Housing Bubble ...

... or Housing Sponge?

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For reasons nobody seems to be able to provide, interest rates remain at historic lows (see left), fuelling demand for housing and making more expensive housing more affordable even at increased prices.

For people already in the housing market, moving from one home to another in the same area is a matter of moving equity; cashing in on the new-found value in their existing home and investing this equity into a new home, perhaps with a slightly higher mortgage (often with lower monthly payments). Inflated house prices have no impact to these people since they are swapping equity.

What normally makes these inflated markets hard to sustain is the availability of entry-level housing. With entry-level housing at $300,000 and above in the suburbs, a first-time-buyer needs to find $60,000 to put down on a home to avoid paying PMI (private mortgage insurance). Since there are very few first-time-buyers with this kind of equity in the bank, lenders have been getting creative in offering 100% financing, often avoiding PMI premiums by selling two loans (the first loan is a traditional mortgage, often interest only, for 80% of the value; the second is something like a Home Equity line at a higher rate of interest to cover the 20%). Some lenders are even having buyers roll their closing costs into the loans by having them pay more than asking price for the home and having the seller kick-back the closing costs from the additional monies (e.g. a $300,000 home sells for $305,000 with 100% financing and the seller pays $5,000 in closing costs. The seller receives the asking price of $300,000 and the buyer has a mortgage for $305,000).

While these practices are working in the present market, when interest rates rise as they surely will, it will be these entry-level-homes that come onto the market first (as first-time-buyers get into difficulty making their loan repayments). Markets will see an increase in the number of foreclosures as owners simply walk away from their homes because they have no equity in the home. This could impact prices throughout a region by pulling prices lower based upon comparable sales.

Another factor to consider is the number of investors in a given market. The national survey by the Board of Realtors shows roughly 30% of homes are purchased as investments. Since some markets make for better investments than others because homes cost less, there are sure to be national variations where a higher percentage of homes are investments (Florida for example). In a declining housing market, a significant portion of these investors may be tempted to liquidate their assets, thereby driving prices down further. Note: The smart investor will recognize house prices have historically always come back stronger and take the opportunity to buy in the declining market and hold for the long term.

While these combined factors suggest there is a strong likelihood of regional price corrections when interest rates rise, there is another factor to consider: Housing is a function of supply and demand. Supply is not balanced throughout the country since available land is scarcer in some locations (e.g. older cities). Since most value is in land and not buildings in these areas, when land prices rise due to scarcity, the property value has to rise with it. (Which is why savvy investors have been buying old cottages near major cities and tearing them down to build new homes).

Taking the scarcity of land into account might lead you to conclude there is less likely to be a decline in prices in areas where buildable land is nearly exhausted and more likely to be a decline in areas where land is more freely available for new construction.
Factor in the demographics of the baby-boom generation and consider how they will be paying for a long retirement. What will they be doing with homes in areas where they no longer want to live? We must not underestimate the impact boomers will have in every housing market in the US over the next twenty years.

Above all it will pay to remember that the housing market is predictably slow to react. Prices shown for sales today are based on deals that were agreed upon two, three or four months ago. As prices drop (or rise), the changes are reflected in settled prices several months later. Appraisers use these settled prices to put a value on future sales, so any decline in prices takes several months to work through the system, and all of it is visible to Realtors working in the market on a full-time basis. The changes are predictable and slow by comparison to the stock market. Bubbles burst with a pop! The housing market is more like a growing sponge than a bubble; sometimes it is squeezed and water (money) drops out slowly, at other times is soaks up water (money) and expands. Sponges don't pop.

In conclusion, housing remains a strong investment option since land is finite and people need a place to live. As long as the population continues to grow, demand will continue to push prices in an upward direction over the long-term. Plus, there is no other place where you can leverage other people's money quite so easily and predictably over the long-term. If all else fails, buy low, hold and sell high!