May102015

The risk of stagflation in the US housing market

The combination of weak or falling home prices and a rising cost of ownership is the worst of both worlds in residential real estate.

yellen_raise_ratesStagflation is broadly defined as an economic condition of high inflation and slow growth. Stagflation was last noted in the 1970s when rising oil prices drained resources from the economy simultaneously slowing growth and raising prices. Economists consider stagflation the worst of both worlds because ordinary people endure rising prices without rising wages to compensate.

The US housing market faces its own version of stagflation when mortgage interest rates begin to rise. When mortgage rates go up, the cost of borrowing will increase, and unless wages rise considerably, the cost of borrowing will increase faster than wages go up. (See: Will rising wages offset the impact of rising mortgage rates?)

If the cost of borrowing rises faster than wages, then future buyers will not be able to borrow the large sums today’s buyers can borrow; thus home price appreciation will slow (or perhaps even reverse). This is the slow growth part of the stagflation scenario.

Some potential homebuyers remain on the sidelines hoping today’s reflated housing bubble prices will come down. The people sitting on the sidelines believe lower prices will bring with it a lower cost of ownership, but it won’t work out that way. Even if prices fall due to rising mortgage rates, the cost of ownership will continue to rise.

housing_double_dipIn the real world, particularly in Coastal California where supply is tight, people borrow to the maximum limit allowable to obtain the highest quality of housing they can. There is no excess affordability to provide any buffer to the shock of rising mortgage rates.

When mortgage rates finally start to rise, people will still continue to borrow to the limit of their income, so the cost of ownership will not fall. In fact, the cost of ownership will continue rising with wages, so the housing market will continue to endure high inflation, the second part of the stagflation scenario.

What we will see over the course of several years is weak or falling home prices and a rising cost of ownership, the worst of both worlds in residential real estate.

Overvalued home prices could put new owners at risk

The Economist magazine estimates Canada’s housing prices overvalued by 35%

By Matt Kwong, CBC News Posted: Apr 22, 2015 5:00 AM ETflying_house_prices

… a recent Economist magazine analysis that tracked Canada’s housing prices as being overvalued by 35 per cent, MacBeth says it’s clear the world is forecasting grim tidings for Canadian real estate.In fact, if the Economist’s figures are any indication, experts warn, Canada could be facing the kind of devastation the U.S. went through when its housing bubble burst in 2006.

“Our bubble is bigger,” says MacBeth, author of When the Bubble Bursts: Surviving the Canadian Real Estate Crash, …

The Economist isn’t alone in its assessment. Bank of Canada governor Stephen Poloz suggested in December that the country’s housing market could be overvalued by as much as 30 per cent.

The ratings agency Fitch and the International Monetary Fund also warned about overvaluation of Canadian properties.

Last month I noted that the US Price-to-rent ratio suggests housing is 30% overvalued. It’s the same analysis in Canada, but nobody in the United States is worried about a housing bubble. Why is that?

During the 00s Canada did not inflate a national housing bubble comparable to ours (although some cities certainly became very inflated). When out housing bubble crashed and we lowered mortgage rates from 6.5% to 3.5% to support prices, Canada was forced to do the same. What most housing pundits erroneously call a recovery here in the US is really the reflation of the old housing bubble, but since Canada didn’t have a housing bubble when we did, the mortgage interest rate stimulus merely inflated house prices there and makes their prices look bubbly by comparison.

Both the US and Canada face the same uncertainty about the future of house prices. We blithely assume the removal of mortgage interest rate stimulus will have no impact on the endlessly rising house prices in the US, but Canadians are more realistic about what may happen when this stimulus is removed.deflation psychology

According to MacBeth, those best positioned to weather a possible market correction would be debt-free millennials — those between the ages of 18 and 34 — still looking to buy.

“If they haven’t bought yet, their best strategy is to save up more for a down payment, and wait for the housing bubble to burst,” he said.

As I pointed out above, this is not clear thinking or analysis. If the housing bubble burst is caused by rising mortgage rates, future homebuyers may pay a lower price, but they won’t enjoy a commensurate lower cost of ownership due to rising mortgage rates.

I became well known for advising people to wait out the deflation of the housing bubble of the 00s, so if I believed lower prices would benefit anyone, I would advise waiting, but that’s not the case today. The conditions during the last bubble were different in a good way for buyers. That housing bubble was going to deflate because millions of foreclosures flooded the market with supply and lowered both the price and the cost of ownership. That won’t happen during the deflation of the reflation recovery (aka housing stagflation) because lenders won’t flood the market with supply, and mortgage rates will go up, not down.

Japan_deflationIf buyers have no reason to expect a lower cost of ownership, they gain no real benefit from waiting. Perhaps waiting reduces their risk of taking a loss at resale, but it does nothing to make owning any cheaper.

MacBeth also feels that those homeowners belonging to the baby boom generation, those between the ages of 55 and 69, “should be in good shape,” so long as they’ve accrued healthy home equity over the years.

“But, there are a few categories of baby boomers who could get into trouble with retirement because they borrowed equity in their homes” for renovations, or for co-signing mortgages for their children to become first-time owners.

Or if they Ponzi borrowed themselves into oblivion like so many did here.

He projects as much as a 50 per cent drop in house prices to match current income levels.

It won’t be that bad, particularly since Canadian banks watched how US banks can-kicked their way out of trouble.

Toronto real-estate broker Barry Lebow … believes a market correction now would be traumatic.

“I’m in the business and it scares me,” he said. “We’ve got a huge percentage of the population that has never seen a downturn in real estate, including a good percentage of real estate agents. When a downturn comes, it’ll be like gravity has been revealed.”

That’s how it works with every bust. By the time market prices get so extended from fundamentals that a crash is likely, most owners comfort themselves with recent price action and assure themselves real estate only goes up. The more secure everyone becomes that prices can’t go down, the more likely a crash in imminent because late buyers overpay by overextending themselves.

I don’t believe we will see a repeat of the 2007-2008 crash when mortgage rates rise. The next crash will be a housing stagflation as I outlined above. Sales volumes will crater, realtors will suffer, and recent homebuyers who expected huge appreciation will be disappointed.

slow-recovery


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