Image by Alfred Kenneally via unsplash.com

published on April 21, 2022 - 2:37 PM
Written by Gabriel Dillard

Following unprecedented spikes in housing prices, researchers are looking closely at what they fear could be a bubble. Pent-up demand has built up a cycle fueling itself forward outside of what they consider “market fundamentals.”

At the same time, those in the industry feel confident about the scrutiny behind home loans, separating the current market from a time 15 years ago when nearly anyone could get a mortgage. What most can agree on, however, is coming out of the lessons of the Great Recession, the market has legs to stand on should that bubble burst.

 

Feeding frenzy

The Federal Reserve Bank of Dallas last week released a paper titled “Real-Time Market Monitoring Finds Signs of Brewing U.S. Housing Bubble.” It claims the “exuberance” of investors paying beyond a home’s appraised value is driven by a “widespread belief that today’s robust price increases will continue.”

“This self-fulfilling mechanism leads to price growth that may become exponential (or explosive), resulting in the housing market becoming progressively misaligned from fundamentals until investors become cautious, policymakers intervene, the flow of money into housing dries up and a housing correction or even a bust occurs,” the report reads.

It takes more than rising prices to indicate the presence of a bubble, said Dallas Fed Senior Research Economist Enrique Martinez-Garcia, one of the study’s authors.

Price-to-rent and price-to-income ratios began behaving abnormally in 2021, Martinez-Garcia said. These ratios compare home prices to an area’s rental income and average personal income.

“We look for markers in the data that are consistent with how real house prices or related measures of profitability (house-price-to-rent ratio) or affordability (house-price-to-income ratio) would behave differently when their dynamics are driven by a bubble,” said Martinez-Garcia. “That is, when their dynamics are driven by the expectation of continued house price gains in the future even when the fundamentals of the market no longer seem consistent with those gains.”

A similar willingness for investors was mirrored in the lead-up to the 2008 housing crisis, when a “fear of missing out” drove up expectations for returns on investment.

This kind of investor exuberance can create a self-fulfilling prophecy of housing values out-of-step from fundamentals. The “fundamentals” they look at are disposable income, mortgage rates, construction costs and lot availability — all factors governing supply and demand.

“This is to us fairly robust evidence of a red flag in housing as investment,” said Martinez-Garcia.

 

Comes down to demand

Even though homes are being sold sometimes $30,000 to $50,000 above listing price, the fact people are willing to pay that price means it’s worth it to them, said John Vartanian, owner of Clovis-based MAV Mortgage, a mortgage lender and bond market analyst. The loans backing those purchases are sound, Vartanian added.

“The core issue is simple supply and demand, prices are increasing but they’re not increasing at a level people can’t afford it because otherwise they wouldn’t be increasing that much,” Vartanian said.

In the lead-up to the Great Recession, lenders did not require much in the way of income verification. There were even cases with no documentation in loan applications. Those were called “no doc loans,” Vartanian said. That’s not the case in this market.

“People are quick to equate the rise in home prices to 2008, but they are two different animals,” he said.

Following the pandemic, the self-employed person looking for homes got the most scrutiny, having to provide bank statements and proof of income, Vartanian said.

“Until this supply gets figured out, you’re going to have more demand than you have for supply and that is what is fueling it — not the ease of financing,” he said.

 

Read the indicators

Martinez-Garcia said there are three indicators the Federal Reserve is analyzing that might show a bubble is expanding. The expectation is that in response to inflation and decreased disposable income, housing prices should cool down.

“If expectations about future house prices and price gains continue to be robust, that might provide further evidence that the run-up is increasingly out of step of the market fundamentals,” said Martinez-Garcia.

In the Fresno market, there has been a large pent-up demand for homes, said Steve Flach, president of the Fresno Association of Realtors and sales manager of the Fig Garden office of Guarantee Real Estate.

Many buyers have been outbid by aggressive offers. That has created a large reserve of people trying to get into homes, Flach said. Between February and March, the number of homes sold in Fresno County increased 29.6%, from 920 homes sold to 1,192.

And while many have become frustrated by their inability to buy a home, there are still buyers wanting to play in an overheated market. Money in the Central Valley goes a lot further than in other areas of the state. That has attracted a lot of buyers to the area.

Martinez-Garcia is also looking to the impact tightening monetary policy should have. Decreasing access to money should take buyers out of the market as the price to borrow becomes more expensive.

The Federal Reserve expects to increase the Fed Funds Rate between six to eight times by March 2023. Long-term loans such as mortgages typically follow the short-term rate banks lend to one another. Since January, the standard 30-year loan has gone up from mid 2% to 5% said Vartanian.

Martinez-Garcia said if exuberance continues in spite of rising mortgages, it could indicate a housing bubble.

Fed responses to inflation are not going to fix supply issues, said Vartanian.

Even taking out half of the buyers in a home still leaves competitors bidding against one another.

 

Inflation factor

The third thing Martinez-Garcia is looking for is the impact of shipping disruptions and construction costs. The concern is if demand cools, prices may continue to grow rapidly if supply is further restrained, said Martinez-Garcia. Even higher gas prices could push housing prices up in places such as Texas where returns at the gas pump fuel economies dependent on the energy sector.

At the very least, what researchers fear is that as prices increase, low-income and first-time homebuyers are priced out of the market. “But when the money dries out, this can result in a price correction,” said Martinez-Garcia.

Andres Jauregui, director of the Gazarian Real Estate Center at Fresno State and real estate professor with the Craig School of Business, sees income as a vulnerability to the market.

Income has increased, but faster inflation has decreased real income, said Jauregui.

Those declining real incomes are making homes less affordable. Developers are trying to put houses online, but “you can’t just build houses overnight,” said Jauregui.

With homes becoming less affordable and mortgage rates increasing, Jauregui predicts price growth to slow down. Jauregui thinks home prices will begin to grow at a more modest 5%-8% rate.

Real estate experts have forecast 5%-6% growth, said Flach. He could see 8%-10% in the local area.

What experts can agree on is the average homebuyer has the proof they can pay for the homes they live in. In 2008, mortgages were being issued that never should have been written, with people purchasing beyond their means, said Jauregui.

If those lending guidelines change — allowing people to qualify in an unsustainable way, then Vartanian said he will begin to worry.


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