Housing Bubble 2.0?
Although we focus on commercial real estate, we also pay attention to residential real estate, particularly how it might impact multifamily commercial properties. At the start of 2023 there is a wide gap in expectations. Some have a positive outlook, pointing to mortgage rates that have fallen back to levels seen in September. Many believe the worst of the interest rate increases are now behind. But other experts we follow are warning about a housing bubble with big price declines ahead for residential real estate.
It is worth emphasizing that residential real estate and commercial real estate markets are different. Opportunities and problems in one are not necessarily the same for another. The rise in interest rates and financing costs are certainly a challenge in both. However commercial real estate does not seem to face the same degree of risks as residential. And I expect a more favorable investment environment for commercial properties in general than residential.
Residential real estate at the moment represents a very different and unique dynamic. After COVID shutdowns and government direct payments there was a surge of home buying the residential real estate market is working on digesting. The question heading into 2023 is will there be just a mild case of indigestion or is the housing market going to get sick again like what transpired in 2008?
Housing at a Crossroads
The housing market definitely cooled off last year. The National Association of Realtors reported sales of existing homes fell slightly in December to a seasonally adjusted 4.02 million from 4.08 million in November. On a year-over-year basis sales fell 34 percent. Median home prices increased, but only slightly at 2.3 percent, as prices rose in all regions. This marked 130 consecutive months of year-over-year price increases—the longest streak of increases ever recorded.
In further signs of a cooling housing market new residential building permits declined 1.55 percent in December on a month-over-month basis, while new residential housing starts declined 1.4 percent. Meanwhile builder confidence remained unfavorable with a reading below 50 of 35 in January (readings above 50 signify a positive outlook). However, after 12 consecutive months of falling confidence January did witness a slight improvement from a previous negative reading of 31.
Optimistic Case for Housing
The optimistic case for residential real estate is straight forward. The Federal Reserve appears nearing the end of rate hikes. Mortgage rates likely put in their tops and have recently receded. After a mild economic contraction at the start of last year the economy is again growing. Inflation is also continuing to moderate and the worst of the supply chain disruptions and energy issues around the Russian Ukrainian conflict appear to be behind. Globally, even China is finally opening up again. The economic environment seems to be improving.
Despite record home prices that even on an inflation adjusted basis eclipse the 2007 top, the United States faces a housing shortage. Over the decade after 2008 fewer new homes were built than in any decade since the 1960s. By 2019 FNMA estimated the national housing shortage had reached 3.8 million units. Although home buyers may have become overly optimistic, home builders did not.
Even if prices decline, the situation today is far different than 2008 when there was much more supply relative demand. And now we also have the demand factor of the large millennial generation looking for opportunities to buy houses. Furthermore, baby boomers are increasingly looking to stay in their houses with home care options, rather than elder care facilities, as they grow older. Higher interest rates also mean many folks with older fixed rates will stay put, rather than selling and buying a new home elsewhere at a higher mortgage rate.
Pessimistic Case for Housing
The pessimistic case on housing is also straightforward and compelling. The U.S. government held interest rates artificially low and injected trillions of dollars into the economy including with direct payments to individuals. This led to inflation and a surge in home buying and residential real estate prices from mid 2020 to early 2022. So much so that prices even on an inflation adjusted basis exceeded the previous housing bubble.
Now with interest rates higher and no big government checks coming in the mail, this bubble is going to pop. Higher home prices and mortgage rates drove the Housing Affordability Index to a lower rating In November than experienced in the prior housing bubble. Home sellers may be reluctant to take lower prices, but eventually as inventory levels build they will be forced. A future economic recession isn’t necessary for prices to fall, but if a recession transpires it would make this only worse. The bottom line is home prices rose too much, too fast and are now unaffordable. Prices will go down.
Final Housing Thoughts
We are working hard to find the right commercial real estate opportunities to buy. But when it comes to residential real estate our view is that for buyers, time is on your side. Patience is likely to be rewarded with lower prices in the future. So, staying on the sidelines for now in many residential markets likely makes sense. And favoring commercial real estate over residential real estate has merit as an investment looking forward.
In considering the optimistic versus the pessimistic case on residential real estate, I expect the truth lies somewhere between. It appears thanks to a mix of government policies home prices have become unaffordable and will decrease significantly in many markets. This bubble is likely to pop. But the aftermath will probably be better than the Great Recession. The economy and housing supply and demand dynamics appear more positive. If this proves to be housing bubble 2.0, the sequel should be far less dire than the original.