Many Americans may be worried about a real estate market crash. They are concerned about the unexpected impact of the COVID-19 pandemic on housing prices.
At first, the 2020 stock market crash worsened those fears, as home sales tumbled. Then, housing sales unexpectedly turned up, hitting new highs.
People who were caught in the 2008 financial crisis may be spooked that the pandemic will lead to another crash. That's unlikely; according to an interview with Selma Hepp, deputy chief economist at Corelogic, “There is not the same oversupply of homes this time. Instead, there is an undersupply."
The best way to predict a crash is to look for these 10 warning signs. Some of these have occurred, 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.
- Asset bubble bursts
- Increase of unregulated mortgages
- Rapidly rising interest rates
- Inverted yield curve
- Change to the federal tax code
- Return to risky derivatives
- Greater number of house flippers
- Fewer affordable homes
- Rising sea levels
- Warnings from officials
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 bursts, unregulated mortgages increase, interest rates rise rapidly, the yield curve inverts, and Congress changes the federal tax code.
The other five signs could contribute to a crash, but are less critical. They include a greater number of house flippers, warnings from experts, fewer affordable homes, and a return to risky derivatives.
Let’s look at each more closely.
Asset Bubbles Burst
Most crashes occur after an asset bubble has burst. One sign of a potential bubble is rapidly rising home sales. In February, existing home sales reached a pre-pandemic peak. Homes were selling at an annual rate of 5.76 million a year. That all changed after the national emergency was declared. Sales of homes plummeted to a rate of 3.91 million units in May.
Surprisingly, the pandemic then boosted home sales. Families that could move out of crowded cities headed to less densely populated areas. Those who worked at home also wanted larger spaces. Thanks to the Fed’s actions, interest rates were at 50-year lows. This further spurred demand.
By July, the sales rate reached 5.86 million homes. By October, it had blossomed to 6.86 million, beating the pre-pandemic peak.
Home prices also suggest a housing bubble. The pandemic hasn't slowed home prices at all. Instead, they've skyrocketed. In September 2020, they were a record $226,800, according to the Case-Shiller Home Price Index.
The pandemic has created high unemployment rates. This could lead to foreclosures, as people can't afford to pay their mortgages. But that is unlikely to affect the housing market in 2021, according to Hepp. "The foreclosures that do occur in 2020 or 2021 won’t affect the market until 2022," she said. "It will take that long for the houses to go through the foreclosure process and affect the market.”
Increase in Unregulated Mortgage Brokers
Another concern is when the number of unregulated mortgage brokers increases. In 2019, they originated 54.5% of all loans. That's up from 53.6% in 2018. Six of the 10 largest mortgage lenders are not banks. In 2018, five of the top 10 were unregulated.
Unregulated mortgage brokers don't have the same government oversight as banks. That makes them more vulnerable to collapse if the housing market softens again.
Rising Interest Rates
Higher interest rates make loans more expensive. That slows home building and decreases 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.
The Federal Reserve has lowered interest rates to zero to help businesses during the coronavirus pandemic. As a result, mortgage interest rates have dropped to record lows. The Fed has promised to keep rates at that level until 2023.
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 with those 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 had fallen, 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 has raised rates at a much slower pace since 2015.
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 briefly inverted in February and March 2020. On March 9, 2020, the yield on the 10-year note fell to 0.54% while the yield on the one-month bill rose to 0.57%. The curve later returned to a normal shape. By Dec. 18, the yield on the 10-year note was 0.95% while that on the one-month bill was 0.8%.
Changes to the Tax Code
The housing market responds dramatically when Congress changes the tax code. Initially, many thought that the Tax Cuts and Jobs Act (TCJA) could have a negative impact on housing. The plan raised the standard deduction, so many Americans no longer itemized. As a result, they couldn't take advantage of the mortgage interest deduction. For that reason, the real estate industry opposed the TCJA.
Research has shown since then that the tax changes had little effect on the housing market. Reduction in home purchases by middle-income families who took the standard deduction was offset by other income groups. The law doubled the standard deduction, giving more income to low-income families who could then afford a home. High-income families continued using itemized deductions. Other tax cuts also made them more able to buy new homes.
Banks Return to Using Derivatives
The real estate market could collapse if banks and hedge funds returned to investing in risky financial products to the extent they did in 2007. These derivatives were a major cause of the financial crisis. Banks sliced up mortgages and resold them in mortgage-backed securities (MBS).
Over time, the MBS became 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.
Increase in 'Flipped' Homes
Home flipping played a major role during the 2008 recession. Speculators bought homes, made moderate improvements, and sold them as prices continued rising. In 2006, flips comprised 11.4% of home sales.
Flipping has slowed considerably. In the third quarter of 2020, 5.1% of all home sales were bought for quick resale. That's down from the 6.7% of sales in the second quarter of 2020. It's also lower than the post-recession high of 7.2% in first-quarter 2019.
The decline in flipping is due to the reduced inventory of housing stock. At the same time, flipping has become more profitable. Attom Data Solutions reports that the pandemic's effect on flipping is contradictory and difficult to forecast.
'Flipped' homes are bought, renovated, and then sold in less than a year.
Affordable Housing Plummets
A booming housing market sends home prices rising. Another sign of a housing bubble is that the availability of affordable housing shrinks. Housing growth outstrips income growth.
There are signs that this is happening. In 2017, only 39.1% of rental units across the country were affordable for low-income households. That's down from 55.7% in 2010. The shortage is the worst in cities where home prices have soared.
In 2019, the median sales price of existing single-family homes rose faster than the median household income for the eighth straight year.
Rising Sea Levels
Regional real estate markets could collapse in coastal areas vulnerable to the effects of rising sea levels. 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 properties 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.
Officials Warn of a Housing Crisis
Official warnings are the least critical indicator of a housing market collapse. They can often get it wrong, too. For example, William Poole, a former president of the Federal Reserve Bank of St. Louis, warned of a subprime crisis in a March 2017 op-ed. He based it on the fact that 36% of Fannie Mae's loans required mortgage insurance. That's about the level in 2006. On the other hand, Poole correctly warned of the subprime crisis in 2005.
In short, pay attention to an official warning of a housing crisis when many of the other indicators are also flashing red.
What We Can Learn From the 2008 Housing Market Crash
The 2008 crash was caused by some 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.
To meet this demand for mortgages, banks and mortgage brokers offered home loans to just about anyone. They didn't care about the creditworthiness 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.
The Housing Market Outlook in 2021
The housing market in 2021 will not collapse, but will be buffeted by several conflicting forces. On the positive side, the Fed has promised to keep interest rates low, spurring homebuying. Vaccines will become more widely available, ending the pandemic by September 2021, some experts predict.
Corelogic's Hepp believes that the "forces that drove the housing market expansion in 2020 will continue. These include a desire for more space for those who continue to work from home and a preference for suburban living over crowded urban spaces." Some analysts predict that housing will remain the strongest major sector of the economy.
The economic damage from the pandemic will continue to affect the housing market in 2021. Record levels of unemployment will result in rising numbers of mortgage delinquencies and foreclosures. This will peak in July 2021, according to CoreLogic, without causing a real estate collapse. By that time, improvement in the economy overall as a result of the vaccine will lift the housing market with it.