005 he opened a HELOC for $250,000.
• Total mortgage debt is $850,000 assuming he maxed the HELOC.
• Total mortgage equity withdrawal is $637,000 including his downpayment.

This guy borrowed and spent over $600,000 in about 3 years (2003-2005). It must have been quite a party.