Endgame - The bubble stops inflating
Prices stop rising when money for higher prices stops flowing. The two sources of money for purchasing real estate are buyer down payments and loans from lenders. We begin with the point where loan funds are constrained.
Lenders cannot impose both LTV and DCR limits on buyers without eliminating a primary mortgage underwriting tool, the mortgage-equity approach to value. Thus lenders must choose between their two favorite risk management tools. The emphasis moves back and forth between LTV and DCR depending on a variety of factors. The restriction of lender funds as a driver of higher prices comes when the lenders refuse to agree with buyers' opinion of future income increases and higher values. When this happens, lenders switch from an emphasis on LTV to DCR (where DCR is computed using NOI that is dependent on current actual, not projected, rents).
This manifests itself in the form of lower loan-to-purchase price ratios. For example, a buyer may apply for a 75% loan to purchase price based on his valuation of the property using projected income. The lender makes a loan that is 75% loan to value, based on the lender's different opinion of value grounded in existing rents. The dollar amount of the 75% loan-to-value loan offered is 70% of the actual purchase price. The effect is that the lender says to the buyer: "We will finance the part of value we believe in, that part which is based on current income; you must finance the all of the rest in the form of a higher down payment." The lender considers that portion of the purchase price that exceeds the lender's valuation a speculation.
We next address the point at which the buyer refuses to finance, via higher down payments, an additional increment of speculative value.
