Chapter 2 Real Estate Cycle and the Secondary Market

I. The Real Estate Cycle

The Real Estate Cycle The REAL ESTATE CYCLE, like the business cycle, refers to the activity of the real estate market as it reacts to the forces of supply and demand. A cycle is characterized by a general expansion of real estate activity which peaks and then begins to contract leading to a bottoming out of activity. At this point activity again turns up leading to a new peak of activity. A widely accepted rule of economics is that all business activity, including the real estate market, reacts to the forces of supply and demand. It is also an accepted principle that supply and demand will always seek to balance each other. A widely accepted rule of economics is that all business activity, including the real estate market, reacts to the forces of supply and demand. It is also an accepted principle that supply and demand will always seek to balance each other.

Figure 2-1

A. SUPPLY AND DEMAND When demand for a product (such as housing) exceeds the supply, the price for the product tends to increase. SELLER’S MARKET Higher prices encourage the suppliers, in this case home builders, to increase production. Higher prices encourage the suppliers, in this case home builders, to increase production. As production increases, more of the demand is satisfied until a point is reached where production outstrips demand. At that point, prices begin to fall and production will taper off until demand catches up with supply, and the cycle begins again. BUYER’S MARKET

B. BALANCE Economic theory holds that in a healthy economy, supply and demand should be in balance. Balance is the economic principle that value is created and maintained when opposing economic market forces are in a state of equilibrium. The forces that affect supply and demand are constantly changing and thereby constantly shifting supply and demand out of balance.

II. Factors Influencing Real Estate Cycles

Factors Influencing Real Estate Cycles Imbalances in supply and demand may be either short-term or long-term, depending on their causes. Factors that influence the cycle are the availability of mortgage funds, demographic changes within the population, the state of local and national economies, the cost of labor and materials, and finally political and social attitudes. Factors that influence the cycle are the availability of mortgage funds, demographic changes within the population, the state of local and national economies, the cost of labor and materials, and finally political and social attitudes.

A. MORTGAGE FUNDS The availability of mortgage funding affects both supply and demand for housing. For many years it was assumed that local economic trends created the strongest influence on supply and demand in the market place and thus on the real estate cycle. While local economic health is still a major factor, it is becoming more and more overshadowed by the national economy. For many years it was assumed that local economic trends created the strongest influence on supply and demand in the market place and thus on the real estate cycle. While local economic health is still a major factor, it is becoming more and more overshadowed by the national economy. DISINTERMEDIATION The housing market is itself very sensitive to minor changes in the interest rate.

Example: Let us assume that a house has a sale price of $100,000. The buyer puts down 20% of the sale price as a down payment. The monthly payment for an $80,000 thirty-year mortgage on the house at 7.5% interest is $ Now let’s assume that the price of the house increases to $150,000 and the rate remains the same. The down payment is still $20,000. The monthly payment for a thirty-year mortgage on $130,000 at 7.5% will be $ A one percent increase to an 8.5% rate would make the payment $

B. POPULATION Population demographics are an important factor in the success of a local real estate market. Population demographics are an important factor in the success of a local real estate market. DEMOGRAPHICS refer to the study and description of the population of an area. Demographics include such factors as age, education, gross income, disposable income, number of family members, and savings and spending patterns. Demographic data is important to community planners, developers, politicians, and real estate professionals in order to recognize and plan for changing trends in their areas and communities.

C. SOCIAL ATTITUDES A major factor that has impacted both the availability of housing and mortgage funding has been the changing social behavior patterns of the population. A modern example is the increase in the portion of the population that is in its prime home buying years. Both baby boomers and their children are now seeking housing Both baby boomers and their children are now seeking housing High divorce rates Later marriages

D. POLITICAL ACTIVITY The supply and demand for housing and credit depends on notoriously unpredictable political forces. Because the national government is the largest borrower in the country, its activities have a huge influence on the economy. DEFICIT SPENDING by Congress forces the government to borrow money, making less money available for construction and home loans.

E. REGULATION Regulation by local, state, and federal governments is pervasive in almost every activity engaged in by our citizens. This regulation takes the form of federal, state and local tax laws, environmental regulations, lending laws, and local zoning and building codes. The vast majority of these laws and regulations have been enacted to protect the environment, promote public safety, or to protect consumers from predatory loan practices. PREDATORY LOAN PRACTICES At the local level, homes are subject to property taxes and IMPACT FEES which can often deter or prevent further development.

III. The Role of the Secondary Mortgage Market

The Role of the Secondary Mortgage Market The supply of funds available for investment in real estate mortgages is channeled into either the primary or secondary market. PRIMARY MARKET SECONDARY A real estate loan is an investment, just like stocks or bonds. Real estate loans can be bought and sold just like other investments. The present value (cash today) of the lender’s right to receive future payments over the life of the loan can be calculated by comparing the rate of return on the loan to the rate of return on other investments with the same DEGREE OF RISK. The present value (cash today) of the lender’s right to receive future payments over the life of the loan can be calculated by comparing the rate of return on the loan to the rate of return on other investments with the same DEGREE OF RISK. QUALIFY A BORROWER QUALIFY A PROPERTY The secondary market provides cash liquidity to primary lenders through the purchase of mortgages.

IV. Agencies of the Secondary Market

Agencies of the Secondary Market For the purposes of our discussion, the secondary market may be said to include three agencies: 1. Fannie Mae 2. Government National Mortgage Association (Ginnie Mae) 3. The Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac”) The secondary market is able to function as it does because of the standardized underwriting criteria applied by these agencies. UNDERWRITING CRITERIA

A. Federal National Mortgage Association (FNMA –“Fannie Mae”) Fannie Mae dominates the secondary mortgage market. Originally it bought and sold only FHA and VA loans deeds. FNMA underwent several reorganizations and is now a privately owned and managed corporation called “Fannie Mae.” Fannie Mae funds its operation by selling securities which are backed by its pool of mortgages to the public. It buys the mortgages from lenders.

B. GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) The GOVERNMENT NATIONAL MORTGAGE ASSOCIATION, or “Ginnie Mae,” was created with the passage of the Housing and Urban Development Act (1968). It is a wholly-owned government corporation. A primary function of GNMA is to promote investment by guaranteeing the payment of principal and interest on FHA and VA mortgages. GNMA carries out this function through its mortgage-backed securities program. BOND-TYPE SECURITIES PASS-THROUGH SECURITIES FULLY MODIFIED PASS-THROUGH SECURITIES

C. FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC) The FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC), which is also known as “Freddie Mac,” was created through the Emergency Home Finance Act (1970). The FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC), which is also known as “Freddie Mac,” was created through the Emergency Home Finance Act (1970). The primary function of FHLMC was to aid savings and loan associations who were hit particularly hard by the recession of FHLMC is now regulated by the U.S. Department of Housing and Urban Development (HUD). FHLMC is now regulated by the U.S. Department of Housing and Urban Development (HUD). FHLMC emphasizes the purchase of conventional mortgage loans, and also actively sells the mortgage loans from its portfolio, thus acting as a conduit for mortgage investments. IMMEDIATE DELIVERY PROGRAM FORWARD COMMITMENT PURCHASE PROGRAM

NOTE: In 2008, the federal government took control of Fannie Mae and Freddie Mac in an effort to keep the two mortgage giants from failing, disasters that would have made home loans still harder to get. The government agreed to pump billions of dollars into Fannie Mae and Freddie Mac and assume responsibility for trillions of dollars of their debt, while handing control of the companies to federal regulation by the Federal Housing Finance Agency (FHFA).

V. Quality Control

The secondary market has an enormous influence on the primary market, not only because of the increased availability of funds that it provides, but also because of the standards of quality it imposes on lenders. Because lenders wish to be able to sell their loans to the secondary agencies, they must follow the underwriting guidelines of those agencies. The secondary market is trying to improve the quality of the loans it purchases and ensure the reputation of residential mortgages as a safe investment. The secondary market is trying to improve the quality of the loans it purchases and ensure the reputation of residential mortgages as a safe investment. The secondary market encourages lenders to implement their own quality control programs.

VI. CHAPTER SUMMARY The real estate cycle has four phases, beginning with an expansion of real estate activity that leads to a peak, and then a decline to a bottom or trough. Expansion then begins again, leading to another peak and the completion of the cycle. The cycle is driven by supply and demand. Supply and demand for both real estate and mortgage money is affected by economic, social, and political factors. Political regulation of housing and lending, while intended to protect consumer health, safety, and quality of life, has often tended to increase the price of housing for consumers. The establishment of a national secondary market to buy and sell mortgages has worked to soften drastic swings in the real estate cycle by insuring that mortgage money is available at all stages within the cycle. The major players in the secondary market are FNMA, FHLMC, and GNMA. The establishment of a national secondary market to buy and sell mortgages has worked to soften drastic swings in the real estate cycle by insuring that mortgage money is available at all stages within the cycle. The major players in the secondary market are FNMA, FHLMC, and GNMA.