Wednesday July 11, 2018 by The Mettle Group
Earlier this year I sat as an attendee at the WCI conference, also known as the Physician Wellness and Financial Literacy Conference in Park City, UT. I was approached by a physician attendee who recognized me and asked: “Josh – when will the real estate bubble pop?”
He went on to explain that his young family had outgrown their home and were uncomfortably waiting for the next real estate crash to come before moving up to his dream home, or at least a home that would fit his growing family. I asked him, “Why do you believe we are in another real estate bubble?”
His answer was surprising to me, he had swallowed the myth that today’s real estate prices (which are the highest ever in most areas of the country) were evidence we are near the next cliff and a crash is imminent.
I was puzzled that he had not sought more data-driven reasons to arrive at his conclusion, and the idea for this article was born. I’m grateful for WCI to give me the opportunity to answer his questions, and yours, in a data-driven format.
If you’re like many doctors I speak with, you probably believe we are on the brink of a real estate crash and you are asking yourself if you should try to time the market or buy now. Here are a few of the common myths about the current real estate situation that many people believe:
Prices are at an all-time high, we must be near the top!
The market is just too hot, I’m going to wait it out a few years until it cools and I can get a better deal!
There is no way all those people can realistically afford homes – a crash is imminent!
However, if you look at the data and the current economic situation, you’ll quickly realize how different the current environment is from where we were in 2008 (the last time home prices were at an all-time high).
The problem with the emphatic statements above is that they are myths, and they may be stopping you from living the life you want.
By the end of this article, you’ll realize that it’s not a bad idea to move up to a bigger, better, more comfortable home. Instead, you’ll realize that you should buy that dream house right now if it fits in your budget.
The vast majority of the country has lower monthly housing payments relative to median income today than during the previous twenty years. Today the national payment to income ratio is at 22.8%, meaning that on average, homeowners are paying 22.8% of their gross income to cover their monthly housing expenses (principle, interest, taxes, and insurance). You can see from 2000 to 2007 that ratio exploded upwards to 34.6%, which in hindsight was clearly not sustainable. Today’s payment to income ratio is clearly lower than historical norms for two reasons.
With incomes rising and interest rates still well below historical norms, housing is relatively affordable for most areas of the country.
There are certainly exceptions to the national averages. California, Washington D.C., New York, Delaware, Maine, and Oregon are well above the 25% payment to income ratio historical averages and very well may near be reaching their cyclical top in prices, unless income growth in those states continue to rise quickly it is likely real estate appreciation will slow or even dip for a period of time.
That does not mean a crash is imminent, it means I would be more cautious buying in those areas, I would want to be confident I was going to live in the home for five to ten years, and I would not want to stretch myself beyond what is comfortable for a payment.
“The Debt Service Ratio for mortgages is near the low for the last 38 years. This ratio increased rapidly during the housing bubble, and continued to increase until 2007. With falling interest rates, and less mortgage debt, the mortgage ratio has declined significantly.” –Calculated Risk
To buy a home, you need income and for most of us, that means a job. Since the Great Recession, the U.S. has been consistently creating jobs, over the last twelve months 2.28 million net new jobs have been created.
Having a job alone isn’t enough. You have to have a well-paying job to afford a home in most places. The data on earnings shows that all those new jobs are forcing employers to compete for talent by increasing hourly earnings.
We now have more people working and they’re earning more money than they were before the last crash, thus they can afford housing at a higher price.
“Even though CoreLogic’s national home price index got to the same level it was at the prior peak in April of 2016, once you account for inflation over the ensuing 11.5 years, values are still about 18% below where they were.” – Dr. Frank Nothaft – CoreLogic Chief Economist
As a Utah resident, I’m happy to say job growth has been particularly good in Western states. It stands to reason the states with the quickest pace of job growth will also be the states with the most competition for housing and likely the highest rates of real estate appreciation in the coming years.
The U.S. economy has added 2.28M net new jobs in the most recent twelve month period, meanwhile, there has only been 1.16M new dwelling building permits pulled. Over the last year, the U.S has created 1.97 net new jobs for every one dwelling being built. Historically that average has been closer to 1.25 to 1.5 new jobs created for every new housing unit.
Clearly, home builders are not building fast enough to keep up with the demand coming from new job creation. Until builders catch up, we will have greater demand for housing that we have supply, and home prices should continue to rise in most areas of the country, especially those areas with quickly expanding economies.
As of May 2018, the U.S. Bureau of the Census reports a 5.2-month inventory of homes in the U.S. The months’ supply indicates how long the current inventory of homes for sale would last at the current sales rate if no new additional homes were built.
Looking at the graph below, clearly, we are not in an oversupply situation like we were before the crash. Once the supply level approaches seven months’ supply, I start to get nervous.
It’s no secret the Mortgage Meltdown and the ensuing Great Recession were fueled by cheap, easy credit, with little if any consideration to the borrower’s ability to realistically make on-time payments and pay the loan down over time.
Years of real estate appreciation had warped the minds of credit policymakers and borrowers alike, the accepted dogma was that real estate only went up, why worry about a borrower’s ability to repay, they can always sell or refinance the debt.
That didn’t work out so well…
Today, however, underwriting standards are tight as a tick. Clients need solid credit, documented two-year history of income, a reasonable assessment of the likeliness of that income continuing, and down payment funds must be verified as the clients’ own.
Mortgage credit standards are measured in mass by a couple of different organizations, both have similar findings. Today underwriting standards if anything are too strenuous.
The Urban Institute measures default risk and states a level of twelve percent is reasonable on their modeling system. Today we are near six percent, meaning they believe we could double default risk and still be within their reasonable tolerances.
The Mortgage Bankers Association measures similar credit and underwriting standards with their Mortgage Credit Availability Index. This index measures how easy or difficult it is to obtain mortgage financing, the higher the score the easier, the lower the score the more difficult to obtain credit.
As you might have guessed, the index blew its top off approaching a 900 on the index in the years preceding the 2006 real estate bubble that lead to the Mortgage Meltdown. As delinquency rates started to increase, lenders quickly got their wits about them and started tightening credit standards.
That was a lot like watching a toilet flush. As credit standards tightened, those owning property with no chance of paying, those with the assumption real estate would always go up, which afforded them options to refinance and pull cash out or sell at a higher price, had their dreams crushed and titles to their homes taken away.
The Mortgage Credit Availability Index bottomed just below 100 in 2011 and as of March 2018 has not yet hit 200. Today’s buyers are legit, they have income, credit, assets, full appraisals to set valuations, and qualify to actually pay back the mortgage debts they are taking out.
Not surprisingly after 10 years of incredibly tight mortgage lending standards, mortgage loans are performing incredibly well. Delinquencies and defaults are near an all-time low, which speaks to the overall strength of the real estate and mortgage market.
It appears mortgage lenders have learned their lesson and nearly a decade after the bottom of the Meltdown; tight lending standards accomplished their goal of keeping delinquencies low. Currently, mortgage foreclosure rates are about one percent.
“Unemployment and lack of home equity are two factors that can lead to borrowers defaulting on their mortgages. Unemployment is at the lowest level in 18 years and for the first quarter, the CoreLogic Equity Report revealed record levels of home equity growth with equity per owner up $16,300 on average for the year ending March 2018.” – Dr. Frank Nothaft – Chief Economist at CoreLogic
One of the things that led to the Mortgage Meltdown and Great Recession was that Americans were using their homes like cash registers, constantly pulling out cash every few years, and far too few had substantial equity in their homes when the economy slowed.
That is exactly the opposite of what we are seeing today.
Black Night just reported that Americans are sitting on a record amount of tappable equity, currently estimated to be in excess of $5,420,000,000,000 ($5.42 Trillion in tappable equity).
Tappable equity is defined as the amount of equity between your current mortgage balance and eighty percent of the current value of your home. For example, if you owe three hundred thousand on your home and your home is worth five hundred thousand, you would have one hundred thousand of tappable equity. This is equity that is easily accessible with a HELOC (home equity line of credit) or a new first mortgage.
Unlike the previous real estate run up from 2002 to 2006, Americans are not yet tapping their equity. In fact, Americans are paying down their mortgage balances at record levels which has led to record amounts of tappable equity creation, estimated at $381 Billion in the first quarter of 2018 alone. That is an incredible amount of wealth being created in three months!
Record amounts of tappable equity could be bullish for small business owners and the U.S. economy as a whole, this equity is a potential source of investment in new businesses or it could be utilized to restructure higher interest rate debts. It also tells us that Americans are being judicious with their home equity and thus far are not treating their home equity like an ATM machine.
The housing recovery began at the starter home level and was aided by significant first-time homebuyer tax credits and record low-interest rates. As demand grew from the bottom up so has the rate of real estate appreciation that has not been balanced since the recovery began.
CoreLogic reports low-end homes have appreciated by fifty-five percent, while high-end homes have only appreciated by thirty percent since 2013. It is unusual that low-end homes would appreciate eighty-three percent greater than high-end homes; it is a trend that will not continue forever.
We are seeing signs the high-end real estate marketing is coming to life. Premium home searches now make up over forty-one percent of all home searches online and luxury homes days on market is at the lowest levels in over a year.
One potential explanation is that middle and low-end homeowners have seen considerable equity gains over the last decade and are now able to sell for substantial gains and buy with significant down payments. Couple those large down payments with a strong economy and rising wages, its logical more buyers would be showing up in the luxury market.
Bloomberg reports high-end homes in premium markets across the country have surged over the last year. In many areas across the country, this trend is just starting and the high-end appreciation has not yet caught up to the low end and middle range homes.
“Median home values nationally rose eight percent in March compared with a year earlier, while neighborhoods of San Francisco and San Jose, California, have increased more than 25 percent.
Prices in Delaware and New York, such as the Hamptons, also surged more than twenty percent.” -Blomberg News
This may be an opportunity to sell in a middle market that has seen significant gains and buy in a high-end market that is yet to see the run-up in values. Every market is different and these opportunities may not exist where you live, if you are considering moving up, it’s worth checking with a local REALTOR to determine if your location has seen this similar split market with the low to mid-range homes leading the way with appreciation thus far.
The Federal Reserve conducted the largest monetary policy experiment in history, commonly known as the QE (quantitative easing) program, and resulting in the U.S. central bank holding a massive $4.5 trillion portfolio of U.S. Treasuries and mortgage bonds. QE began in 2008 and officially concluded in 2014; however, the income from the QE investments continued to be rolled into new bond purchases until late 2017.
Since the Fed exited the market as a net buyer of mortgage bonds, interest rates have moved higher leading some to believe that higher interest rates will put an end to real estate appreciation. While it is clear that long-term mortgage rates have reversed their thirty plus year trend lower, it is not yet clear the higher rate trend will negatively impact real estate values. Surprisingly to most people, thus far the opposite has happened.
Home price appreciation has accelerated as interest rates have been rising throughout 2018. While this is somewhat counterintuitive, interest rates tend to rise in good economic times, when unemployment is low and the economy and wages are rising. The wave of qualified buyers and limited supply of homes for sale has overpowered rising interest rates thus far.
“Constrained home supply, persistent demand, very low unemployment, and steady economic growth have given a jolt to the near-term outlook for U.S. home prices. These conditions are overshadowing concerns that mortgage rate increases expected this year might quash the appetite of prospective home buyers.” – Terry Loebs – Founder Pulsenomics
Interestingly this is not the first time higher interest rates have accompanied rapid real estate appreciation, as a matter of fact; the last six times mortgage rates increased by more than one percent, residential real estate prices increased.
After more than a decade of declining homeownership rates, owning the real estate Americans inhabit is regaining its allure. The official homeownership rate peak was at 69.2% in 2005. As credit standards began to tighten, many were no longer able to qualify for financing, and soon thereafter the real estate crash was upon us.
The parents that lost their homes and the children who remember their parents going through that unsavory experience both had a bad taste for owning real estate. Many had decided never to buy a home and that renting was going to be a better choice for them.
We are now nine years into the real estate recovery and it appears consumer sentiment towards owning real estate is starting to change. Not only has the homeownership rate bottomed and begun its ascent higher for the last two years, Gallup also recently reported that one out of three Americans believe that owning real estate is the best long-term investment.
It appears the emotional scars that were left by the Mortgage Meltdown and Great Recession may just now be healing for some. As the scary memories of being foreclosed upon subside and Americans return to homeownership, it’s likely we see more buyers enter the market in the coming years.
Our country has experienced economic growth for almost a decade. Economic expansion cannot happen forever, the economy will need to take a breather at some point and most analysts believe a recession can’t be too far off.
“Experts largely expect the next recession to begin in 2020.” – Pulsenomics
“The economic expansion that began in mid-2009 and already ranks as the second-longest in American history most likely will end in 2020 as the Federal Reserve raises interest rates to cool off an overheating economy, according to forecasters surveyed.” – Wall Street Journal
Here is a graph comparing the opinions of those surveyed by both the Wall Street Journal and Pulsenomics:
According to the Merriam-Webster Dictionary, a recession is defined as follows:
“A period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters.”
During times of recessions, the economy slows noticeably, but that does not mean we are headed for another housing crisis. The last housing crisis was a result of fake demand that was a false signal to homebuilders to massively increase the number of homes they were building.
That fake demand stemmed from cheap and easy credit, which fueled the greed in all parties involved and eventually led to a massive oversupply of homes and the eventual crash.
Today lending standards are solid (maybe too much so) and the demand for housing is real. Homebuilders thus far cannot keep up with demand and we have a housing shortage.
Today’s situation is the polar opposite of what we saw before the last crash. It is highly unlikely that the next recession leads us into another real estate crash. In fact, looking back forty five years and six recessions, housing prices continued to appreciate in all but one recessionary period.
“If a recession is to occur, it is unlikely to be caused by housing-related activity, and therefore the housing sector should be one of the leading sources to come out of the recession.” – Mark Fleming – Chief Economist First American
Bottom line, an economic recession may be likely in the coming years, but a full-blown housing crisis is very unlikely.
As I wrote this article, I’ve simultaneously been emailing my architect who is helping my family design our new home. I’ve been in my current home since 2010 and when I bought it, I thought I would never move, this was definitely going to be our forever home I thought. It’s in a great neighborhood, killer views, and after eight years of work, we have it fixed up and looking exactly like we want it. Time to move!
As my kids have gotten older and my personal taste and preferences have changes, I’ve started to want to be outdoors more. Instead of living in the thick of it, I want to watch it from afar. I want my kids to grow up on streams, trails and mountain bikes instead of PlayStations and iPhones.
So we are leaving the “forever house” for the next “forever house”, one that I believe will enable me to create deeper relationships with my kids before they take off for college and begin their own journey in life.
This does not mean that I think you should overspend and pray that real estate will go up forever. We all know that real estate is going to have its ups and downs; the longer you hold real estate the higher the probability you have of time protecting you against short-term zigs and zags of the market.
One last word of advice as you consider buying your dream home, one that better fits your lifestyle and family for decades to come. Do not overspend! Do not put yourself in a situation where your home turns into a financial burden that detracts from your lifestyle, your ability to be a great spouse or parent and practice your profession the way you want to.
I personally have never bought a home that cost more than twice my annual income (and that is my max budget for my new forever home as well). I tell clients that two to three times your annual income, in my opinion, should be the limit, especially when you have kids, college, weddings, and retirement coming faster than most of us realize.
In closing, my advice is to live life without fear that another real estate crash is coming, but in doing so, do not forget what brought about the last real estate crash.
Happy house hunting!