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Are we in a Housing Bubble?

Dated: April 18 2021

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Are we in a Housing Bubble?

Some of you may look at this graph and say we are in another bubble. After all, home values are increasing at an annual rate of 26%, not far off the 30% we saw in 2005. You may also say “there is no way this growth is sustainable”, “People are overpaying for homes”, “How can people even afford these prices?”. And you would be partially correct. But bubbles have more to do with home affordability and less to do with home values. Take a look at the graph below. There is no bubble. Except if you look closely at the end of the graph, you will see a sharp increase. That is the start of the housing bubble that we are currently in.

Why does affordability matter?

Buyer demand is tied to affordability. When homes are more affordable, more buyers can qualify for a mortgage. When more buyers qualify for a mortgage, there are more buyers in the market to buy homes. The increase in buyer demand increases home values. And as we will soon find out, the opposite is also true.

What will pop the bubble?

Interest rates.

Home values have increased over 20% since COVID hit, but buyers have not felt the increase in their mortgage payments. Why? Because interest rates have been at record lows. In January 2020, the median sales price was $225,000 and the average interest rate was 3.62%. This would have giving you a mortgage payment of $1047.54. In January of 2021, the median sales price was $269,000 and the average interest rate was 2.74%. This gives you a mortgage payment of $1120.32. So even though home values increased 19.6%, your mortgage payment only increased by 6.9%. Coincidently, home values were increasing at 7% the years prior to COVID. Let’s take a look at what happens when rates return to 3.62% and assume home values increase at the same rate. In January 2022, the median sales price will be $321,724. Your mortgage payment will be $1497.85. That’s an increase of 33.7%. That is when we will see buyer demand start to fall. With less buyer demand, home values will start to drop. As home values start to drop, homeowners will start to sell their homes increasing the supply causing home values to drop more.

When will interest rates increase?

Interest rates have already started to climb. The average interest rate in February was 2.81%. In March, it jumped it 3.08%. And they will continue to climb. Keep an eye on the 10-year treasury note. As it increases, as will interest rates. My prediction is that the 10-year treasury note will hit 2 and interest rates will hit 4% this of summer. Once this happens, the Federal Reserve will reimplement Operation Twist to drive interest rates back into mid 3s. But this will only be a temporary fix. Buyer demand will start to decline.

Future Interest Rates

When will the bubble pop?

The Tucson housing market has less than two weeks of inventory, an all-time low. If inventory increased by 10x, we would still be in a seller’s market. If the rate of new listings increased to 30% more than normal, and the rate of buyer’s buying homes dropped 30% less than normal, it would take almost a year for the seller’s market to end.  So even after interest rates start increasing, it will take time before we start seeing prices fall. My prediction is that one year after the average interest rate hits 3.5%, we will reach the top of the bubble. Summer 2022.

Future Home Values

How much will prices go down?

The amount that prices will fall ultimately depends on how high the market goes prior to turning. My prediction is for the median sales price to return to around $280k. This is because over the last 30 years, the average mortgage payment has typically stayed between $1200-$1300, after adjusting for inflation. And $280k at 3.62% would put us around $1250/mo. This is assuming inflation does not get out of hand and stays under 3%, which I believe it will. If inflation does take off, this number will be much higher, and we may not even see a price drop.

What about the wave of foreclosures?

They are not coming. This is a big myth being spread by those who do not fully understand how debt forbearance and foreclosures work. There are currently 2.5 million homeowners enrolled in a mortgage forbearance program. However, these homeowners have options other than foreclosure. You can find these options here. If the borrower does not qualify for one of those options, they may enter the foreclosure process. But that process is not immediate, in Arizona it takes at least 90 days. So those who still have equity in their home, an estimate 97% of them do, will just sell their home, and pay off the loan, avoiding foreclosure. So, of those 2.5 million homeowners who are in debt forbearance, maybe 10% will start the foreclosure process, and of those 250,000, maybe only 5% will actually be foreclosed on. This is not enough to have an affect on the market.

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