Summary: Wondering what a housing bubble is and if we’re in one? Find out 3 reasons why we are not in a housing bubble (and so much more) in this comprehensive article.
Home prices are soaring at all time highs. Housing inventory is shockingly low. Corporate spending is skyrocketing. Builders are bringing as much product to market as possible. It seems like everyone is either buying a home or talking about buying a home. This all feels eerily familiar, doesn’t it?
It’s really no wonder so many people are asking themselves, “Are we in a housing bubble?” and “When will the housing market crash?”
I’m here to bring you some good news. We are NOT in a housing bubble and we are not anticipating a housing crash anytime soon. We may be hearing the same song, but it is a completely different dance this time.
What is a housing bubble?
A housing bubble is when the housing market is “full of air” due to growth being artificially stimulated and sustained. In other words, a housing bubble is created when there are price increases that are not supported by the fundamentals. In a bubble, home values are based on something that is not real or extremely fragile.
The last housing crash was certainly the result of a housing bubble driven by the credit boom. Demand for housing was being driven by financial institutions who were giving individuals loans for homes that they never should have been able to get. Individuals could obtain home loans without any proof of employment and no cash. Banks were even willing to give a loan for more than 100% of the home’s actual value.
This artificially inflated home prices and there was no real equity securing any of these loans. Once borrowers started to default on their loans in mass quantities, the bubble popped, property values tumbled, and we all know the rest of the story.
What followed was a massive wave of distressed inventory, rock bottom housing prices, millions of individuals with their credit in shambles and financial institutions begging for government bailouts.
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Are we in a housing Bubble?
Based on the definition above, we are not in a housing bubble this time. People seem to throw around the term “bubble” anytime housing values are going up, but the market is not full of air this time. In fact, it’s just the opposite. This is a period of record housing market expansion.
We currently have a housing market with record levels of equity, individuals can afford their payments and are well qualified for their mortgages, and a massive demographic shift has resulted in a severe supply/demand imbalance. This is all driving real increases to property values.
Why the real estate market’s growth is real
Meaning we are not in a housing bubble
Take yourself back to your highschool economics class where you learned that the imbalance of supply and demand is what determines pricing. When demand is greater than supply, prices rise and the intensity of this imbalance indicates how sharply prices will go up. The largest factor driving home values up today is unquenched demand.
The significant supply and demand imbalance tell us that home values will continue to rise and solid lending practices, low interest rates, and record equity levels tell us that this growth is likely to be sustained.
There are 3 reasons we know we are not in a housing bubble: High Demand, Low Supply, and Solid Financing. Let’s take a closer look at the specific factors that are driving demand, stifling supply, and the financial factors that are ultimately sustaining the growth.
What is driving demand?
#1 - New household formation is occurring at record highs
The biggest buzz word used to explain the unprecedented level of demand in real estate right now is “Demographics”. Today, the largest segment of the largest generation, millennials, is approaching the average age of the first-time home buyer, 31 years old. Millennials will be entering their peak homebuying age from 2022 to 2024. It is estimated that 72 million millennial home buyers will be entering the market. This equates to an unprecedented level of demand for housing that we just don’t have.
#2 - More Buyers in the Space
Consider how many different buyers are seeking out SFR ownerships in addition to owner occupants. There are notably more foreign and domestic “Mom and Pop” investors as well as many institutional investors and fund managers are purchasing single family housing to hold as investment property. Short term rental buyers and iBuyers all bring additional crowding to an already tight space.
#3 - Paradigm shifts about how society views work and home life
Needless to say, the way we view work and home life has been forever changed by the pandemic. Employers learned that they can operate efficiently with little to no “on site” staff and they also realized how a remote staff or a hybrid work schedule can improve their bottom line and allow for better workforce retention and recruitment. Many individuals are finding themselves able to enjoy a more flexible work life balance and are taking the opportunity to leave high density areas for more low density suburban and even rural areas. Interest in the single family home has been reinvigorated and individuals are willing to pay a premium for more space, an extra room or two, and quality of life amenities like pools, home gyms, and outdoor living areas. The influx of buyers into more suburban and even rural areas has resulted in a noticeable increase in demand for single family housing, a demand that many markets are struggling to keep up with.
Many high earners from high density cities who can now work from anywhere are taking their high incomes and relocating to more affordable markets where their money can go much further.
There is even a growing trend among urban dwellers that now only have to go into the office one or two days a week who are keeping a small apartment or condo in the city, but are purchasing a second home further out where they can enjoy more space and a better quality of life for the remainder of the week. So rather than a one for one swap for housing, one individual is securing multiple properties and further contributing to demand.
Why Can't Supply Keep up?
#1 - The United States has a massive housing deficit
In 2020, Freddie Mac estimated that there was a shortage of approximately 3.8 million homes in the United States. However, the National Association of Realtors estimates the current housing deficit to be much higher, between 5.5 to 6.8 million homes. There is not enough housing for the number of households in this county and the deficit continues to grow despite the booming new housing construction industry.
It is particularly interesting to note that affordable housing is the most deprived segment of the housing market. According to Freddie Mac, in 1980, 40% of all homes built were “starter homes” but today only 7% of all homes built are starter homes.
#2 - It’s increasingly difficult to create more housing
Construction costs, labor shortages, and supply chain issues have made it difficult to bring new necessary supply online. You likely saw the headline news, lumber prices soared, nearly tripling in price over the last year. At its peak in May, a spike in the price of lumber added $36,000 to the average cost of a new single-family home in the U.S. But lumber wasn’t the only challenging cost to manage, builders reported surging prices and supply chain issues on everything from steel and copper to windows, doors and appliances. At the same time labor shortages are leaving builders with ultra short lists of tradesmen and vendors.
During a conversation with one of our preferred builders in Florida last week, he mentioned that the cost of land has tripled and sometimes quadrupled in the areas where he acquires lots. Lots in neighborhoods that he could buy last summer for $5,000-$7,000 are now selling for $15,000-$20,000.
Building in this volatile climate has made it difficult for builders to protect their own profit margins while bringing new housing online that the country desperately needs. We know that builders have higher profit margins in higher cost homes, so naturally, this squeeze will disincentivize many builders from the affordable housing space where we need housing inventory the most.
#3 - People aren’t moving
Normally, first time home buyers are purchasing affordable homes as they begin to form households and then they choose to upgrade into more expensive housing as their family grows. Retirees tend to downsize as they age or relocate to enjoy a better quality of life or to be close to their grandchildren. This normal churn of housing allows for the housing market to remain balanced, however in addition to the demographic shifts we are seeing, many are simply unwilling to compete in this frenzied housing market, where they likely to have to compete in bidding wars and settle for housing that might not check all their desirability boxes.
The impact of mortgage forbearances and the lengthy moratorium on evictions has also likely contributed to less normal churn in the housing market. Though arguably less of an impact than we originally anticipated, roughly 2.2 million borrowers are currently in mortgage forbearance programs and approximately 11 million individuals are remaining in their rental homes under the moratorium on evictions. This, again, reduces the very normal and needed “churn” of housing.
Strong Financial Conditions That are Sustaining the Housing Market
#1 - Mortgage Interest rates are at record lows
Interest rates continue to remain at historic lows, which has allowed buyers to retain their purchasing power in spite of increasing prices. Borrowers can afford their monthly payments.
Most lenders are forecasting that interest rates will remain low for the foreseeable future or tick up at a very gradual rate, making a snap reaction in property values unlikely. If interest rates go up too much or too quickly, we could see this reduce the number of buyers, curbing demand, so this is something we should pay close attention to.
#2 - Mortgage loan qualification standards are tighter than ever
We learned our lesson from the last crash. Borrowers are well qualified for their mortgages, with employment verification, and strict income requirements.
The borrower profile is stronger than ever with first time home buyer and repeat buyers average credit scores above 720 and average back end debt-to-income rates above 36%.
#3 - Homeowners are sitting on record levels of equity
Only 62% of homes in America have a home mortgage and, according to recent reports from CoreLogic, it is estimated that the overwhelming majority of American homeowners are very securely in their homes, with enough equity that they could choose to sell their homes if they had to without experiencing a net loss. They estimate that mortgages in a negative equity position account for only 2.6% of all mortgaged properties.
CoreLogic also reported, the average American homeowner with a mortgage gained 19.6% in equity in the first quarter of 2021 from the first quarter of 2020. This equates to a $33,400 gain, the highest annual gain per borrower in at least a decade.
The national CoreLogic Home Price Index recorded an 11.4% rise in the year through March 2021, which equates to $216,000 of equity growth on average for homeowners with mortgages.
The fact that homeowner equity has more than doubled over the last decade gives homeowners a crucial financial buffer to push through hardships brought on by the pandemic, making it an important financial tool for Americans.
This firm equity position of American homeowners is evident and bolsters many from financial risks. The amount of collapse that would have to occur to shake the firm footing of so many borrowers would be unprecedented.
#4 - People have cash!
You’ve most certainly heard the stories of multiple cash offer scenarios or buyers bidding on homes with waived appraisal contingencies (this means they must come to closing with additional cash). Redfin recently reported that all-cash offers accounted for 30% of offers on housing, up nearly 5% from this time last year. While this is not necessarily a healthy thing for a housing market, it does reveal the healthy cash position that many buyers are in. I’ve heard it wisely suggested before, while it might not seem prudent for someone to over pay for a home, we really don’t need to be worried about an individual who has enough cash on hand that they can choose to spend it on the home they really want.
It is also important to consider the massive number of mortgage borrowers who refinanced their homes over the last 18 months. Freddie Mac estimated that on average, US households who refinanced over the last year lowered their interest rate by an average of 1.25% and are saving themselves on average over $2,800 a year on their mortgage payments, improving their monthly financial position.
So, what factors would cause a housing bubble and lead to a market crash?
As mentioned above, I don’t see the housing market crashing anytime within the next few years. Our housing market is being driven up by a simple supply and demand imbalance. Right now we have hyper demand, which is causing prices to go up. For prices to come down, outside of another black swan event, we would either need to see demand significantly decrease or supply increase.
Keep in mind, just because we are not in a housing bubble or at risk of a housing market crash at the moment, does not mean that we have an extremely healthy housing market. There are definitely some things we should keep an eye out for and closely monitor, because the market is always changing.
Here are a few signs that the housing market could be at risk of a market crash or correction:
Sign #1 - Interest rates go up significantly
Low interest rates are a big part of what is allowing individuals to continue to afford homes as prices continue to rise. If interest rates go up, the number of people who can no longer afford to buy a home will also increase. Arguably, interest rates could likely stand to go up a little bit and it could help us ease our way to a more healthy rate of housing growth, but any rapid movement here could cause housing prices to react quickly.
Sign #2 - Affordability Crisis
Run away home prices would not be good for the majority of Americans. Housing is a basic necessity, and it must be affordable for everyone at some level. The largest demographic of homebuyers are young, first time home buyers who need entry-level, affordable housing and this is where we have the most significant housing shortage. As the significant supply/demand imbalance forces entry-level home values up, it will become harder and harder for this growing cohort of buyers to afford the down payments or qualify for the loans needed to enter the market. This could result in more government assistance programs or even new loan products that could further and unnaturally disrupt the supply/demand imbalance.
Sign #3 - Overbuilding
Fortunately, I think it would take a lot for this to become an issue. Increased construction costs, supply chain issues, and labor shortages are preventing builders from bringing too much supply to market too quickly, but this is something we should continue to monitor. Oversupply of housing will lead to a softening of pricing. Fortunately, this also happens gradually and not all at once. However, real estate is highly local, so it is possible some areas could be more vulnerable to overbuilding than others. An oversupply of housing will cause prices to soften gradually. This is something that as real estate investors we should be particularly aware of as we enter secondary and tertiary markets. Historically, builders haven’t always had the best track record of knowing when to stop.
Sign #4 - The Fed stops buying $40B/month of Mortgage Backed Securities (MBS)
The Fed is currently buying $40B of MBS each month. Most economists think this is no longer necessary and if the Fed stops subsidizing the mortgage market (Fannie/Freddie) then private money will fill the void. Generally, the markets don’t respond favorably to announcements of less intervention from the Fed. This is something we should watch for and we should likely anticipate some mortgage interest rate turbulence on the heels of such an announcement.
Are we in a housing bubble? All signs tell us no. Today’s housing market is NOT full of air.
Will the housing market crash? We think this is very unlikely, at least in the near future. It is much more likely that we are experiencing a period of housing market expansion and that home prices will likely continue to rise, though the growth rate could begin to slow.
Here is the best news, at RealWealth™ and as real estate investors, we have never paid too much attention to the idea of “timing the market right” because, ultimately no one can predict the future of the housing market with absolute precision. We like “buying low and selling high” to capture appreciation just as much as any other real estate investor, but we understand that if we are purchasing fundamental long-term buy-and-hold rental properties, we insulate ourselves from the whoas of volatility. We bet on the long term, balanced, and fundamental strategy, not the “hail mary”.
We teach RealWealth investors how to invest in affordable markets, where positive cash flow is still possible with maximum leverage (20% down), and we encourage investing for the long term, knowing that over time all asset values go up, they always have. We identify markets that have strong rent to value ratios, where laws are landlord friendly and where the average homeowner can afford the average home.
Then we curate a network of brokers, property managers, rehabbers, and builders in those markets who can help RealWealth investors acquire and manage rentals from out of state.
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