At what point do increasing home prices stop being a “recovery” from the last housing bubble and start becoming a risk of a new bubble?
One oversimplified answer is “when home prices reach their original bubble levels.” Which they’ve done. Sort of.
But this is not 2007, and today’s housing challenges are different from those that drove the Great Recession and real estate collapse last time. Here’s a jargon-free look at housing issues and risks in the United States today that you won’t need a Ph.D in Economics to follow.
Housing Recovery: Complete?
According Zillow’s Home Value Index, average U.S. home values peaked in spring 2007, at $196,000. At their nadir in December of 2011, they bottomed at $151,000. In February 2017, average U.S. home values once again reached $196,000.
This doesn’t, of course, mean that every home in the United States has the exact same value today that it did 10 years ago. Zillow’s Home Value Index doesn’t adjust for inflation, so “real” home values are still lower today than they were 10 years ago.
It also doesn’t cover the diversity of home appreciation—or stagnation—seen across the country. Homes in many areas are still very much underwater. The housing recovery has been an uneven one, with homes in some cities worth more today than they were 10 years ago and homes in others still struggling to recover lost equity.
Metro areas in the South and West have disproportionately seen housing recoveries, while most of the Northern and Eastern markets in the United States have struggled to regain ground.
Related: 7 Real Estate Investors Discuss What They’re Seeing in Their Local Markets
But in raw nationwide numbers, real estate values have caught up to their previous high water mark.
Affordability in Broad Terms: Home Price to Income Ratios
Home affordability is a slippery thing. For example, someone who borrowed an adjustable rate mortgage back in the bubble might have technically had an affordable home payment—until their initial low rate expired and their payment shot up and started adjusting.
One easy way to look at home affordability is the ratio of home price to income (PTI ratio)—how many times higher the median home price is than the median salary. Freddie Mac looked at the last “stable” housing period, from 1993-2003, and found an average ratio of 3.5, considered by many analysts to be a healthy ratio. At 4.1, the ratio leaves the so-called normal range and starts entering what Freddie Mac calls “unusual” ratio levels.
During the last housing bubble, the ratio of home prices to income spiked up to 4.8. It then dropped in the recession, to 3.2 in 2011. At the end of 2015 (reliable median income numbers for 2016 haven’t been released as of this writing), the ratio was bumping up against the danger zone again, at 4.0.
And home values rose 7.2% in 2016—faster than incomes, according to most analysts. (See the Zillow home values links above.)
Take the PTI ratio numbers with a big ol’ grain of salt though. To begin with, they’re nationwide numbers, but more critically, this ratio gives only a small glimpse into the complex topic of housing affordability.
Credit Markets & Affordability
The ratio of home prices to incomes only tells part of the story. Another way to look at affordability is what percentage of a median earner’s monthly take-home salary is required to pay the mortgage on a median home. Actual monthly payments depend on factors like mortgage interest rates, property taxes and insurance rates. And monthly take-home salary depends on federal, state, and local tax rates.
Interest rates have been extremely low for a long time. Compare today’s interest rates, hovering in the 4-4.5% range, to interest rates in the 1980s, which at times surpassed 18%.
To put that in perspective, a 30-year mortgage for $200,000 at 4% interest costs $954.83/month for principal and interest. At 18%, the same loan costs $3,014.17.
The Federal Reserve has gradually started raising interest rates, so expect this artificially cheap borrowing environment to disappear.
Obviously, the cost of credit matters, but credit availability also matters. Credit markets in the 2000s were extremely loose, the market flooded with no-income documentation loans, extreme subprime loans, and other loans with minimal credit and income qualification requirements. That helped inflate the bubble in a superheated way.
In the aftermath of the housing collapse, credit markets tightened to a clenched fist. They’ve been gradually loosening since 2012, which is good news for homebuyers looking to qualify, but something to watch for bubble hawks. “Since 2012, there has been abundant liquidity in the market, making more dollars available to lend and pushing banks to hunt down more borrowers,” explains the U.S. Office of the Comptroller of the Currency.
So why does it feel like housing is so unaffordable?
Because there’s almost no new housing being built for lower and middle-income families. In 2016, a shocking 85% of all new rental housing built fell in the luxury category. As for new homes for sale, only 28% of new housing today is built to sell below $250,000. Contrast that with 43% before the Recession.
Does that mean that all the demand is for luxury homes? Absolutely not. Trulia compared the number of home searches to the number of home listings and found a large shortfall in lower and middle-income home listings. Nearly 27% of home searches were for starter homes, yet only 21% of available listings were for starter homes. But for higher-end homes? They found a huge 11% surplus in listings compared to interest.
This gap is widening, too. Over the last three years, Trulia’s “market mismatch score” has gone from 5.6 to 6.0 to 7.4, as the supply of luxury homes sees a supply glut and the supply of starter and trade-up housing has been thin while demand has strengthened.
Why Are Developers Only Building Luxury Homes?
That’s a complex question, with many answers. One answer is that margins are higher for luxury homes, so developers have a greater incentive to build them. Some developers report that they cannot earn a profit building lower-end properties due to today’s high construction costs.
But consider location, too. Much of the demand for housing over the last five years has been urban, as Millennials and empty-nester Boomers search for downtown homes in walkable neighborhoods. Urban areas tend to have far more development regulations, and some cities restrict building density based on concerns that their (often aging) infrastructure can’t handle higher density housing.
In many cities, the land is so valuable and the regulations so tight that the economics of building new affordable housing just don’t make sense for developers.
The alternative location for building affordable housing is farther away from urban centers. But these un- and underdeveloped areas often pose a risk for developers, with no proven demand for housing there. Why gamble on low-margin projects in an area so far from the urban center that it may not sell at all?
So for the last five years, residential development has been all about luxury homes. Which begs the question who’s buying them?
The Distorting Impact of Foreign Buyers
In America’s largest cities, wealthy foreign (particularly Chinese) buyers have been snapping up luxury homes.
Specifically, Chinese buyers have spent $27.3 billion in buying U.S. residential real estate over the last four years. That’s more than the combined total of the next four largest foreign countries’ investment in U.S. homes.
When foreign buyers move into a local market in force, they change the entire economics of the real estate market. Instead of being based on the local economy and local incomes, home prices spike up based on completely unrelated external forces.
As local home prices become detached from local incomes, a massive affordability rift opens. It impacts all home values, not just the luxury homes being scooped up by foreign buyers. As luxury homes go up in price, local homeowners looking to trade up can no longer afford to do so; thus, they can’t list their own mid-range homes for sale. Suddenly, there is very little supply of mid-range homes on the market, which further distorts prices.
So, Are We Entering Another Bubble?
Home values in many areas in the country are returning to pre-crash, bubble levels. Compounding that problem, affordability is decreasing as home prices outpace income gains and interest rates rise.
Does that mean real estate prices are overvalued? Are we in another bubble?
“Bubble” is the wrong word. What we have is a serious imbalance in many cities’ housing markets, which are distorted toward high-end homes. What we don’t have enough of is lower and middle-income housing.
How to increase affordable housing supply is a massive subject in itself, but a good starting place is city governments working more flexibly with developers to encourage higher-density development with less red tape. Modernized infrastructure in older cities will help support higher-density building. Better tax incentives can encourage developers to build affordable housing. City governments can be more open minded to novel affordable housing ideas, like container housing or micro-housing. Some cities, like Vancouver, are experimenting with taxes on infrequently occupied housing to discourage foreign buyers looking for rarely-used second homes. And as the luxury home market over-saturates, developers will be forced to turn their efforts to more affordable housing.
If they don’t, they’ll find those luxury homes collapsing under their own weighty prices.
What are your thoughts on the current state of U.S. and Canadian housing markets? Is your market overheated or undercooked?
Give us a peek into your crystal ball for where housing markets are headed!