Real Estate of Affairs: Will the Bubble Burst or Find Balance?
For the last couple of years, homes have enjoyed double-digit valuation increases – on average - creating a huge equity bonanza. This housing bubble is unsustainable for a number of real-world reasons. Is the bubble about to burst? Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Houston, We (May) Have a Problem
Recent mortgage rate increases have already taken a toll on the demand side of the housing market equation. According to real estate brokerage firm Redfin, monthly mortgage payments are up 39% from a year ago. This is impacting prospective homebuyers. Take Houston's red-hot housing market, for example. According to the Houston Association of Realtors (HAR), a homebuyer will need a 27% increase in income over last year to be able to compete for a medium-priced home in Houston. Whew!
And, according to property data firm CoreLogic, homes in the rapidly growing Houston region are overvalued. Based on such reasoning and data, Federal Reserve Bank economists argue that home price growth has soared beyond market fundamentals. This brings to mind the Great Recession (December 2007 – June 2009) when rising home prices and high demand made it more and more difficult for prospective buyers to afford homes, leading to a real estate market bust.
Similar, But Not the Same
But there may be hope on the horizon. Real estate experts believe there are important differences between today’s high valuations and the ones that heralded the Great Recession – differences that (this time) might lead not to a catastrophic bubble bust, but rather to a gradual, more sustainable supply-demand equilibrium.
Those differences include:
Blame for the Great Recession has largely been attributed to inadequate oversight of U.S. financial institutions, which created increasingly complex and risky mortgage instruments and encouraged families and investors to acquire homes they couldn’t afford. These misdeeds created a housing market bubble destined to bust and an economy crushed by recession.
In Texas specifically, the economy continues to benefit from population and job growth that could support gradually slowing (but still higher) home prices as folks move in from expensive West Coast and northeastern U.S. real estate markets.
These elements should support a transitional period during which home prices will likely continue to slowly appreciate while wages and rents catch up (assuming the Fed’s battle with inflation shows meaningful progress).
Moving Toward Equilibrium
I think we can get to a supply-demand equilibrium in the housing market - but it could take a while. According to both Freddie Mac and CoreLogic, home price increases could slow to a crawl…4%, 5%, 6%...over a period of several years. This would cause a shift away from homeowners building equity as a result of frenzied marketplace competition to building equity by paying down the principal on their mortgages. This kind of normalcy would foreshadow better economic times compared to the Great Recession housing bust of epic proportions.
Under these (hopefully) more “normal” conditions, homeowners would occupy existing homes for longer periods of time before trading up, further shrinking demand and slowing home sales. HAR is already forecasting that Houston's existing home sales (but not necessarily prices) will decrease 15% from a year ago due to the fact that fewer folks have signed contracts to buy homes for several weeks in a row.
And, because mortgage rates are likely to nudge upward as the Fed governors battle inflation, this additional diminished affordability (due in large part to those higher mortgage rates) could peel away additional layers of the demand onion as prospective buyers continue to rent or remain in existing properties. HAR estimates that 10% of Houston households have already been priced out of the local market compared to 13% nationwide due to reduced affordability by mortgage rate increases, and inflation’s adverse impact on purchasing power. The U.S. Bureau of Labor Statistics calculates that hourly wages adjusted for inflation have declined almost 3% from a year earlier.
Signs are There
There are visible signs of slowing home price appreciation. This might be painful for homeowners, but it should help wages regain traction - momentum that would allow both housing supply and demand factors to move (but not rush) toward equilibrium. This scenario would edge out some buyers in the short- to mid-term, but it would also help stabilize home valuations and avoid a bubble burst.
Inventory shortages will continue to play a bullish role in affecting home valuations across the country. And home builders will keep a sharp eye on the impact of mortgage rates on the affordability of homes. Reduced - but still high - demand for housing will continue to encourage home building despite high construction costs and labor shortages.
The most likely future scenario for the housing market is not a bubble bust like we witnessed during the Great Recession, but a more gradual drift towards a healthy and lasting supply-demand equilibrium. It will be one where homes, by and large, hold their value, and where homeowners accumulate their equity the old-fashioned way.
Various negative impacts (e.g., interest rates) on demand will have a greater impact on achieving a near-term supply-demand equilibrium in the housing market than factors like reduced material and labor costs.
SIDE NOTE: Recession and the Stock Market
In a separate, but somewhat related matter, a subscriber recently asked me an interesting question: Recession forecasts abound. A friend I trust suggested to me that during a recession (defined as a decline in GDP over two consecutive quarters), the stock market does not necessarily perform poorly. Is he right?
The stock market is concerned with how much profit businesses earn. Recessions are determined by changes in production. Although production and profitability are linked, production changing by a certain percentage doesn’t mean that profitability will change in the same direction by the same percentage.
The stock market is the market for publicly-traded corporations. It’s only concern is with publicly-traded corporations. In contrast, GDP is concerned with a broader group of entities (which includes production by privately-held businesses as well as by government entities).
The most important distinction between the two is that the price of a stock is essentially a prediction - a function of how much the market collectively expects a given company will earn. (i.e., the present value of the expected future cash flows from that company.)
So, if the stock market has recently decided that publicly-traded corporations are, collectively, about to become less profitable (which, by the way, could well be the case in a recession), that doesn’t mean that the market is probably about to go down. It means the market has probably already gone down.