I am often asked my opinion on various matters pertaining to real estate and investing. Over the past couple of years no question has been asked as much as “Are we in a housing bubble?”. This was a question being asked in 2017, 2018, 2019, and now, after seeing the incredible growth in home prices since the start of the pandemic, even more so in 2021.
It isn’t just home buyers or those contemplating selling that are asking the question. Many investment commentators, and even major business publications like Barron’s, have recently addressed the question. I don’t know that I qualify as an investment commentator, and the Altus Insight certainly isn’t a major publication, but since so many have asked, I might as well throw my opinion into the mix as well.
Before jumping into the analysis, a couple of disclaimers:
- Altus is obviously deep in the trenches of real estate. This intimacy provides us with expertise and experience that a Barron’s reporter can never obtain. However, it also creates the possibility that our biases towards real estate can limit our ability to review information dispassionately (a can’t see the forest through the trees type situation). I will let each of you individually make your own determination where we might land in that regard.
- Readers who were receiving my investment missives all the way back in 2005 and 2006 (including some who we continue to work with to this day) can vouch that I was voracious in my warnings of the coming residential market implosion. I can’t say that I thought prices would fall anywhere close to where they ended up falling, but the concern was enough that we got out of most residential positions and were largely unimpacted by the residential implosion. Unfortunately, my prescience didn’t extend to other real estate classes and I got absolutely smoked in retail and office, where we had shifted our focus when moving away from residential.
- Altus currently has zero investment presence in non multi-family residential real estate (single family homes, etc.). I personally still own some rentals, all of which have been owned for quite some time, and a majority of which I am in some stage or another of liquidating.
- I don’t like making predictions. I prefer trying to understand the variety of possible futures and then make decisions based on the risk/reward analysis around those possible outcomes. I feel strongly enough in my analysis of the current housing bubble (or lack thereof), that I am making an actual prediction. Which, if similar to more broad forecasts made by economists across the globe, means I am probably wrong.
First, the facts:
- Home prices in most parts of the country are skyrocketing. Austin, as just one example, saw the median home price increase 25% in the past year. Salt Lake City as another example had home prices rise over 20%. Those are big numbers. But there are other parts of the country not having the same experience. Cities like San Francisco are experiencing a fall in prices as the long discussed urban flight has become a reality. Overall home prices were up 12% in February versus pre-pandemic February of 2020. Most buyers, especially first-time homebuyers, purchase their home with well over 50% leverage. This means that if they were to sell, their return on investment (if it can be classified as such) would be over 24% for the year. In absolute terms, the increase in the market value of the housing stock was the highest since…you guessed it, 2005.
- Median home price to median income is one way housing affordability is measured. According to this measure, home prices are now the third most expensive in the history of the country; and will shortly and almost assuredly move up and passed Q4 1953 in the next month or two… The only higher peak? Again, you guessed it, 2005. The current affordability ratio is 6.32, still 10% shy of the 2005 high, but way, waaaaaaaayyyyyyy higher than the “healthy” ratio of 2.5. The historical average is 5, though the price peaks have an outsized impact on the average, with the three aforementioned peaks being joined only by a brief period in 1979 when the ratio peeked just over 5 before dropping back. There have only been four periods with a ratio over 5 since the start of the Great Depression.
- Housing preferences were immediately and severely impacted by the explosion in people working from home due to the shutdown. The same shut down curtailed spending as people were stuck at home and generally unable to spend money on the goods/services/experiences they would have otherwise spent money on (i.e. vacations). At the same time, the government printed and gave away more money than at any point in the country’s history. Suddenly homeowners realized they needed home offices and/or discovered they didn’t need to hate living in an urban core, so there was a spike in buyers. Buyers that would not have otherwise been buying homes. That is not a sustainable source of buyers into the future. And in fact, as more and more companies are now sounding like they will require in person office attendance, (even if on a reduced schedule) this may result in forced selling for those that fled the urban cores because they didn’t need to be in the office and now realize they moved too far for a comfortable commute.
- Interest rates have come up a little off record lows, but they are still on the lower end of historical norms. Oddly, history shows us that prices often increase as interest rates increase because interest rates increased as the economy improved; and buyers were more optimistic. In this case, the economy has been improving since 2009 (though mostly tepidly) with little to no corresponding increase in rates. Going further, the Federal Reserve has clearly communicated that they have no intention of raising rates until well into the next economic expansion, which is specifically tied to an unemployment rate number that has been reached only once since such numbers have been tracked. When was that? Wait for it…wait for it…1953, one of the two times mentioned above when home prices were higher than they are currently. This turned out to be just before a recession (and of course, the 2005 peak was also right before a recession). With home affordability stretched (see paragraph 2), slight changes in interest rates immediately flow through to the amount buyers can afford. This in turn has an immediate impact on demand and home prices.
All this paints a pretty ugly picture. I obviously must think we are in bubble territory, no?
Not quite. Unlike in the mid to late Aughts, I feel like the current situation in nothing like the 2005 – 2007 bubble and I don’t feel like we are in a bubble at all, for many different reasons:
- The affordability measure mentioned above is but one way to take such a measurement. Another is to measure housing costs to median income. The National Association of Realtors tracks this information. While they are certainly motivated to tell a high affordability story, their data appears to be sound. Their index measures affordability as needing 25% of a median family income to afford a median mortgage. A score of 100 on the index indicates that the median income can afford a median house. A higher score indicates increased affordability, and a lower score indicates decreased affordability. As of January 2021, housing affordability had increased versus 12 months ago (January 2020), as increases in household income increased considerably more than the increase in a median mortgage payment. This is partially due to rates being a little lower than they were in January 2020, but it is more tied to income. In the Midwest region median home prices are low enough that a family income of $36,000 is enough to buy a median home. The median family income is just under $89,000, but let’s assume it is only $36,000, or a measurement of 100 on the index. Twenty five percent of $36,000 is $9,000. If the cost of housing (a combination of home prices and interest rates) increases 10%, the new median housing cost is $9,900. This would mean income would also need to increase 10% to offset the housing cost increase and maintain the 25% ratio. However, because the median family income is $89,000 (a value of 247 on the index), a 9.5% increase instead of a 10% increase in income is needed to maintain the same index score. More importantly, to be able to absorb the 10% increase in housing costs, an increase in income of only 4% is needed in real terms. All this is to say housing costs have not gone up over the past 12 months, and even when they do start going up the impact on affordability is not as severe as headline numbers would seem. For those curious, the West region is the least affordable, but with still a reasonable index reading of 131.
- The affordability index has been most impacted by falling interest rates. A reduction in rates from 5% to 2.5% (the approximate post 2008 range) leads to a 26% decrease in mortgage costs, while also dramatically increasing the speed of the loan amortization. This decrease in interest rates has increased housing cost affordability, while also resulting in really high historical home equity levels. The more equity someone has in their home, the less likely they are going to walk from it if things get rough. The fewer people throwing up their hands and giving up, the less inventory hitting the market in an economic downturn. The fewer properties hitting the market, the less the downward pressure on prices, etc.
But affordability was also given a massive shot in the arm by the fall in prices in 2007 and 2008. In many parts of the country median prices have only in the past couple years recovered to where they were at the pre-recession heights, despite 10+ years of inflation and cost input increases.
- While interest rates have been falling over the past 10 years, incomes have been rising. Maybe not in line with historical post-recession recoveries, and in many cases maybe not even keeping up with inflation, but rising none the less. That means more income to pay for reduced housing costs.
- Along the same lines as paragraph 3, the difference in loan underwriting standards is dramatically different now than it was pre-2008. The loan types available are also dramatically different. There is little to no institutionalization of liar loans (where the borrower states their income without verification), and certainly not with sub-prime borrowers (borrower credit score below 640). In most cases lenders are also requiring larger down payments than pre-2008. And lastly, no neg. am loans. These differences are huge in composite. More highly qualified borrowers, investing more money out of pocket into their purchases, into situations with loans that at worst stay flat while home prices have risen, but in most cases are amortizing so equity in the properties is increasing. This is not a situation of lending excess as was the case in the Aughts. The higher the equity to debt ratios, the more stability in prices there is in any market. And there is ridiculously high amounts of equity in the housing market currently.
- The basic supply and demand curves have two important lessons for us in this the current housing environment:
- Cost of a product has to be lower than the sales price of a product for more product to be produced. Housing costs have increased dramatically over the past several years. Increased regulations, increased difficulty to obtain entitlements, increased salary requirements, etc. have played a role. Now the physical input prices have gone through the proverbial roof. Lumber prices are up between 200% to 300% over the past twelve months (depending on who you ask). The cost of other inputs have spiked as well. As impactful, there are major issues obtaining delivery of needed inputs. A friend of mine that owns a welding fabrication company has lead times as much as 6 months for some of his raw material inputs. These same products were available within a day or two previously. Concrete plants are running reduced schedules and smaller fleets because they can’t get enough cement to run at full capacity. These shortages not only increase cost (supply and demand) but also push back delivery schedules. Even with lower interest rates, more time equates to higher interest cost. Like the increased cost of materials, the increase in cost of money also has flow through to price. The supply chain issues may well go away at some point in the future, but until they do, we have a cost floor that when in conjunction with demand, will keep prices from imploding.
- Speaking of demand, when the housing markets crashed in 2006 – 2008, home building (and we can throw multifamily into that mix) pretty much dried up. Housing starts plummeted for several years. But the population didn’t stop growing nor aging during that time period. An increase in demand without an offset increase in supply moves the price intersection of supply and demand upward. Home builders have tried, but even before the pandemic have been unable to catch up.
Further, demand hasn’t increased linearly. In the 2000s it was the Gen X’ers that were moving into their home buying years, but they are a much smaller generation than the Baby Boomers they were replacing as first time home buyers. Now, the Millenials are moving into their prime buying years. This generation is much larger than Gen X and even larger than the Baby Boomers. This demand is not going away, and in fact continues to accelerate. Limited supply, increased demand = increased prices.
- Because of the opportunity afforded by the housing price drop leading up to the Great Recession, billions and billions of investment dollars flowed into the for rent housing market. Even after the low hanging fruit was snatched up, those investors wanted more, creating the advent of build for rent (BFR as it is known in the industry). Prices being paid and returns being accepted are crazy to me. My belief is that some/many of these investors are going to see dramatic underperformance, or even losses, but in the short run their increased appetite for properties is a demand on housing stock that hasn’t previously existed. Increased demand, limited supply = increased prices.
- The last point in my argument is buyer/investor/consumer sentiment. Even while being cynical of the market returns for the BFR investors (there are always exceptions of course), their underwriting is based on cash flow – real investment returns. This was not the case in the 2000s. I remember being in sales offices of new subdivisions where “investors” were lined up to place deposits on houses. Their game was to hold the right to purchase the houses at the defined prices and then watch the market go up until close to the time the houses were to be completed. They would then flip the contract to a different buyer because prices had gone up so much in the time it took to build the house that they could profit and the contract buyer could get a nominally better price than buying in a later phase of the subdivision. It was enough of an issue that many builders added clauses to their contracts restricting the practice. Worse, many investors speculators were buying homes on “neg am” mortgages, often with little to no money down (I have a friend that borrowed 105% of his purchase price in 2005), and then letting the houses sit vacant for a few months before reselling them for a profit. The “good” ones had it figured out such they would complete their purchase early in the month so that month’s interest would be included in the loan. They could go through the original month of purchase, and the full next month before a payment was due. Add another 30 days before a lender could call a loan in default, and buyer basically had 90 days of no payments. They would then turn and flip the property to take advantage of the price increases having made only 1 or 2 payments (and in many cases zero). This, my friends, was full on tulip style mania. People were buying houses not for the utility of the house, but because of the theory that housing prices never go down. The crazy loan structures and accommodative underwriting allowed more and more unqualified buyers to get into the mania. This was a true set up for disaster. And despite dozens, or even hundreds, of offers on properties, we just aren’t into the mania stage yet. Buyers are still buying properties to live in or to rent out, not to ride the speculation wave.
None of the above should be taken to mean that I don’t think there can’t/won’t be another housing bubble. Neither should it be construed that I don’t think housing prices won’t take a hit if there is an economic disruption. Nor should anyone believe this means I don’t think there aren’t bubbles within certain markets.
What constitutes a bubble is not clearly defined, but if I overlay the idea of a bear market, a 20% decrease in prices would be required. Can it happen? Absolutely. Will it happen? In some markets perhaps, and other markets (San Francisco/Manhattan/Chicago) likely. But across the entirety of the country’s single family housing stock? I don’t think we are anywhere close to there yet.
Maybe I am wrong, but at least from an investing perspective that would be okay too. A severe drop in home prices in the high demand environment could create an opportunity even larger than what we were able to benefit from coming out of the Great Recession.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.