Is the Current Real Estate Market at a Top?

In 2017, a majority of Americans began worrying that the real estate market was going to crash. In fact, 58 percent of those surveyed agreed that there will be a “housing bubble and price correction” in the next two years. As a result, 83 percent of them believed it was a good time to sell.

Here in the Charlottesville area, the market has maintained its low inventory of resale homes, which has driven prices steadily higher for homes in the city – especially near the Downtown Mall and UVA – while the rental market has added ever more new units to take advantage of the fact there are fewer affordable houses to buy, and the new home construction field has ramped up its own inventory to capture the buyers who do not want to rent.

But will our area face the same warning signs that are being seen across the country?

Warning Signs

According to recent research, there are plenty of signs that the housing market is heading into bubble territory. Most crashes occur only because an asset bubble has popped. 

One sign of an asset bubble is that home prices have escalated – we have seen this in the two Charlottesville neighborhoods already mentioned. National median family home prices are 32 percent higher than inflation. That’s similar to 2005, when they were 35 percent overvalued.

The Housing Bellwether Barometer is an index of homebuilders and mortgage companies. In 2017, it skyrocketed like it did in 2004 and 2005. That’s according to its creator, Stack Financial Management, who used it to predict the 2008 financial crisis. 

Similarly, the SPDR S&P Homebuilders ETF has risen 400 percent since March 2009. It outperformed the S&P 500 rise of 270 percent.

The Case-Shiller national index hit record highs in December 2016. Price increases are concentrated in seven urban areas. Home prices in Denver and Dallas are 40 percent higher than their pre-recession peaks. Portland and Seattle prices are 20 percent higher. Boston, San Francisco, and Charlotte, N.C., are 10 percent above their peaks. 

Home prices in Denver, Houston, Miami, and Washington, D.C. are at least 10 percent higher than sustainable levels, according to CoreLogic.

At the same time, as has been seen in our area, affordable housing has plummeted. 

In 2010, 11 percent of rental units across the country were affordable for low income households. By 2016, that had dropped to just 4 percent. The shortage is the worst in cities where home prices have soared. For example, Colorado’s stock of affordable rentals fell from 32.4 percent to only 7.5 percent since 2010. 

Subprime crisis?

In March 2017, William Poole, a senior fellow at the Cato Institute, warned of another subprime crisis. He warned that 35 percent of Fannie Mae’s loans required mortgage insurance. That’s about the level in 2006. 

In some ways, these loans are worse. Fannie and Freddie lowered their definition of subprime from 660 to 620. The banks are no longer calling borrowers with scores between 620 and 660, subprime. Poole was the head of the Federal Reserve Bank of Kansas who warned of the subprime crisis in 2005.

In 2016, 5.7 percent of all home sales were bought for quick resale. These “flip” homes are renovated and sold in less than a year. Attom Data Solutions reported that’s the highest percentage since 2006, during the last boom.

As we saw here in the Charlottesville area, many people who were caught in the 2008 crash are worried that the 2017 bubble will lead to another crash. But it was caused by forces that are no longer present. 

Nine Reasons Why a Housing Crash Isn’t Imminent

There are many differences between the housing market in 2005 and the current market. In 2005, subprime loans totaled more than $620 billion and made up 20 percent of the mortgage market. In 2015, they totaled $56 billion and comprised 5 percent of the market.

Banks have raised lending standards. According to CoreLogic’s Housing Credit Index, loans originated in 2016 were among the highest quality originated in the last 15 years. In October 2009, the average FICO score was 686, according to Fair Isaac. In 2001, the average score was 490 to 510.

Tighter lending standards has made a difference in the “flip” market. Lenders only finance 55 percent of the home’s value. The “flipper” has to come up with the rest. During the subprime crisis, banks lent 80 percent or more.

The number of homes sold today is 20 percent below the pre-crash peak. There’s only a four-month supply of homes available for sale. As a result, about 64 percent of Americans own their own homes, compared with 68 percent in 2007.

Home sales are lower because the recession clobbered young people’s ability to start a career and buy homes. Faced with a poor job market, many furthered their education. As a result, they are now burdened with school loans. That makes it less likely they can save enough to buy a home. That will keep demand down.

Home prices have outpaced income. The average income-to-housing cost ratio is 30 percent. In some metro areas, it’s skyrocketed to 40 or 50 percent. Unfortunately, metro areas are also where the jobs are. That forces young people to pay more for rent to be close to a job that doesn’t pay enough to buy a house. 

Thirty-two percent of home sales today are going to first time homebuyers, compared to 40 percent historically, says the NAR. Typically, this buyer is 32, earns $72,000, and pays $182,500 for a home. A two-income couple pays $208,500 on average.

Homeowners are not taking as much equity out of their homes. Home equity rose to $85 billion in 2006. It collapsed to less than $10 billion in 2010. It remained there until 2015. By 2017, it had only risen to $14 billion. Obamacare is one reason for that. Bankruptcy filings have fallen 50 percent since the ACA was passed. In 2010, 1.5 million people filed. In 2016, only 770,846 did. 

Some people point that national housing prices have exceeded their 2006 peak. But once they are adjusted for 11 years of inflation, they are only at the 2004 level. Between 2012 and 2017, home prices have risen 6.5 percent a year on average. Between 2002 and 2006, they rose 7.5 percent annually. In 2005, they skyrocketed 16 percent. 

Homebuilders focus on high end homes. New homes are larger and more expensive. The average size of a new single family home is almost 2,700 square feet. That compares to 2,500 square feet in 2006.

Conditions That Could Cause a Collapse

Higher interest rates have caused a collapse in the past. They make loans more expensive. That slows home building and decreases its supply. It also slows lending, which cuts back on demand. Overall, a slow and steady interest rate increase won’t create a catastrophe.

It’s true that higher interest rates preceded the housing collapse in 2006. But that’s because of the many borrowers who had interest-only loans and adjustable-rate mortgages.  Unlike a conventional loan, the interest rates rise along with the fed funds rate. Many also had introductory teaser rates that reset after three years. 

When the Federal Reserve raised rates at the same time they reset, borrowers found they could no longer afford the payments. Home prices fell at the same time, so these mortgage-holders couldn’t make the payments or sell the house.

Raising Rates

The history of the fed funds rate reveals that the Fed raised rates too fast between 2004 and 2006. The rate was 1 percent in June 2004 and doubled to 2.25 percent by December. It doubled again to 4.25 percent by December 2005. Six months later, the rate was 5.25 percent. 

The Fed raised rates at a much slower pace since 2015. It raised it to 0.5 percent in December 2015. Then, it raised it one-fourth point by the end of 2016 and to 1.25 percent by June 2017. 

The real estate market could collapse if banks and hedge funds returned to investing in risky financial products. These derivatives were a major cause of the financial crisis. Banks sliced up mortgages and resold them in mortgage-backed securities. 

These securities were a bigger business than the mortgages themselves. That’s why banks sold mortgages to just about anyone. They needed them to support the derivatives. They sliced them up so that bad mortgages were hidden in bundles with good ones. Then when borrowers defaulted, all the derivatives were suspected of being bad.

The Trump tax reform plan might trigger a fall in prices that could lead to a collapse. Congress has suggested removing the deduction for mortgage interest rates. 

That deduction totals $71 billion. It acts like a federal subsidy to the housing market. The tax break helps homeowners have an average net worth of $195,400. That’s much greater than the $5,400 average net worth of renters. Even if the tax plan keeps the deduction, the tax plan takes away much of the incentive. Trump’s plan raised the standard deduction.

As a result, Americans would no longer itemize. When that happens, they can’t take advantage of the mortgage interest deduction. The real estate industry opposes the tax plan. 

The market could collapse if the yield curve on U.S. Treasury notes became inverted. That’s when the interest rates for short-term Treasurys become higher than long-term yields.  Normal short-term yields are lower because investors don’t require a high return to invest for less than a year. When that inverts, it means investors think the short-term is riskier than the long-term. That would play havoc with the mortgage market and signal a recession. The yield curve inverted before the recessions of 2008, 2000, 1991, and 1981.

Real estate markets could also collapse in coastal regions vulnerable to the effects of rising sea levels. The Union of Concerned Scientists predicts that 170 U.S. coastal cities and towns will be “chronically inundated” in 20 years. 

Another study found that 300,000 coastal properties will be flooded 26 times a year by 2045. The value of that real estate is $136 billion. By 2100, that number will rise to $1 trillion. At most risk are homes in Miami, New York’s Long Island, and the San Francisco Bay area.

Flooding has hit coastal towns three to nine times more often than they did 50 years ago. In Miami, the ocean floods the streets during high tide. Harvard researchers found that home prices in lower-lying areas of Miami-Dade County and Miami Beach are rising more slowly than the rest of Florida. 

A study using Zillow found that properties at risk of rising sea levels sell at a 7 percent discount to comparable properties. By 2030, Miami Beach homes could pay $17 million in higher property taxes due to flooding by 2030.

By 2100, that could rise to $760 million, according to the Miami Herald. Other vulnerable cities are Charleston, S.C.; Atlantic City, New Jersey; Boston, Mass., and Annapolis, Md.

Most of the property in these cities are financed by municipal bonds or home mortgages. Their destruction will hurt the investors, and depress the bond market. Markets could collapse in these regions, especially after severe storms.

Will Home Prices Fall?

In the last housing bubble, homebuilders submitted permits for new construction. That was less than 1 million in 1990 during the recession. It gradually rose throughout the 1990s, exceeding 1 million in 1998. It remained at that level until 2002, when it surpassed 1.5 million. It hit a new record of 2 million in 2004 and 2005.

In 2006, housing prices began falling. Homebuilders sought more than 1.5 million permits. That fell to less than 1 million in 2007. By 2009, it had collapsed to 500,000.

They’ve only gradually recovered to 1.3 million in 2017. They are expected to drift lower to 1.1 million by 2020. 

When Will the Housing Market Crash Again?

The next market crash will occur in 2026, according to Harvard Extension School professor Teo Nicholas. He bases that on a study by economist Homer Hoyt. Real estate booms-and-busts have followed an 18-year cycle since 1800. The only exceptions were World War II and stagflation. 

In 2017, Nicholas said the real estate market was still in the expansion phase. The next phase, hyper-supply, won’t occur until rental vacancy rates begin to increase. If that occurs while the Fed raises interest rates, it could cause a crash. 

How to Protect Yourself From a Crash

If you’re among the majority of Americans who are worried, then there are seven things you can do to protect yourself from a real estate crash. 

Buy a house to live in, not to flip

Two-thirds of the homes lost in the financial crisis were second and third homes. When the sale price dropped below the mortgage, the owners walked away. They kept their homes, but lost their investments.

Get a fixed-rate mortgage

As mortgage rates rise, your payment will stay the same. It’s better to live in a smaller house than take a risk and lose it later on. If you get a variable rate mortgage, find out what the interest rate will be when it resets. 

Calculate the monthly payment and make sure you can afford to pay it with your current income. Take the difference between that future payment and what you are paying today with the lower interest rate and save it. That way you will have the funds to pay your mortgage if your income falls. 

Buy the worst house in the best area you can afford

Make sure the area has good schools, even if you don’t plan on having children yourself. Potential buyers will. You can always improve the house over the years if your income permits. Good neighborhoods aren’t going to suffer as much in the next downturn. They will also bounce back quicker.

Make sure your house has at least three bedrooms

That will attract families if you need to resell.

Well-diversified portfolio of assets

Diversification means a balanced mix of stocks, bonds, commodities and equity in your home. Most financial planners don’t include home equity as an asset, but they should. It’s the biggest asset most people own.

Buy the smallest home you can reasonably live in

To limit the damage of a real estate collapse, buy the smallest home you can reasonably live in. Try to pay off your mortgage early, so you don’t lose your home in a downturn. Boost your investments in stocks, bonds, and commodities so they equal or exceed your home equity. 

Don’t succumb to the temptation to refinance and take out the equity

If there is an asset bubble in housing, don’t succumb to the temptation to refinance and take out the equity. Instead, revisit your asset allocation to make sure that it is still balanced.

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Charles McDonald
Charles McDonald
Charlottesville Solutions
2013 Woodbrook Court, Charlottesville VA 22901
REALTOR® - Licensed to sell Real Estate in Virginia
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