Lately, there has been chatter about whether the U.S. housing market is in a bubble and if it will be the catalyst for the next market crash.
A “housing bubble” or “real estate bubble” forms when housing prices rise unsustainably, driven by demand, speculation, and amplified spending. Recently, Google reported that the search “When is the housing market going to crash?” spiked by 2,450%! The sizable increase in searches tells me that a potential bubble is on the minds of a lot of people and should be addressed.
While home prices across the country have soared to record highs, the reasons behind the increase make a bubble seem less likely. Let’s dive into why this may be.
Supply and Demand
The COVID-19 pandemic caused major supply chain disruptions and shortages that led to soaring material costs. According to this CNBC article, lumber prices rose by 67% at one point this year and an astonishing ~340% year over year! It’s not just lumber costs either; prices for drywall, copper, and steel all experienced eye-popping spikes in cost.
The CNBC article also points out National Association of Home Builders (NAHB) estimates that the price surge “added $35,872 to the cost of an average new single-family home and $12,966 to the market value of an average new multifamily home.” This alone made the prospect of building a new home unfavorable.
These disruptions led to a housing supply shortage that drove prices higher as buyers had less inventory to choose from, leading to intense bidding wars. At the same time, mortgage interest rates hit record lows and attracted even more buyers since lower rates increase how much home buyers can “afford.”
The situation has been a perfect storm of increasing demand coupled with a sharp and sudden reduction in supply, fueling much of this spike.
The bright side? We are already seeing some signs of the housing market starting to cool down. According to the National Association of Realtors (NAR), existing home sales for August posted a 2% monthly decline, the largest drop since April, and overall home sales slipped by ~1.5% from a year ago.
In addition, the share of home listings with a price cut rose for the fourth straight month, and the increase in median home prices has started to slow.
These are positives for the housing market as it appears much of the imbalance was a supply-and-demand issue and not because of fundamental cracks in the housing market.
Foreclosures
A question that remains unanswered is what impact the end of the various mortgage forbearance programs will have on the housing market. Could their end lead to a massive spike in foreclosures and put banks on the hook for large loan losses as in 2008? It doesn’t seem likely, and there are a few reasons for that.
The good news is that with the recent increase in home prices, very few borrowers have negative equity. Negative equity is when the outstanding mortgage balance is greater than the value of the home. Currently, ~98% of borrowers have at least 10% equity, which is in stark contrast to the Great Financial Crisis, when ~40% of borrowers had less than 10% equity and 28% were underwater!
This is important because if real estate prices declined by 10%, most homeowners today would still have positive equity, which puts less stress on mortgage lenders (mainly banks) in the event of a spike in foreclosures.
Many borrowers defaulted during the financial crisis because they were so far underwater, they decided it wasn’t worth making any more payments. Today? Borrowers would be less likely to default as they could sell their property and avoid foreclosure.
Currently, an estimated 1.6 million homeowners are in various forbearance phases. Since the start of the year, the percentage of servicing loans in forbearance has consistently declined. In June, ~600,000 fewer consumers were in mortgage forbearance compared with the start of the year.
Even more encouraging is the noticeable drop in April, when many borrowers exited forbearance. This is a positive sign as they would have been eligible for additional extensions but did not need them.
Source: Mortgage Bankers Association.
While the signs are encouraging, there are some causes for concern. The number of delinquent mortgage borrowers remains nearly three times higher than before the pandemic, with ~1.9 million borrowers more than three months behind on their mortgage.
The risk is that with the economy still feeling the effects of the pandemic, the ending of the mortgage forbearance programs, and the unlikelihood of more stimulus from Congress, we could see the numbers spike again. That would be worrying as the total amount owed by borrowers in forbearance is ~$90 billion.
Different Times
While many comparisons have been drawn between the housing market of 2008 and today, significant differences exist.
For starters, lending requirements are much stricter today. During the early 2000s, lenders approved far too many no-doc loans with little to no down payment requirements. The approval process today is far more stringent and thorough.
The mortgage credit availability index shows just how out of control things were in the early 2000s. The chart below illustrates that the amount of home loans given out today is at a much safer and more normal level.
Another positive development can be seen in mortgage originations by credit score. At the height of the housing bubble, ~27% of mortgages went to those with credit scores below 660, which pales in comparison with ~5% today. This difference illustrates the emphasis being placed on making loans to creditworthy borrowers.
Source: Federal Reserve Bank of New York.
The appreciation in home prices since the pandemic has been remarkable. However, appreciation was stable the six years prior, especially when compared with the gains witnessed in the six years leading up to the Great Financial Crisis. During that period, home prices appreciated at an annualized rate of ~10%!
Many of the increases today are in specific real estate markets, which was not the case leading up to the housing crash.
Source: Black Knight.
Lastly, the amount of net equity that homeowners are cashing out is substantially less than during the Great Financial Crisis. In the fourth quarter of 2020, an estimated $48.0 billion in equity was cashed out from refinancing, which is significantly less than the peak of $108.1 billion during the second quarter of 2006.
This is an important metric to continue to follow as any sharp increases would warn of potential trouble.
Source: Freddie Mac.
While it wouldn’t be shocking to see a small uptick in the number of foreclosures, a massive spike doesn’t appear to be on the horizon.
As the economy continues to improve, I am cautiously optimistic that we are heading in the right direction. Of course, the risk of the pandemic lingers, and if new variants pop up, then we would need to reassess things ... again.
Discuss your situation with a fee-only financial advisor.
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