After the Peak – Will Housing Crash?

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9/5/2018 | Casey Fleming |  Some folks experienced the Great Recession as children or teenagers.  For them the idea that housing prices might level off or even crash is something they’ve heard about, but have never experienced.  For the rest of us, however, the memory is quite present and begs the question – will housing crash?

Statistics still bear out that the housing market is still strong and that prices are moving up.  The Case-Shiller Home Price Index showed a 6.2% year-over-year increase in home prices across the nation for June, according to Spice-Indices.com.  Some Metro areas are hotter, of course.  Las Vegas home prices led the nation in the previous 12 months with an increase of 13.0%, with Seattle close behind at 12.8%.

Nevertheless, many analysts agree that home sales are slowing down and prices are peaking this summer.  According to a report by NAR, home sales slipped across the nation in July for the fifth straight month, and are now running 1.5% below that of a year ago.

Bottom Line – Housing Prices Are Leveling Off

Will Housing Crash?

Statistically, there are more homes on the market in the areas that we here at LoanGuide.com track, and anecdotally, there are fewer multiple offer situations and fewer bidding wars than before.  So, it is likely that we have reached peak value or will soon.  What happens next, then?  Will hosing crash?  Are we about to experience 2008 again?

In a word, no. (In one man’s humble opinion.)

In order to understand why this slowdown in the real estate market will be different, we have to understand what drives prices up – and therefore what drives them down when those factors collapse.

It is also critical to understand that there is a difference between sales volume and housing prices.  As housing prices level off it is possible that sales volume will increase, rather than fall.  When we talk about the “Real Estate Market” it’s important to remember what we’re talking about.  In this article we’re talking about housing prices, not sales volume.

A Brief Refresher on Econ 1A and the Housing Crash

The market price of anything depends on supply and demand.

The market could get back to equilibrium

Supply depends on the cost to produce or bring to market the thing being sold and the motivation of the seller.  When it comes to resales of existing housing stock the cost to produce is not terribly relevant, as the seller usually has only one house, that cost is now a fixed cost, and they are almost certainly making a profit.  What matters in the sale of homes is the motivation of the seller.  Sometimes it is to maximize the amount of money received for the home; sometimes it isn’t.

Demand depends on the desire a typical buyer has for the thing being offered and their ability to pay for it.  It’s more complicated than you might think.  Let’s break it down.

What is Demand, Really?

Demand is an economist’s term for desire.  Desire, of course, can have a lot of components.  When it comes to real estate, desire can be broken into three distinct categories: emotional, practical, and financial.

The emotional desire doesn’t really change with economic trends.  People want stability in their lives, they want to be able to personalize their living environment (to “nest”), and they want security.  Whether the market is strong, weak or collapsing, those drivers remain the same.

Practical desire also tends to be independent of broad economic changes, with one exception.  People tend to want to live in good weather, near family, near recreational activities that they value, in good school districts; you get the idea.  This is why they say that the three most important aspects of real estate are location, location and location.  People care where they live.

The one exception where practical desire depends on broad economic trends?  Employment.  People want to live near good paying jobs while they are still working.

The financial element of desire is entirely related to economic trends, or more precisely, the belief in the future.  All statistical measurements of the economy (including those I cited above) measure the past.  But buyers make decisions based on what they believe the future holds in store.  When buyers see home prices rising, their desire to buy a home increases because they see it as an opportunity to build long-term wealth.

Related: Rent vs. Own: Leverage is Everything

But we know now that housing prices don’t always go up, right?  Think back to 2008 when housing prices collapsed dramatically.  What happened?  Once it was clear that the housing market was collapsing, home buyers believed (correctly) that values were going down, not up.  Even though housing prices were much lower than before the 2007 peak buyers stayed away in droves because they believed that prices were still falling.  No one wants to buy something now when they can buy it later cheaper, right?  Especially the largest investment you’ll ever make, up to that point in your life.

The emotional and practical elements of demand are driven by human nature (and arguably American culture) and will always be strong, but the financial element of demand varies and can move demand dramatically.

As analyses of the changes in the housing market come out (like this article, for instance) buyers are likely to find their beliefs about the short-term value of investing in their own home altered.

Ability Plays a Role, Too, However

No matter how much someone wants something they can’t or won’t buy it unless they have the ability to pay for it.  The ability to pay for housing depends on cash in the bank (for a down payment, closing costs and reserves), reliable income to make the payments, and a history of being able to manage large amounts of debt.

Why have housing prices done so well in the last few years?  In part it may have been that housing prices corrected too far during the Great Recession, and that they needed to come back up.  But in large part we can point to the longest economic expansion in history from 2009 through 2018, a dramatically low unemployment rate, decreasing interest rates, a rising stock market and finally, a back-log of home buyers that would naturally have come into the market (but did not) during the years after the recession.

In other words, rising stock prices and savings rates increased assets for the typical home buyer.  New jobs and a very low unemployment rate increased incomes.  Declining interest rates improved the cost and availability of credit.  All three components driving the ability of the typical buyer to purchase a home have increased notably in the last ten years.  And, for a variety of reasons, supply has remained very tight.  With strong demand and tight supply, housing prices were bound to rise.

Note that the primary reason for the housing crash in the Great Recession was that the ability of buyers to pay for homes changed dramatically with the collapse of easy credit.  (One third of the ability to pay triangle.)

Anyone Can Look Back

Looking back is easy!
Photo by Brett Sayles

It’s looking forward that’s hard, right?  The best way to predict future market behavior is to look at the past.  In the last 20 years we have had two recessions, both of which impacted housing prices.  The Great Recession from 2007 – 2009 we’ve talked about, but the recession caused by the dot-com bubble bursting in 2000 may not be as present in your memory.

Housing prices were driven up prior to the dot-bomb recession not by easy (or cheap) access to credit, but rather by newly-created wealth minted by the burgeoning dot-com revolution.  But as with many things when lots of money is involved, enthusiasm outran common sense and many companies were founded without a sustainable business model.  They raised massive capital, spent it wildly competing for employees, and then imploded, laying them all off, sparking a mini housing crash.  Average incomes rose too quickly to be sustained when companies collapsed, and wage earners (not so much executives) had to search for work at more pedestrian pay levels.

The Great Recession was a bit different in that housing prices were driven up by increasing wealth and income, to be sure, but they were rising at a much more sustainable pace, and the businesses that were born of wildly unsustainable business models were for the most part long gone.  Rather than a stock market bubble driven by too-rapid expansion of industry, this was a real estate bubble driven by too-rapid (and nonsensical) increase in the availability of credit.  And that is a HUGE difference.

As the economics blog FiveThirtyEight points out, most of the wealth lost in the dot-com bubble was lost by the wealthiest of individuals.  When the wealthy lose money, they don’t tend to change their spending habits much.  After all, they still have plenty left.  The poorest among us, if they are homeowners, are more likely to have most of their wealth tied up in their home.

A housing crash, therefore, acts very differently.  In the Great Recession most of the bottom two quintiles in terms of household net worth lost, well, most of their net worth.  The consequent slowdown in consumer spending was bound to bring the economy to a grinding halt, and it did.  That began a vicious negative feedback cycle, where declining home values led to less spending, which led to job losses, which led to even less consumer spending, which led to even more declines in housing value.

We’re Still Looking Back, Aren’t We?

Yes, I’ll get to that now.  There are a number of reasons that our impending slowdown in housing demand is much more like the dot-com recession than the Great Recession.

This time around housing prices have not been driven up by speculative, easy credit (like in the Great Recession) but rather very low unemployment, slowly increasing wages, higher consumer confidence and to some degree greater wealth.  Moreover, credit (in the form of mortgages) is much saner and more sustainable today.  Thanks to the CFPB, lenders are no longer making loans that are likely to blow up with wild increases in payment or that borrowers could never repay.

The economy is still strong, so consumer confidence and consumer spending should remain reasonably high.  The average household savings rate has held steady for the last few years at about 7% of earnings — well below its peak at about 15%, but well above the low during the Great Recession at about 2.5%.

Back to Econ 1A and the Housing Crash

So, reaching back to the beginning of this article (remember that?) we notice that so far there’s no reason to believe that the ability to pay element of the demand curve will weaken.  We also know that the emotional element doesn’t change with economic times.  The only element of the demand curve that could come under pressure really is whether home buyers will change their behavior based on whether they believe values will rise, fall or stay the same.

As one economist pointed out there is huge pent-up demand for homes, because many would-be home buyers (Millennials, but also move-up buyers) have deferred purchasing a home for years, because there was so little inventory they became frustrated with trying to get into the market.  Now that the number of listings is starting to increase it seems unlikely that these home buyers will disappear overnight.  After all, they still want to buy a home and have the income and savings to do it.

There will be a pause in the pace of price increases, to be sure, and there may even be a leveling off and a slight correction.  The dot-com recession lasted a few months and caused a housing price correction of 10% or so, depending on your location.

This time around, however, the pull-back in the home-buying frenzy doesn’t seem to be caused by any general slowdown in the economy, but rather by the fact that housing prices have risen far enough, fast enough, that some sort of pause seems necessary.  Much has been made of the fact that interest rates are up, increasing the cost of owning a home, but the increase amounts to only a small increase in payment each month relatively.

The Housing Affordability Index tells us that the price of housing has outpaced income growth, and that isn’t sustainable.  But a leveling off of price increases and / or a slight correction, coupled with rising wages due to the low unemployment rate, will bring that number back down within a few months to a couple of years at most.

Bottom Line – A Small, Quick Correction

So, at the risk of being wrong (hey, it wouldn’t be my first time) it appears to me that home prices are leveling off now and the market is moving towards equilibrium for the first time in many years.  I expect more listings to come on the market as home sellers start to realize that they may have missed the peak and are now psychologically ready to sell.  (Subject to a calendar-driven slowdown in listings that occurs in fall and early winter.)

I expect a small number of home buyers to stop actively looking for a home, but most of the frustrated home buyers over the last few years will take this opportunity and get active again.

I expect housing prices to level off to flat in most areas of the country for a few months, although the momentum of the hotter areas (Seattle and the San Francisco Bay Area in particular) will carry through for at least a couple of months.  Some areas will see a small correction in housing prices, especially if they are in geographic areas with a narrow employment base.

I expect mortgage rates to remain flat for the next year (within a small range).  Yes, this goes against the general consensus, but barring an upward turn in inflation long-term interest rates have no reason to rise.

I expect by this time next year housing prices will once again begin to rise, although at a reasonable, sustainable rate for the foreseeable future.

Casey Fleming is a mortgage advisor in Silicon Valley, originates mortgages throughout California, and is author of the book The Loan Guide: How to Get the Best Possible Mortgage

 

Resources consulted for this article:

Housing Market Predictions

Existing Home Sales Cool Again

Existing Home Sales Slip

Why the Housing Bubble Tanked the Economy and the Tech Bubble Didn’t

American Home Prices Could be at a Tipping Point

Leverage is Everything

Housing Price Index

U.S. Household Personal Savings Rate

Housing Affordability Weakening at Fastest Pace in Quarter Century

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