Is Coastal California housing at the peak of another bubble?

California is not in another housing bubble yet, but prices are high relative to income thanks to low mortgage rates.

peak_buyerNobody wants to be a peak buyer, so fear of a housing bubble stops some people from buying homes, but are these fears well founded? Are we inflating housing bubble 2.0 (actually 4.0 in California)?

Because houses seem so expensive and prices rose so rapidly, particularly in California where kool aid intoxication is a cultural addiction, many people are wondering if we are inflating another housing bubble. My answer to that question is no.

We are not inflating a new housing bubble — we are reflating the old one, but the interest rate stimulus used to reflate the bubble is applied to stable loan terms; stable loan terms make for stable house prices.

The last housing bubble inflated prices well above the stable equilibrium of cost of ownership relative to rents based on a foundation of toxic mortgage products, most notably the Option ARM. The current rapid rise in prices is caused by different circumstances, and it’s being built on a foundation of stable 30-year fixed-rate mortgages.toxic_option_arm

When the federal reserve lowered interest rates from the bubble-era 6.5% to the current 3.6%, they imbued the market with tremendous affordability. This lowered the cost of ownership well below the historic relative valuation with rents. This provided buyers with the ability and the incentive to bid up prices and buy homes with stable loan products. While there is no question we are reflating the old bubble, we are doing so with affordable payments and stable loan products; it’s a difference that makes all the difference.

If this does turn out to be a bubble and future house prices are lower, it won’t be for the same reasons the last three California bubbles deflated. If prices go down in the future, it will be due to rising interest rates taking the affordability out of the housing market (See: Zillow: Coastal California house prices may decline as mortgage rates rise).

As long as low interest rates make bubble-era pricing financeable under stable loan terms, prices won’t go down. Additionally, as long as lenders keep cloud inventory off the market, prices will continue to hold their own.

Are We Entering Housing Market Bubble 2.0?

The housing crash of 2008-2009 had global repercussions. With home prices skyrocketing again, are we in danger of another bubble? Our experts debate.

Jason Hall, July 14, 2015bear_rally

Home prices are climbing — fast. According to the National Association of Realtors, May’s price jump marked 39 consecutive months of price increases. And while it’s only natural that prices have climbed from the lows they sank to after the housing bubble burst, they jumped a remarkable 7.9% from May 2014 to May 2015.

Actually, it is not natural for prices to climb so quickly after a bubble deflates. Ordinarily, after the collapse of a financial bubble, prices remain near the bottom for a very long time, and that bottom is hard to predict as the collapse is punctuated by numerous bear rallies.

Is this Housing Bubble 2.0? And if so, is it getting ready to burst? We asked three of our experts to weigh in on the topic. Here’s what they had to say.

Dan Caplinger

There’s definitely an argument to be made that the U.S. housing market has moved back into bubble territory.

Monthly home-price data has shown year-over-year gains for more than three straight years, and when you look at markets across the nation, about two-thirds of all states have seen prices return to within 10% of their record-high levels. Moreover, as Jason and John point out below, certain localities are facing major restrictions in housing supply. Factor in high demand from low interest rates and a recovering economy, and there has been substantial growth in prices.low_interest_rates

One of the biggest factors supporting housing has been the low-interest-rate environment. Nervous economists have hoped that the Federal Reserve would step in with interest rate increases in order to reduce the incentive to buy homes and to keep the pace of any price hikes slow. So far, though, the Fed has been reluctant to return interest rates to more normal levels, and even though the longer-term bond market has seen modest rate increases, mortgage rates remain at attractively low levels.

Even though the level of mortgage debt throughout the economy is well below where it was in the mid-2000s, keeping rates low could spur more borrowing in the near future. The more housing prices climb, the greater the fall could be once the Fed starts to act.

This is the major unanswered question facing housing, and anyone who claims they know what will happen is delusional. My best guess is that as mortgage rates make housing less affordable, home sales will crumble, and if affordability becomes very problematic, then house prices may go down too. Unless hoards of millionaire Chinese stock traders and real estate investors flood the US housing market with cash, prices can only go as high as financed buyers can push them.I_want_to_believe

John Maxfield

I understand why a person might think we’re in the midst of another housing bubble, but I believe the concern is unwarranted.

Two friends of mine recently put their home on the market in Portland, Oregon. In less than a week, they received 15 offers and sold it for $60,000 more than their asking price. Another friend and his wife are trying to buy a home in Austin, Texas. They originally planned to spend $500,000 but have since doubled their budget to $1 million in order to compete for the kind of home they want.

Anecdotes don’t reveal much. Portland recently passed the same kind of growth restrictions that caused all the problems here in California, so now Portland will endure long-term problems with affordability too. Many people have pointed to the Texas markets as overheating recently as well. Rather than a sign of stable demand, these anecdotes point more to the problem of frenzied buying in a financial mania, refuting the point the author is trying to make.

But the problem isn’t that there’s a bubble, which would imply irrational price inflation; it’s that there simply isn’t enough supply to satisfy demand.

A lack of supply can easily be the precipitating cause of a bubble. We will know it truly is a bubble if prices keep going up beyond any rational valuation mostly because people buy with expectation of future appreciation.

Generally speaking, prices rise when the supply of listed homes falls below six months’ worth of sales. Right now the inventory of unsold homes equates to 5.1 months’ worth of sales at the current pace:

Thus, assuming the laws of supply and demand still govern the housing market, it seems to me that prices are doing precisely what one would rationally expect them to do.

“Months of Supply” is worst indicator of housing market activity, and it shouldn’t be relied on.

months of supply

Jason Hall

As Dan pointed out, a lot of markets are sneaking up on their pre-bubble peaks. But it’s worth noting that those prices are nearly a decade old at this point.

This means nothing. The prices made no sense then, and they only make a sense now due to artificially low rates. Valuation has little to do with how long ago some price level was reached.stupid

The housing market has come a long way, and housing, like politics, is local. Furthermore, the crash that started a global financial crisis wasn’t so much a housing crash as it was a speculation crash; housing became something that way too many people thought they could make money on.

Today’s housing market is as much about first-time homebuyers as the recent crash was about people trying to flip houses for profits. I submit the following as evidence:

As The Motley Fool’s Morgan Housel wrote a few years back, the U.S. adds more than 1 million new households per year. New-home construction was consistently below that mark for most of the past five years, meaning inventory hasn’t kept up with growing demand. In other words, normal supply and demand are playing a big role in price increases, and there’s a lot of pent-up demand, as the growth in first-time buyers indicates.

Pent-up demand is the argument of failure realtors use when they have no other reason to promote buying. It’s an entirely specious argument that says nothing about current or future prospects for house prices. The pent-up buyer demand is a myth, and anyone counting on those buyers to return in large numbers is deluding themselves.

NAR chief economist Lawrence Yun is on record stating that new home inventory is a big reason prices are climbing. In other words, there are more buyers and not enough inventory. That growth in first-time buyers is also corresponding with a strengthening jobs market. In other words, demand could grow higher — sending prices up even more — in the next few months.

But to Dan’s point, interest rates are the wild card. It’s likely that rising rates — almost a foregone conclusion at this point — will put some pressure on housing prices in many markets over the next few years. It’s also likely that builders in high-demand markets will ramp up building as demand increases as well.

oh_noo_koolaidFirst, most of these people are uneducated and unemployed. Even when they find a job, they are likely to rent an apartment, perhaps for a very long time. They certainly aren’t going to be in a position to buy a house any time soon, if they ever do.

The ones who are college grads may find higher paying jobs when they leave the nest, but those people also generally have copious amounts of student loan debt. Perhaps they will contribute some single-family home demand in the form of rental housing, but it may be many years before they are in a position to buy either.

Eventually, this age group will be in a position to buy a house, but it will be much, much later than the generation that had access to no-money down mortgages and liar loans. For those that believe this pent-up housing demand will propel house prices ever higher, this demand may remain pent up for a very long time.

Add it all up, and higher rates and more new-home construction are sure to have some impact, but it’s not likely that we’ll see another collapse in the foreseeable future.

I agree that we probably won’t have another crash any time soon, but not for any of the reasons this guy provides. His analysis is a classic example of being right for all the wrong reasons.

There is reason to be concerned that the rapid increase in prices is a new housing bubble because such rates of appreciation are clearly not sustainable. I anticipated we would see a rebound three to five years from now when the shadow inventory was finally worked off, but lenders embarked on a different path and chose to suspend that inventory in the clouds, so we enjoyed our recovery rally early. In either case, prices only rise until they hit market friction from lower affordability and more inventory, which they did two years ago.

We won’t see a crash, but we won’t see continued double-digit appreciation either — unless we really do inflate another housing bubble.

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