Housing Market Bubble – Pop or Flop?
Home prices continue to soar to new heights, and we continue to see a decoupling from fundamentals.
We’ve been saying this for more than a year now.
Critics of a bubble theory say, “Just because home prices are rising doesn’t mean that we are in a bubble.”
Fair enough. I understand the economics here – and so do my readers.
What’s driving up prices?
1. Supply and demand imbalances.
2. Rising labor costs.
3. Rising material costs.
4. Historically low borrowing costs.
5. Borrowers have assets and are putting more cash down.
6. Investor exuberance.
Investors – now buy between 30% and 35% of US homes.
I am talking about the level of price increase. The sheer magnitude of the price escalation we are seeing.
Let’s take a step back though. Tell me, does this make sense?
The house across the street is selling for $750k. And the sellers bought in at $500k two years ago. Had they bought it three years ago, they would have been in at $450k.
This is the sort of absurdity I am seeing in Jacksonville, Florida. And the same scenarios are playing out all across the country.
Prices remain at record highs and continue to move higher due, in part, to record low inventory. The greater the misalignment in market pricing, the more severe the subsequent correction will be.
The Federal Reserve Bank of Dallas released a report yesterday, saying “”Our evidence points to abnormal US housing market behavior for the first time since the boom of the early 2000s… Reasons for concern are clear in certain economic indicators … which show signs that 2021 house prices appear increasingly out of step with fundamentals.”
The Fed identified two specific indicators highlighting the decoupling of fundamentals:
1. Home price-to-rent ratio
2. Home price-to-disposable income
The below shows some great research by Bill McBride of Calculated Risk. I highly encourage you to checkout his Newsletter. LINK
In nominal terms, the Case-Shiller National index (SA) and the Case-Shiller Composite 20 index (SA) are at new all times highs (above the bubble peak). The National Index is 48% above the bubble peak, and the Composite 20 index is 35% above the bubble peak.
In real terms, house prices are now above the previous peak levels. There is an upward slope to real house prices, and it has been over 15 years since the previous peak, but real prices appear historically high.
This Price-to-Rent graph shows the price to rent ratio. The price-to-rent ratio had been moving more sideways but picked up significantly recently. On a price-to-rent basis, the Case-Shiller National index is at a record high, and the Composite 20 index is back to March 2005 levels. By all of the above measures, house prices appear elevated.
The below graph shows median income vs median sales price vs mortgage debt service payments. Before 2000, average families spent about 6% of their disposable income on their mortgages. That increased to more than 7% in the housing bubble. As the Fed pushed interest rates towards zero, families were able to spend less on mortgages. That value bottomed at 3.7% in 2020. As rates rise, the green line, in turn, will rise. If rates rise faster than incomes, borrowers won’t have as much money to spend on mortgage payments. This means home prices can’t continue going up at this rate when rates rise. The rapid rise in home prices is unsustainable.
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Bottom Line is: While this might be an ideal time to sell a home, buyers could see values decline in the next few years.
Are we just waking up to the fact that a bubble is growing? Did everyone forget what happened back in 2007? True – it’s different this time. We are not in the midst of a subprime mortgage meltdown. And borrowers are better positioned financially thanks to improved lending standards.
The challenge to the buyer/borrower, however, remains the same – they will owe more on their homes than they are worth.
Housing market bubbles lead to (1) overpriced homes, (2) investments based on distorted expectations of returns, and (3) reduced economics growth.
Not only are these dangers real, but their impact will be particularly acute. Our current economic climate continues to yield runaway inflation. This inflation can be felt everywhere. We have also talked about the potential for stagflation; growth is muted, yet prices continue to rise. And we expect to see four to six Fed rate hikes this year, further decelerating economic growth.
So the question is – will we see the flow of money into housing begin to dry up causing a correction? Or will we see worse – a bubble pop?