In: Real Estate

Are We Headed For Another Real Estate Crash?

Real estate prices are high. Really high. In San Francisco, for instance, the average price of a home is now more than a million dollars in some districts, more than four times the national average.

Unsurprisingly, Americans are worried about this. In a study reported by Forbes, more than 58 per cent of those surveyed said that they thought that the housing market was in a dangerous bubble situation and that prices could pop at any moment in the next two years. That study was back in 2016, so if Americans are right, crashing prices are just around the corner.

Most experts reject the idea that we’re in for another 2008-style crash in the housing market. More likely, they say, is that we’re headed for a correction, like the February pullback in the stock market. A correction, they point out is a very different phenomenon to a crash. During a crash, intrinsic values go out of the window as credit tightening artificially reduces prices. Loans aren’t available to buyers, and so sellers have to accept big discounts if they want to shift their properties. In corrections, prices fall for different reasons. For instance, incomes might not rise as fast as people expect, and therefore, property prices cannot grow in tandem.  Or developers might rectify supply issues, helping the market equilibrate downwards.

Warning Signs In The Housing Market

It would be nice to think that we’re headed for a “correction” in the property market – a mild fall in prices that will soon be swallowed up by an overall rising trend. But there are significant warning signs that the property market is unsustainable.

Historically, property prices track inflation. When inflation goes up, house prices usually rise by about the same amount in the long term. Rising house prices at the rate of inflation make sense: it’s not possible for people to pay ever-increasing amounts for housing in real terms over the course of decades. But there’s a problem. If you look at house prices versus a long-term chart of inflation-adjusted prices, you quickly see that today’s prices are about 32 per cent above their long-term trend. A boom in prices like this only happened once before in the history of house prices: right before the 2008 crash.

In 2017, home prices boomed, just as they did back in 2005 when practically every money manager on the planet implored their clients to get into the real estate business. They couldn’t lose, they were told, and so hundreds of thousands of retail investors plowed their money into what they thought was a sure bet.

Some smart commentators point out that the current boom is different from those that came before because this time higher prices are more sustainable. In a sense, they’re right. Today’s interest rates are much lower than they were a decade ago, and so property investors don’t have to pay as much on mortgages. Mortgages got bigger over the last ten years, but they also remained affordable, thanks to easy money from the financial system.

But overall affordability hides problems certain segments of the market. For the average person, the cost of housing hasn’t risen, but for those in the bottom 30 per cent of the income distribution, it has. By 2016, only around 4 per cent of rental units in the country were classed as “affordable housing.”

The lack of affordable housing is a signal to investors that something might be going wrong in the market. Just as the subprime mortgage market led to the failure of Bear Stearns, Fannie Mae and Freddie Mac, so too could problems in the lower end of the market this time.

 

Should You Sell?

According to Wren Realty Inc., now is the time to sell and get into other assets. Experts on the housing and mortgage markets are now warning of a renewed subprime crisis, made possible by the return of cheap rates and overindebtedness. What’s more, the problems in the subprime market may be greater than during the Great Recession. Back then, subprime borrowers were classed as those with credit scores below 660, a reasonable cut off at the time. But today, many of the biggest lenders only consider individuals with scores under 620 as subprime, meaning that the problem is likely far worse than many imagine.

Flipping is also on the increase. Back in the height of the housing boom in 2005 and 2006, investors flipped almost one in twenty properties. Flipping became the norm as investors began adding things like granite countertops and ensuite bathrooms in an attempt to make money by speculating on future property prices. Today flipping is at the highest levels since the last crisis, indicating that more speculative buyers are entering the market – a potentially dangerous situation.

Interest Only Loans

During the last financial crisis, many homeowners had to foreclose because the rate of interest paid on their mortgages ticked up. Upward adjustments became unaffordable for many, leading to severe financial problems and losses for banks. Interest only loans were excoriated in the press, but they’ve made something of a comeback, and are now a popular option for buyers who want houses they can’t really afford.

The original appeal of interest-only loans was founded on the idea that house prices could only rise. Homeowners could simply pay interest to the bank, and then after a few years of steady gains in their home’s value, could sell it on to somebody else for a profit.

Although many people benefited from these schemes, it’s a fundamentally flawed concept. Homes cannot generate new value by themselves because they don’t produce anything (except housing services for the people who live in them). Unlike companies, they don’t sell products for a profit, and can’t generate a stream of returns for investors. Ultimately, home prices must revert to their long-term trend, and that’s the correction that savvy investors are waiting for. They know that it’s coming, it’s just a question of how bad it will be. A correction is more likely than a crash, but that remains to be seen.