- Real median home prices are at record levels and significantly above trend, in our view.
- We believe rising mortgage rates and falling affordability suggest prices will peak soon.
- We do not expect a housing bust due to favorable supply demand conditions.
By any measure, the housing market is ‘hot’. As of February, some 50% of sales are above the asking price, versus around 20% prior to the pandemic. Also as of February, the median home is on the market for just 14 days relative to 40-50 days pre-pandemic. As the chart below shows, by 2020 real home prices (adjusted for inflation) had recouped most of the losses incurred after the peak in 2006. Since the COVID-19 pandemic began have risen at an unusually rapid pace. They are now 27% above their long-term trend, an amount like that experienced at the peak of the last cycle.
With all this data, it seems reasonable to ask if housing is in an unsustainable bubble, and if prices are at risk of falling. Our current thinking is that house prices are at or close to a peak, and in markets that have been overly speculative will come down somewhat. However, due to strong supply/demand conditions we believe most markets are more likely to ‘rust’ than ‘bust’. By rust, we mean that nominal prices (not adjusted for inflation) could decline somewhat or stagnate around current levels for several years, to allow wages and inflation to make them more affordable to the average buyer. This is what happened in the 1980’s and 90’s when home prices traded sideways.
In writing this Weekly we would like to acknowledge the work of Mark Vitner, Managing Director and Senior Economist at Wells Fargo, whose insights on this topic were very valuable.
Why median US house prices are likely to peak:
- Mortgage rates are up. Most buyers who use a mortgage care less about the price of the house and more about the cost of the monthly payment. 30-year mortgage rates have risen from 2.65% in Jan 2021 to 5.3% today according to Freddie Mac.
- Payments have risen dramatically. On a $240,000 fixed rate loan the monthly payment is now $1300 a month, up from around $1000 a month at the start of this year – a 30% increase! A borrower who can only afford $1000 per month can now only borrow $180,000. Thus housing, like a lot of things in this high-inflation era, has become a lot less affordable. This is especially true for a first-time buyer who has not benefitted from the rise in prices.
- High end buyers have seen a drop in their wealth. The S&P 500 is down 18.1% through last Friday. This is likely to reduce the price they will pay for homes, in our view, and their immediate appetite to transact.
Why house prices are unlikely to repeat the 2007-2009 crash experience. There are some important differences between now and 15 years ago.
Why median US house prices are unlikely to ‘bust’:
- The inventory of homes is at record lows…whereas there had been record building between the 2002 to 2007 period. In 2007 the inventory of new homes represented 11 months of sales; today it is six months. Existing home inventory in 2007 represented 11 months of supply; today it is just two months! In other words, housing is in short supply.
- Consumers are in better shape. The chart below shows the financial obligations ratio. This is a statistic produced by the Federal Reserve which represents the ratio of household debt payments to total disposable income in the United States. It measures how much household income is being spent on repaying debts and other financial obligations. The situation today could not be more different than 2008. The ratio was at a 40-year high in 2008 and interest rates were averaging two percentage points higher, whereas the figures from the end of 2021 are close to 40-year lows. The ratio will rise with interest rates in 2022 but not to a threatening level, in our opinion.
Lenders are being more prudent in our view. Between 2004 to 2008 mortgage lenders and brokers were lenient in their lending, collecting little information and often not verifying it. The term ‘no-doc loans’ was used to describe this phenomenon. Several large mortgage lenders went bankrupt in 2008-09 due to their aggressive lending. Today bank lending practices are much more closely scrutinized by the Federal Reserve. While banks have been keen to lend, we see fewer signs of excess.
Less speculation. While we don’t have specific data on this, we believe many of today’s buyers are looking for somewhere to live, not speculating on price rises by ‘flipping’ houses. The significant price declines of 2008-09 were largely due to over-levered speculators becoming forced sellers. We do not see that kind of speculation and leverage today.
Millennials are entering their peak years for household formation and spending. The oldest millennials are turning 40 and the youngest are turning 26. According to the US census bureau there are approximately 71 million millennials, and they make up 22% of the US population and 35% of the workforce. With baby boomers retiring at a rapid rate, it is estimated they will make up as much as 75% of the US workforce by 2025. In 1975, 45% of 25–34-year-olds had attained 4 common milestones: 1. Lived away from parents 2. In the labor force 3. Married and 4. Had a child. In 2016 the figure was 24%. Millennials have delayed these things, but now household formation is picking up, providing a source of structural demand. In addition, buyers are likely to spend more on homes and less on other things in our view due to the pandemic’s shift to flexible schedules and the need for more space. This will also push a move to the suburbs.
Wild Card: The Institutional Buyer
In the last 14 years a new buyer of homes has emerged. Institutional investors have sprung up as a new buyer of rental properties. It is hard to gauge how they might react to prices rolling over. Our best guess is that they are stable owners, especially in our ‘rust’ scenario as rents will likely continue to rise. In a bust scenario they might also be a source of stability and new buying as rental yields rise, but they might also cause instability if they decide to exit their holdings and take profits. Since they have been investing for years, the strategy has been successful, but in recent years there has been an increase in the number of investors and as a result, they have been going to smaller markets where they have become a larger percent of the market. These investments may be more unstable.
Location, location, location: All Housing is local
It is important to stress that national statistics are the result of very different local markets and location is always a key factor. Looking regionally, there are some interesting dynamics occurring as a result of the pandemic. Remote work is allowing buyers to relocate from the most expensive urban markets to cheaper ones. For these buyers, interest rates are likely to have less effect since the housing markets they are moving to are cheaper. The biggest beneficiary has been the South.
According to Mark Vitner at Wells Fargo “prices are up mostly in the South, where they have risen 18.1% over the past year. By contrast, prices are up a more modest 7.6% in the Midwest and are up just 7.2% and 6.1% in the Northeast and West, respectively.” He also says, “The South, where the median price of an existing single-family home was $326,900 in February, or 10% below the national average, has been the greatest beneficiary of these inflows.”
Housing and the economy
We believe housing is important for the economy and for investors watching for signs of recession. House values have a significant impact on household wealth, as real estate comprises approximately 25% on average of total US consumer net worth (Ned Davis Research). We believe that house price movement can have a meaningful psychological ‘wealth effect’ on consumer confidence and consumer spending. We also believe housing-related industries, such as lending, construction, real estate brokerage, and home improvement, are important segments of the economy. Our ‘rust’ versus ‘bust’ scenario for house prices helps give us confidence that we are not forecasting a recession in the next year, though we are monitoring housing data closely for signs of further deterioration.
Some final advice
Buying a home is more than a pure financial decision. Unlike a stock portfolio which is purely an investment, you get to live in your house and there are all kinds of intangible emotional factors involved in buying a home. Since we all need somewhere to live, the choice is buying or renting and owning a home just feels different. It also allows you to add value to your home by improving it. The advantage of renting is flexibility, but rents are also rising rapidly. Generally, the longer you plan to live in a home, the more advantageous it is to buy. Given our views on home prices, we suggest the decision be based on personal preferences, not on the expectation of further significant price increases in the next few years. We also suggest buyers avoid getting caught up in the current frenzy, as we expect it to die down, and take the time to make a prudent decision.