The middle class is shrinking and as a result we see fewer first-time buyers, lower homeownership rates and thus increased demand for rental properties. For real estate investors, the contraction of the middle class is a reality which cannot be ignored.
“The American middle class is losing ground,” said the Pew Research Center in a new study. It pointed out that “the middle class made up 50 percent of the U.S. adult population in 2015, down from 61 percent in 1971.” It also said that the middle class earned 62 percent of our income in 1970, but only 43 percent in 2014.
Although the middle class is getting relatively smaller it still needs housing. Since the purchase of a home is increasingly difficult renting becomes the major alternative.
“The decade-long surge in rental demand is unprecedented,” says a new report from the Joint Center For Housing Studies at Harvard University. “In mid-2015, 43 million families and individuals lived in rental housing, up nearly 9 million from 2005 — the largest gain in any 10-year period on record. In addition, the share of all U.S. households that rent rose from 31 percent to 37 percent, its highest level since the mid-1960s.”
As a country we want a vibrant and growing middle class. That’s a goal to which the poor can reasonably aspire, a comfortable financial status and maybe a starting point toward the upper-income brackets. Pew says the “middle class” can be defined as those who make roughly $42,000 to $126,000 annually in 2014 dollars for a household of three.
We want a strong middle class because those are the folks who have a ready capacity to buy from the rest of us. Consumer spending equals roughly 70 percent of our economic activity and as the Federal Reserve Bank of St. Louis explains, “it is no exaggeration to say that consumer spending was the dominant source of economic growth in the United States during recent decades.”
The Debt Bomb
If you’re in the middle class then by definition you should have enough income in most areas to buy or rent as you prefer, purchase a car and eat out with some frequency.
The catch is that income is only part of the equation. You can earn a lot of money and still be effectively “poor” if you do not control debt.
According to the Federal Reserve Bank of New York we’re actually doing pretty well in the debt department. Our total debt balance, says the Bank, fell from a high of $12.68 trillion in 2008 to $12.07 trillion by the third quarter of 2015. That’s more than $600 billion wiped off the family books.
Seen another way, in 2009 household debt equaled 98 percent of our gross domestic product, a percentage which dropped to 80 percent by 2015. That is unquestionably good news for both consumers and the economy in general.
Unfortunately, the nature of debt has changed. Between 2008 and 2015 mortgage debt fell by more than $1 trillion while student debt emerged as a major budget buster, going from $260 billion in 2004 to $1.2 trillion in 2015. What we gained in mortgage savings we lost in student debt.
It’s not just that what we owe has changed, it’s when we owe. Few teenagers rack-up mortgage debt but that’s not the same for student loans. It’s a simple matter to owe tens of thousands of dollars in student debt before the age of 21, debt that will take years if not decades to repay and — importantly — debt that can hold down the ability to get a mortgage.
Student debt is a huge problem for several reasons: First, going to college no longer assures a middle-class lifestyle. The fact is that while student debt is soaring income is not; household income in 2014 was actually 7.2 percent lower than in 1999.
Second, because the debt-to-income ratio (DTI) is commonly limited to 43 percent — the usual standard for Qualified Mortgages (QMs) under Dodd-Frank — then more student debt leaves less room for other kinds of bills, including mortgage financing.
Third, it is possible to defer student debt for several years. This may sound enticing but new FHA rules say lenders can’t ignore student debt even if there are currently no monthly payments. Instead, lenders have to add in an amount equal to 2 percent of outstanding amount each month to calculate the DTI for FHA-backed loans. If you owe $30,000 that’s $600.
The new economics of less income and more personal debt make home buying less plausible for millions of people who once might have been considered potential buyers. For investors the changing fortunes of the middle class mean more people are looking for rental units, and more demand means generally rising rental rates and fewer vacancies.
The Middle Class, More or Less
The declining economics of the middle class explains in large measure why we see fewer first-time buyers, why homeownership levels have fallen, and consequently why the rental market is now so robust.
But what about the future? Will rental properties be affordable if middle-income households have less and less to spend?
The current situation, says J. Ronald Terwilliger, chairman emeritus and retired Chief Executive Officer of Trammell Crow Residential, raises red flags, not only for real estate investors but for everyone.
“For renters, securing affordable housing is particularly challenging — more than 11 million renter households, greater than one-in-four, devote in excess of 50 percent of their incomes to housing. An acute shortage of affordable rental homes is a major factor contributing to these unsustainable housing costs.
“With mortgage credit tightening,” he adds, “the national homeownership rate has plummeted to a 48-year low. The homeownership rates for African-American and Hispanic households have fallen dramatically, while fewer first-time homebuyers are entering the market despite historically low interest rates. As if trapped in a vicious cycle, many young families are finding it difficult to save for a mortgage down payment because of rising rents.
“These problems of rental affordability and homeownership access are likely to worsen over the next 15 years as millions of young millennials, many of them African-American and Hispanic, form households for the first time.”
Terwilliger is saying that our looming problem is not the expanding demand for rental units; it’s the growing inability to pay for them. The conditions which now create higher rental rates and fewer vacancies are great for investors, but those conditions cannot continue indefinitely. At some point tenant incomes have to rise otherwise rents cannot be maintained much less increased.
How will the economy respond?
That’s the magic question.
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