Is there a real estate bubble in the future?
The real estate market has had its booms and busts dating back to at least the 1920's. The psychology of the market place has been studied in everything from tulip bulbs to stocks, and the real estate market is no different. Intuitively, one should exercise caution when prices spike, hit all time highs, inventory is depleted, and everyone from the taxi driver to your pastor says they are making money in the market. The following article looks at some of the more analytical aspects of a bubble.
How to Identify a Real Estate Bubble
Including signs of its end.
Disclaimer: This article is not meant to be legal, tax, or financial advice. Any decision made based on the following information is not the responsibility of the writer.
Financial “bubbles” are dramatic increases in a particular asset’s price that is unsustainable, or not substantiated by the underlying value of the asset. These bubbles are notoriously difficult to recognize, and their end is equally difficult to predict. A run of increasing prices does not necessarily mean there is a bubble, and no one wants to pull their investment when capital appreciation is high.
So what signs point to an unsustainable price increase, particularly in real estate?
We don’t have to look far back for a case study in housing market bubbles. The housing bubble of the late 2000s is still fresh in the minds of many investors. The rise of subprime mortgages and low interest rates fueled housing demand, thus causing housing prices to greatly rise.
Interest rates began to climb as the economy recovered. Housing prices declined as mortgages became more expensive. People started defaulting on the subprime mortgages, accelerating the crash. The bubble had popped.
However, it is much easier to identify these causes in hindsight, and the next inevitable bubble will undoubtedly have different causes. Here are 5 signs that may be the same.
1. Interest rates start increasing after an extended period of low interest rates
We have been in a period of extremely low interest rates for over a decade. This makes mortgages much cheaper. This means two things: More people can afford to take out a mortgage, and the people who could already afford a mortgage can now afford larger mortgages.
This is great for keeping money circulating in the economy, but it can create precarious positions for those without a fixed rate mortgage. If interest rates begin climbing, demand for houses will fall as mortgages become more expensive. Additionally, adjustable rate mortgages become more expense, increasing the chance of default. High rates of default lead to an increase in the supply of houses as the foreclosed houses are put on the market.
Both of these forces combined leads to a decrease in home values, and an existing real estate bubble may crash.
2. Increase in the number of subprime and adjustable rate mortgages
You can find the Consumer Financial Protection Bureau’s most recent data on the number of subprime mortgages issued here. Ellie Mae’s Origination Insight Report has data on the percent of loans that are adjustable rate (ARMs) here.
The most commonly referenced culprit for the last real estate bubble was subprime mortgages. These are mortgages for those whose credit is too low for a traditional mortgage, and they have higher interest rates to compensate for the increased risk.
These allow more people to take out mortgages, increasing demand for housing, causing increased prices. This increase could be a bubble, as an economic recession could lead to high rates of default in these risky mortgages, causing stress in the economy to spill into the housing market.
What’s the current status?
Subprime mortgages still exist today, sometimes rebranded as “non-prime” mortgages. However, changes have been made to prevent the same problem occurring again. The most significant change is the Ability to Repay, which restricts lenders from offering a mortgage without undergoing a process to determine if the recipient will be able to pay it back. Loan to Value ratios are also much higher on today’s subprime mortgages, which also reduces risk.
The number of subprime mortgages has not risen to the levels seen in the last housing crisis, though they are increasing. The level of risk in today’s subprime mortgages is also much lower due to stricter lending standards. As of now, subprime mortgages are not much of a worry.
3. Housing prices are rising based on speculation rather than real demand
There are many different market forces that can explain a rise in housing prices. In a growing economy, the demand for houses should be steadily increasing, especially in economically prosperous areas. If housing prices are rising more quickly than inflation levels, than there must be value creation occurring.
Ask yourself what is causing increased value. Why is demand growing in your area? Is the population growing? Is tourism increasing in your area? Is the average income rising, so more people can afford to buy homes? If you don’t know why prices are rising, then speculation may be occurring, where people buy homes as investments, hoping to sell them for higher.
What’s the current status?
House flippers can cause speculative increase in housing prices. The rate of house flipping as percentage of total real estate sales is increasing according to the 2019 Attom Data Solutions report here. It is unclear as of now if the current pandemic has caused a drop in these home flipping, but it makes sense that uncertainty in the market would decrease speculative activity.
4. Price to Income ratio is increasing
Price to Income ratio is a measure of affordability in the housing market. If prices are rising faster than people’s income, people’s ability to qualify for a mortgage and save for a down payment are reduced. This separation between price and income is the result of low interest rates, so the prices may not be sustainable when interest rates begin to rise.
What’s the current status?
Statistics on average price to income ratio can be found in the annual report from the Joint Center for Housing Studies of Harvard University here.
Price to income ratios are increasing quickly. The median price to median income ratio was 4.1 in 2018 according to the above report, rising from 3.3 in 2011. The rise in this statistic alone does not mean we are in a bubble, but if the other signs accompany it, trouble could be ahead.
5. Housing debt to Income ratio is increasing
Statistics on housing debt to income ratio can be found in this Urban Institute report. It can give you a measure for how much leverage there is in the housing market. Increasing levels of leverage means a riskier position for the market, as prices can inflate and defaults can become more likely in the event a recession.
If an increasing debt to income ratio is coupled with very low interest rates and increasing subprime mortgages and ARMs, it makes it more likely that the market is in a bubble.
What’s the current status
According to the Urban Institute report linked above, average debt to income ratios steadily increased during the 2010s. However, 2019’s FHA Loans had a lower debt to income ratio (43.5%) than 2018 (44%).
Conclusion
The presence of a combination or all of these indicators should raise red flags for anyone heavily invested in real estate. However, bubbles are unpredictable, and financial metrics have their limits in painting a full picture of the market. Investors should always consider the reasons behind price increases, and make their own judgements about the sustainability of those market forces.
References:
ATTOM Data Solutions. “U.S. Home Flipping Increases To Eight-Year High In 2019 While Returns Drop To Eight-Year Low.” PR Newswire: news distribution, targeting and monitoring, March 5, 2020. https://www.prnewswire.com/news-releases/us-home-flipping-increases-to-eight-year-high-in-2019-while-returns-drop-to-eight-year-low-301016909.html.
Consumer Financial Protection Bureau. “Borrower Risk Profiles.” Consumer Financial Protection Bureau. Accessed October 30, 2020. https://www.consumerfinance.gov/data-research/consumer-credit-trends/mortgages/borrower-risk-profiles/.
Consumer Financial Protection Bureau. “Consumer Financial Protection Bureau Issues Rule to Protect Consumers from Irresponsible Mortgage Lending.” Consumer Financial Protection Bureau, January 10, 2013. https://www.consumerfinance.gov/about-us/newsroom/consumer-financial-protection-bureau-issues-rule-to-protect-consumers-from-irresponsible-mortgage-lending/.
Ellie Mae. “September 2020 Origination Insight Report.” https://www.elliemae.com, 2020. https://static.elliemae.com/pdf/origination-insight-reports/EM_OIR_SEPTEMBER2020.pdf.
Golding, Edward, Laurie Goodman, and Jun Zhu. “Fannie Mae Raises the DTI Limit.” Urban Institute, 2017. https://www.urban.org/sites/default/files/publication/91936/fannie_mae_raises_dti_limit.pdf.
Haverkamp, Kirk. “Subprime Mortgages Are Back - with a New Name.” MortgageLoan.com, April 1, 2020. https://www.mortgageloan.com/subprime-mortgages-are-back-with-a-new-name.
Hayes, Adam. “Dodd-Frank Definition.” Investopedia. Investopedia, September 1, 2020. https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp.
Hermann, Alexander. “Price-to-Income Ratios Are Nearing Historic Highs | Joint Center for Housing Studies.” Housing Perspectives, September 13, 2018. https://www.jchs.harvard.edu/blog/price-to-income-ratios-are-nearing-historic-highs.
Lerner, Michele. “Adjustable Rate Mortgages Are Becoming More Popular with Buyers,” February 11, 2019. https://www.washingtonpost.com/business/2019/02/14/adjustable-rate-mortgages-are-becoming-more-popular-with-buyers/.
Rep. The State of the Nation's Housing 2019, 2019. https://www.jchs.harvard.edu/sites/default/files/reports/files/Harvard_JCHS_State_of_the_Nations_Housing_2019%20%281%29.pdf.
How to Identify a Real Estate Bubble
Including signs of its end.
Disclaimer: This article is not meant to be legal, tax, or financial advice. Any decision made based on the following information is not the responsibility of the writer.
Financial “bubbles” are dramatic increases in a particular asset’s price that is unsustainable, or not substantiated by the underlying value of the asset. These bubbles are notoriously difficult to recognize, and their end is equally difficult to predict. A run of increasing prices does not necessarily mean there is a bubble, and no one wants to pull their investment when capital appreciation is high.
So what signs point to an unsustainable price increase, particularly in real estate?
We don’t have to look far back for a case study in housing market bubbles. The housing bubble of the late 2000s is still fresh in the minds of many investors. The rise of subprime mortgages and low interest rates fueled housing demand, thus causing housing prices to greatly rise.
Interest rates began to climb as the economy recovered. Housing prices declined as mortgages became more expensive. People started defaulting on the subprime mortgages, accelerating the crash. The bubble had popped.
However, it is much easier to identify these causes in hindsight, and the next inevitable bubble will undoubtedly have different causes. Here are 5 signs that may be the same.
1. Interest rates start increasing after an extended period of low interest rates
We have been in a period of extremely low interest rates for over a decade. This makes mortgages much cheaper. This means two things: More people can afford to take out a mortgage, and the people who could already afford a mortgage can now afford larger mortgages.
This is great for keeping money circulating in the economy, but it can create precarious positions for those without a fixed rate mortgage. If interest rates begin climbing, demand for houses will fall as mortgages become more expensive. Additionally, adjustable rate mortgages become more expense, increasing the chance of default. High rates of default lead to an increase in the supply of houses as the foreclosed houses are put on the market.
Both of these forces combined leads to a decrease in home values, and an existing real estate bubble may crash.
2. Increase in the number of subprime and adjustable rate mortgages
You can find the Consumer Financial Protection Bureau’s most recent data on the number of subprime mortgages issued here. Ellie Mae’s Origination Insight Report has data on the percent of loans that are adjustable rate (ARMs) here.
The most commonly referenced culprit for the last real estate bubble was subprime mortgages. These are mortgages for those whose credit is too low for a traditional mortgage, and they have higher interest rates to compensate for the increased risk.
These allow more people to take out mortgages, increasing demand for housing, causing increased prices. This increase could be a bubble, as an economic recession could lead to high rates of default in these risky mortgages, causing stress in the economy to spill into the housing market.
What’s the current status?
Subprime mortgages still exist today, sometimes rebranded as “non-prime” mortgages. However, changes have been made to prevent the same problem occurring again. The most significant change is the Ability to Repay, which restricts lenders from offering a mortgage without undergoing a process to determine if the recipient will be able to pay it back. Loan to Value ratios are also much higher on today’s subprime mortgages, which also reduces risk.
The number of subprime mortgages has not risen to the levels seen in the last housing crisis, though they are increasing. The level of risk in today’s subprime mortgages is also much lower due to stricter lending standards. As of now, subprime mortgages are not much of a worry.
3. Housing prices are rising based on speculation rather than real demand
There are many different market forces that can explain a rise in housing prices. In a growing economy, the demand for houses should be steadily increasing, especially in economically prosperous areas. If housing prices are rising more quickly than inflation levels, than there must be value creation occurring.
Ask yourself what is causing increased value. Why is demand growing in your area? Is the population growing? Is tourism increasing in your area? Is the average income rising, so more people can afford to buy homes? If you don’t know why prices are rising, then speculation may be occurring, where people buy homes as investments, hoping to sell them for higher.
What’s the current status?
House flippers can cause speculative increase in housing prices. The rate of house flipping as percentage of total real estate sales is increasing according to the 2019 Attom Data Solutions report here. It is unclear as of now if the current pandemic has caused a drop in these home flipping, but it makes sense that uncertainty in the market would decrease speculative activity.
4. Price to Income ratio is increasing
Price to Income ratio is a measure of affordability in the housing market. If prices are rising faster than people’s income, people’s ability to qualify for a mortgage and save for a down payment are reduced. This separation between price and income is the result of low interest rates, so the prices may not be sustainable when interest rates begin to rise.
What’s the current status?
Statistics on average price to income ratio can be found in the annual report from the Joint Center for Housing Studies of Harvard University here.
Price to income ratios are increasing quickly. The median price to median income ratio was 4.1 in 2018 according to the above report, rising from 3.3 in 2011. The rise in this statistic alone does not mean we are in a bubble, but if the other signs accompany it, trouble could be ahead.
5. Housing debt to Income ratio is increasing
Statistics on housing debt to income ratio can be found in this Urban Institute report. It can give you a measure for how much leverage there is in the housing market. Increasing levels of leverage means a riskier position for the market, as prices can inflate and defaults can become more likely in the event a recession.
If an increasing debt to income ratio is coupled with very low interest rates and increasing subprime mortgages and ARMs, it makes it more likely that the market is in a bubble.
What’s the current status
According to the Urban Institute report linked above, average debt to income ratios steadily increased during the 2010s. However, 2019’s FHA Loans had a lower debt to income ratio (43.5%) than 2018 (44%).
Conclusion
The presence of a combination or all of these indicators should raise red flags for anyone heavily invested in real estate. However, bubbles are unpredictable, and financial metrics have their limits in painting a full picture of the market. Investors should always consider the reasons behind price increases, and make their own judgements about the sustainability of those market forces.
References:
ATTOM Data Solutions. “U.S. Home Flipping Increases To Eight-Year High In 2019 While Returns Drop To Eight-Year Low.” PR Newswire: news distribution, targeting and monitoring, March 5, 2020. https://www.prnewswire.com/news-releases/us-home-flipping-increases-to-eight-year-high-in-2019-while-returns-drop-to-eight-year-low-301016909.html.
Consumer Financial Protection Bureau. “Borrower Risk Profiles.” Consumer Financial Protection Bureau. Accessed October 30, 2020. https://www.consumerfinance.gov/data-research/consumer-credit-trends/mortgages/borrower-risk-profiles/.
Consumer Financial Protection Bureau. “Consumer Financial Protection Bureau Issues Rule to Protect Consumers from Irresponsible Mortgage Lending.” Consumer Financial Protection Bureau, January 10, 2013. https://www.consumerfinance.gov/about-us/newsroom/consumer-financial-protection-bureau-issues-rule-to-protect-consumers-from-irresponsible-mortgage-lending/.
Ellie Mae. “September 2020 Origination Insight Report.” https://www.elliemae.com, 2020. https://static.elliemae.com/pdf/origination-insight-reports/EM_OIR_SEPTEMBER2020.pdf.
Golding, Edward, Laurie Goodman, and Jun Zhu. “Fannie Mae Raises the DTI Limit.” Urban Institute, 2017. https://www.urban.org/sites/default/files/publication/91936/fannie_mae_raises_dti_limit.pdf.
Haverkamp, Kirk. “Subprime Mortgages Are Back - with a New Name.” MortgageLoan.com, April 1, 2020. https://www.mortgageloan.com/subprime-mortgages-are-back-with-a-new-name.
Hayes, Adam. “Dodd-Frank Definition.” Investopedia. Investopedia, September 1, 2020. https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp.
Hermann, Alexander. “Price-to-Income Ratios Are Nearing Historic Highs | Joint Center for Housing Studies.” Housing Perspectives, September 13, 2018. https://www.jchs.harvard.edu/blog/price-to-income-ratios-are-nearing-historic-highs.
Lerner, Michele. “Adjustable Rate Mortgages Are Becoming More Popular with Buyers,” February 11, 2019. https://www.washingtonpost.com/business/2019/02/14/adjustable-rate-mortgages-are-becoming-more-popular-with-buyers/.
Rep. The State of the Nation's Housing 2019, 2019. https://www.jchs.harvard.edu/sites/default/files/reports/files/Harvard_JCHS_State_of_the_Nations_Housing_2019%20%281%29.pdf.