Is a Real Estate Bubble About to Form?

 Is a Real Estate Bubble About to Form?

Having a large number of investments was all the rage in the 1990s, when the dot-com boom was in full swing. If you Google "housing bubble," you'll get about a million results, so you know the real estate market is all the rage these days. An appreciating asset that is owned by two-thirds of American families captivates and entices the public with the immense wealth potential it creates. When this growth comes to a halt—or even worse, when home values plummet—what will happen?

What Led Us Here

Since 2002, home prices have increased by approximately 11% every year. The pace of appreciation in the South is 9% per year, while the Northeastern states are in the lead with a rate of roughly 20% per year. The majority of investors have no idea that stock values have been rising at a faster rate than property values since 2003. By itself, the S&P 500 produces a yearly return of around 18%. Ignoring the equities' better return is understandable given that many investors are still hurting from the massive losses they endured during the dot-com disasters. The latest "hot dot" for investors who are hesitant to get back into the stock market is real estate.

Rising household formation and falling mortgage rates are the two main factors driving real estate's current upswing. The former is a problem with demand exceeding supply; demand for new homes has increased by around 75% during the 1970s, but the rate of new home construction has stayed mostly stable. With the passage of a law in 1997 that exempted the first half million dollars of earnings from the sale of any home, prices have been steadily climbing at a rate of 6.5% per year since 1970. Plus, the majority of real estate investors get to keep all of the money they put into their investments in the form of mortgage interest (also known as carrying charges). If stock prices were subject to the same tax breaks, it would revolutionize modern investing.

Mortgage rates have been lowering for over a year, bringing down monthly payments for homeowners by about 20%. This has contributed to the real estate market's recent upswing. Even more so, adjustable rate mortgages saw further declines; for example, the monthly cost of a three-year adjustable rate mortgage dropped 35% due to a decline of 1.25%. Many homeowners may refinance and take monies out of their "equity piggybanks" as a result of the reduction in rates, which increases the number of qualified first-time homebuyers.

Nowadays, most financial experts and economists would tell you that our economy is being propelled by recently discovered "borrowed money." The ratio of outstanding mortgage debt to household income has increased by 9% since 2002, yet at the same time, many households are reducing their credit card debt by 10% or more by utilizing the funds from their mortgages to pay down their existing debt. People are reducing the amount of money they need to pay each month to pay off their credit card debt by taking out home loans, which are cheaper and more tax-efficient.

As a percentage of total income, most American households now allocate around 13.5 percent, down from 14.8 percent in 2000. Consumers' disposable income should be affected in the long run by this reduction, rather than a short-term increase in spending. We don't see any further benefit to the recent wave of mortgage refinancings given the possibility of mortgage rate stabilization.

An Easy Departure

Rising interest rates are a dark cloud that could derail the recent upturn in property values. The cost of purchasing a first home has risen dramatically for people looking for adjustable rate mortgages due to the Federal Reserve's decision to raise short-term interest rates. The Federal Reserve has not yet finished its plan, although longer-term fixed rates have not increased much. The "refi" market will come to a grinding halt as a result of rising mortgage financing costs caused by the prospect of both short-term and long-term rate hikes, which will have an effect on first-time homebuyers' loan eligibility. Once we observe interest rates being pushed upward, the current wave of real estate appreciation will begin to recede.

There will be a general slowing of real estate appreciation regardless of changes in mortgage rates. Two very improbable things would have to happen for the current pattern of appreciation to continue: either mortgage rates would steadily decline or the federal government would pass legislation encouraging new real estate leverage. On the other hand, you should anticipate a decline in real estate values and a weakening demand for real estate. However, we do not anticipate a real estate price collapse significant enough to destabilize our economy and financial systems, and we do not think a real estate bubble exists.

In summary

Real estate investors who are banking on the current growth trends to persist are setting themselves up for a huge letdown. A return to the long-term 6.5% return rate in real estate price appreciation is likely in the absence of a reduction in interest rates, an improvement in tax policy, or unforeseen changes in population demographics. A reversal in real estate values might be necessary before this happens, and the reversal could be more severe in some regions than others. There will be no repeat of the dot-com bubble crash of the '90s in terms of real estate price drops, which is why we think stock market investments may provide higher short- and long-term returns than real estate investments.

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