Is the Real Estate Market Going to Crash?

Image by © The Balance 2019 

Most Americans are concerned that the real estate market is going to crash. A 2017 survey found that 57% agreed that there would be a "housing bubble and price correction" in 2020. As a result, 83% of them believe it's a good time to sell.

The 2020 stock market crash has renewed fears. Investors, worried about the impact of the coronavirus pandemic, fled from stocks in March 2020.

Key Takeaways

People are still shell-shocked by the 2008 financial crisis. Many of them are worried that another housing crash is right around the corner. But many things occurred in 2008 that aren’t as prominent today. The best way to predict a crash is to look for these 10 warning signs:

  1. Asset bubble bursts
  2. Increase of unregulated mortgages
  3. Rapidly rising interest rates 
  4. Inverted yield curve
  5. Change to the federal tax code 
  6. Return to risky derivatives
  7. Greater number of house flippers
  8. Fewer affordable homes 
  9. Rising sea levels
  10. Warnings from officials

Some of these have occured, but many haven’t. The first five are the most important. If all 10 occur in a rapid fashion, then a crash is more likely.

10 Warning Signs of a Crash

There are 10 signs of a housing market crash. The first five are critical. They are when an asset bubble has burst, an increase of unregulated mortgages, rapidly rising interest rates, an inverted yield curve, and a change to the federal tax code. 

The other five signs could contribute to a crash, but are less critical. They include greater number of house flippers, warnings, fewer affordable homes, and a return to risky derivatives.

Let’s look at each more closely.

1. Asset Bubbles Burst

Most crashes occur when an asset bubble has burst. One sign of a potential bubble is rapidly rising home prices. The national average home price hit a record high of $205,593 in September 2018. This was 10% higher than the July 2006 record high of $184,615, according to the Case Shiller Home Price Index. Similarly, the S&P Homebuilders Select Industry Index has risen 12.05% from December 2009 to December 2019. It tracks the stock prices of homebuilders.

Home prices in Washington, Nevada, Utah, and Idaho, were at least 10% higher than sustainable levels, according to CoreLogic.

The Housing Bellwether Barometer is an index of homebuilders and mortgage companies. In 2017, it skyrocketed like it did in 2004 and 2005. That's according to its creator, James Stack of Stack Financial Management, in an interview with Marketwatch. Stack used the indicator to predict the 2008 financial crisis.

2. Increase in Unregulated Mortgage Brokers

Another concern is the increase in unregulated mortgage brokers. In 2018, they originated 53.6% of U.S. mortgages. Five of the 10 largest mortgage lenders are not banks. They aren't as regulated as banks. That makes them more vulnerable to collapse if the housing market softens again.

3. Rising Interest Rates

Higher interest rates make loans more expensive. That slows home building and decreases its supply. It also slows lending, which cuts back on demand. Overall, a slow and steady interest rate increase won't create a catastrophe. But quickly rising rates will.

Higher interest rates preceded the housing collapse in 2006. Many borrowers then had interest-only loans and adjustable-rate mortgages. Unlike a conventional loan, the interest rates rise along with the fed funds rate. Many also had introductory teaser rates that reset after three years. When the Federal Reserve raised rates at the same time they reset, borrowers found they could no longer afford the payments. Home prices fell at the same time, so these mortgage-holders couldn't make the payments or sell the house. As a result, default rates rose.

The history of the fed funds rate reveals that the Fed raised rates too fast between 2004 and 2006. The top rate was 1.0% in June 2004 and doubled to 2.25% by December. It doubled again to 4.25% by December 2005. Six months later, the rate was 5.25%. The Fed raised rates at a much slower pace since 2015.

4. Inverted Yield Curve

A warning sign for the real estate market is when the yield curve on U.S. Treasury notes inverts. That's when the interest rates for short-term Treasurys become higher than long-term yields. Normal short-term yields are lower because investors don't require a high return to invest for less than a year. When that inverts, it means investors think the short-term is riskier than the long-term. That plays havoc with the mortgage market and often signals a recession.

The yield curve inverted before the recessions of 2008, 2000, 1991, and 1981.

5. Changes to the Tax Code

The housing market responds dramatically when Congress changes the tax code. Trump’s tax reform plan could be having a negative impact on housing. The plan raised the standard deduction, so many Americans no longer need to itemize. As a result, they can’t take advantage of the mortgage interest deduction. That deduction acts like a $71 billion federal subsidy to the housing market. The real estate industry opposed the tax plan.

6. Banks Return to Using Derivatives

The real estate market could collapse if banks and hedge funds returned to investing in risky financial products. These derivatives were a major cause of the financial crisis. Banks sliced up mortgages and resold them in mortgage-backed securities. These securities were a bigger business than the mortgages themselves. So, banks sold mortgages to just about anyone. They needed them to support the derivatives. They sliced them up so that bad mortgages were hidden in bundles with good ones. Then when borrowers defaulted, all the derivatives were suspected of being bad. This phenomenon caused the demise of Bear Stearns and Lehman Brothers.

7. Increase in “Flipped” Homes

In 2016, 5.7% of all home sales were bought for quick resale. These "flip" homes were renovated and sold in less than a year. Attom Data Solutions reported that's the highest percentage since 2006, during the last boom.

8. Affordable Housing Plummets

At the same time, affordable housing plummets. In 2010, 11.2% of rental units across the country were affordable for low-income households. By 2016, that had dropped to just 4.3%. The shortage is the worst in cities where home prices have soared. For example, Colorado's stock of affordable rentals fell from 32.4% to only 7.5% since 2010. The population increased 14.5% between 2010 and 2019, much faster than the national average of 6.3%. Many residents believe part of the increase is due to the state’s legalization of pot in 2012. 

9. Rising Sea Levels

Real estate markets could collapse in coastal regions vulnerable to the effects of rising sea levels. The Union of Concerned Scientists predicts that 170 U.S. coastal cities and towns will be “chronically inundated” in 20 years. 

At least 300,000 coastal properties will flood 26 times a year by 2045. The value of that real estate is $136 billion. That affects the value of 30-year mortgages currently being written. By 2100, 2.5 million homes worth $1.07 trillion will be at risk of chronic flooding. Properties on both coasts are at most risk.  

In Miami, Florida, the ocean floods the streets during high tide. Harvard researchers found that home prices in lower-lying areas of Miami-Dade County and Miami Beach are rising more slowly than the rest of Florida. Properties at risk of rising sea levels sell at a 7% discount to comparable properties.

Most of the property in these cities are financed by municipal bonds or home mortgages. Their destruction will hurt the investors and depress the bond market. Markets could collapse in these regions, especially after severe storms.

10. Officials Warn of a Housing Crisis

In March 2017, William Poole, a former president of the Federal Reserve Bank of St. Louis, in an op-ed warned of another subprime crisis. He warned that 36% of Fannie Mae's loans required mortgage insurance. That's about the level in 2006. In some ways, today's loans are worse. Fannie and Freddie lowered their definition of subprime from 660 to 620. The banks are no longer calling borrowers with scores between 620 and 660 subprime. Poole was the head of the Federal Reserve Bank of Kansas who warned of the subprime crisis in 2005. 

What We Can Learn From the 2008 Housing Market Crash

People who were caught in the 2008 crash may be spooked that another housing bubble and subsequent slowdown will lead to another crash. But that crash was caused by forces that are no longer present. 

First, insurance companies created credit default swaps that protected investors from losses in derivatives such as mortgage-backed securities. In response, hedge fund managers created a huge demand for these supposedly risk-free securities. That created demand for the mortgages that backed them.

To meet this demand for mortgages, banks and mortgage brokers offered home loans to just about anyone. They didn't care about the credit-worthiness of subprime mortgage borrowers. Banks simply resold the mortgages on the secondary market. This created greater risk in the financial markets.

The entrance of so many unqualified buyers into the market sent prices soaring. Many people bought homes only as investments. They exhibited irrational exuberance, a hallmark of any asset bubble.

In 2005, homebuilders finally caught up with demand. When supply outpaced demand, housing prices started to fall. New home prices fell 22% from their peak of $262,600 in March 2007 to $204,200 in October 2010. That burst the bubble. 

But the Fed ignored these warnings. The Financial Crisis Inquiry Commission found that the Fed should have set prudent mortgage-lending standards. Instead, it only lowered interest rates. That generally gives the economy enough liquidity to fuel growth.

The Fed underestimated the size and impact of the subprime mortgage crisis in 2006. Many of the subprime purchasers were individual investors, pension funds, and retirement funds. They invested more heavily in hedge funds, spreading the risk throughout the economy.

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