October 15, 2021:
In this article, we’ll discuss the housing market – the causes of the price boom, how sustainable they are, and how this compared to the mid-2000’s bubble.
Why have home prices gone up so much?
In the 12 months leading to July 2021, single family home prices increased by 20% nationally and an astounding 28% in San Diego.(1) Since that time, the frenzy has calmed down, but demand is still high and prices have held steady. Below we’ll describe the main factors we believe have contributed to this boom. We’ll also try to determine which ones are sustainable, meaning that they are driven by real and persistent changes in the economy, and which are likely to be more temporary.
Pandemic effects on demand
The pandemic strongly shifted relative demand towards housing for two reasons, in our view. First, the rise of remote work increased the desirability of having a nice home to work from. Second, the lockdowns and staggered reopenings led to a decline in spending on many other areas (travel, restaurants, entertainment, etc.). In short, compared to the pre-pandemic period, people cared more about having a nice place to live, and they had more to spend on it.
This isn’t a totally satisfying theory, because it doesn’t explain why home purchase prices went up so much more than rents. Asking rents rose by 9% in our July-July period, which is a lot, but is dwarfed by the 20% rise in home prices. In San Diego, asking rents rose 12% against the 28% increase in home prices.(2) Some of this disparity could be justified by people moving from the “renter” to “buyer” category, but we suspect this is a fairly minor effect.
So, the higher relative demand for living spaces seems to explain a good chunk of the increase in home prices – but not all of it.
Here in San Diego, we have an additional effect related to remote work. We have heard stories about remote workers leaving expensive locations such as the Bay Area and buying houses here in San Diego, which would bring new, wealthy homebuyers to our town. We know for sure that this is happening to some degree, but it’s tough to know how big an impact it’s having. It could certainly help explain why San Diego prices have risen so much more than the rest of the country. (San Diego had the second-highest price increase of any city in the US, surpassed only by Phoenix).
Are these factors sustainable? Yes and no.
- Once everything is fully reopened, we expect that remote work will be a lot more widespread than it was before the pandemic – but less so than during the pandemic. So, the increased premium on having a nice home is likely to be sustainable, but not as big as it has been over the past year and a half.
- The anecdotal in-migration of wealthy Silicon Valley escapees could be sustainable, if an ever-higher number of workers were to switch to fully remote work and choose to move here. However, this also seems self-limiting – the more expensive San Diego gets, the fewer people will want to move here, and the more will want to move out (many San Diego workers are going remote too!).
- The decline in spending on travel, entertainment, and the like is temporary, so the “nothing else to spend it on” effect has already diminished and will disappear entirely.
The 30-39 age demographic, which is very important to housing, is expected to grow through the rest of the decade.(3) But this is a very slow moving trend that was already underway, so it clearly has little to do with the past year’s breakneck home price increases. Still, it’s worth mentioning as a factor that is both sustainable and positive for housing.
We believe there is a major speculative bubble taking place in much of the stock market and a possibly even bigger bubble in cryptocurrencies. There’s little doubt that some of this bubble money is making its way into the housing market. (You don’t even have to cash out your bubble winnings to buy a home, by the way – here’s a WSJ article about people borrowing against their cryptocurrency holdings to buy houses, as well as expensive consumer goods and, of course, more crypto).
It’s not enough to just call this unsustainable. If these are bubbles, they will burst, and whatever positive effect they’ve had on the housing market will go into reverse and become a drag. It’s difficult to know how big the impact might be, but it’s certainly not a positive.
The more an investment’s price goes up, the more investors tend to feel pressure to buy before they miss out on further gains. This “fear of missing out” effect was rampant in San Diego during the mid-2000’s housing bubble. We haven’t seen anything to that degree this time around, but we started to get a whiff of it during the frenzy months earlier this year. It’s difficult to know how much impact FOMO has had, but it’s likely played a part in the price increases.
Like bubble money, fear of missing out only helps on the way up. As soon as prices stop rising, the FOMO demand boost disappears. So whatever effect FOMO has had, we would characterize it as very unsustainable.
Low interest rates
The chart below shows mortgage rates over the past 5 years, with the gray bar indicating the pandemic-induced recession which started in February 2020:
Rates have seen a significant decline since the start of the pandemic. If we split the past five years into two periods, before and after the pandemic began, rates averaged 4.1% before and 3.0% after. That decline has a big impact: compared to the pre-pandemic period, the average post-pandemic buyer could have paid 14% more for a house without any change to the monthly mortgage payment.
It seems pretty clear that lower mortgage rates have been a factor in the recent home price surge. But that can cut both ways; an increase in rates would turn from a tailwind to a headwind. How sustainable are rates at these levels?
That turns out to be a very controversial topic, and one in which very smart people disagree. The main point of contention is whether the recent rise in inflation will be temporary or more protracted. We’re going to discuss this a lot more in our next article; here we’ll just say that we believe the answer can’t be known with any certainty, so we think it’s wise to be prepared for either outcome.
With that goal in mind, we’ll outline a few interest rate scenarios to see what impact they would have on housing affordability. For each rate, we calculate how much home prices would have to drop to preserve the same affordability of monthly payments. (This is not to say that there is always a one-to-one relationship between rates and prices; we’re just trying to illustrate the affordability “pressure” that might come with an increase in rates).
- If mortgage rates remain at the post-pandemic average of 3.0%, it will neither help nor hurt affordability from this point.
- To offset a rate rise to 4.1% (the pre-pandemic average in the above chart), home prices would have to decline by 13%.
- To offset a rate rise to 4.9% (the high point in the graph reached in 2018), prices would have to drop by 21%.
- If the inflation-worriers turned out to be right, and rates broke above their pre-pandemic range, perhaps mortgage rates might rise to 6%. This is not an outlandish number… it’s about 1% above the level reached in 2018, and is somewhat below the average rate for the decade of the 2000s. To offset the affordability hit from a 6% mortgage rate, home prices would have to drop by 30%.
None of these are predictions. (We think anyone who has a confident multi-year interest rate forecast is deluding themselves). Our purpose here is just to illustrate the affordability effect of different rate levels. Hopefully it’s clear that home prices could be pretty vulnerable if mortgage rates were to rise.
Comparison to the mid-2000’s housing bubble
There is one major similarity between the current period and the housing bubble of the mid-2000s: home prices have gone nuts. And, importantly, they have done so in excess of growth in local rents and incomes, which are the main economic underpinnings to home prices. The chart below shows how expensive home prices are compared to incomes and rents in San Diego.It’s short of bubble peak levels… but it’s up there:
However, that similarity gives way to many important differences from the bubble era. The most significant is that mortgage rates are a lot lower now. Here’s a graph that shows the same ratio as above, but instead of measuring home prices, it measures monthly payments. It really shows how powerful mortgage rate changes can be: despite the high purchase prices shown in the graph above, monthly payments (compared to incomes and rents) are actually on the low side of the last 40+ years:
As we discussed in the prior section, a big change in mortgage rates could suddenly make this chart look very different. But if interest rates can hold near these levels, monthly payments are actually pretty reasonable, and perhaps this new level of housing valuations can be sustained.
There are other differences as well:
- Mortgage lending was famously reckless (and sometimes fraudulent) during the housing bubble. As far as we can tell, there’s not much of that going on this time around. Mortgage underwriting is a lot more cautious, borrowers are largely securing historically low fixed-rate loans as opposed to the interest-only and adjustable rate loans that were so popular leading up to the housing bust, and most owners have equity in their homes. This is all important, because it reduces the chance of people dumping their homes due to declining prices.
- As outlined above, there were actually some pandemic-driven fundamental changes that might have legitimately boosted home valuations in a sustainable way.
- This is subjective, but we just don’t see the kind of crazy behavior that we did during the housing bubble. Back in 2004-5, people just thought you were a complete idiot if you believed home prices could go down. Granted, there is some fear of being priced out now, and some people are more exuberant than we think is justified. But on the whole, we observe substantially more caution and circumspection than we did during the bubble.
Home prices, both nationally and especially in San Diego, have risen in great excess to rents and incomes. There have been many drivers behind this price increase, some of which are likely to persist. But other drivers will probably fade, and still others could turn from helpful to harmful.
We don’t believe that housing is in a bubble. But it is very expensive, at least in terms of purchase prices, which is risky on a couple of fronts. First, big price increases tend to bring out new supply, which can lead to price decreases. (Even in notoriously supply-constrained California, a recent statewide loosening of zoning laws has made it easier to build than it used to be). Second, home prices have probably never been more vulnerable to a potential rise in mortgage rates. If we could predict where interest rates will end up in 5-10 years, we’d have a much clearer outlook for home prices. But we can’t, and we don’t think anyone else can, either.
How this web of uncertainties translates to real-world advice depends a lot on one’s priorities. Here are a couple hypothetical cases:
- If you were considering downsizing, or selling a rental property that had become a hassle, your main priority would likely be your home’s selling price. In that case, now might be a good time to pull the trigger. Wherever prices may go in the future, at least you’d know that you were getting out at a time when valuations were very elevated compared to history. (Just to show that we’re following our own advice: Rich’s Mom just sold her house of 30+ years, and is now happily renting a condo).
- If you were considering buying a long-term home, you’d probably care more about locking in a good monthly payment than about future changes to what your house might be worth on paper. Here, it might make sense to buy (and finance with a fixed rate mortgage) despite high prices, because very low mortgage rates have kept monthly payments somewhat reasonable. However, we think it would be wise to carefully consider the fact that things aren’t always as permanent as we intend them to be. If life changes (such as to your job, marital status, or health) ever forced you to sell sooner than anticipated, and rates had gone up substantially at that point, you’d be at risk of losing a lot of money. This isn’t necessarily a reason not to buy; it’s just a risk to consider when buying in a high valuation/low rate situation such as today.
For many non-hypothetical people, a good approach might be to keep doing what they’re doing, and to let things play out. The situation in the housing market is very complex, and we see a lot of uncertainty about where home prices might go in the years ahead. Perhaps the best advice we can give is to keep that uncertainty at top of mind.