Time to Read: 7 minutes
At BWM Financial, one of our key rules to investing is don’t fight the trend. How does this apply to today’s residential real estate market? As shown below, the trend in residential real estate has clearly been on an upward trajectory since the financial crisis, with real home prices climbing to a current level of 10.5% year-over-year growth.
Solid fundamentals underpin bubbly prices
The 10.5% growth rate represents the greatest year-over-year appreciation seen in the US in more than 50 years. This rate puts the housing market into what we would consider “overbought” territory nationwide. While sheer price movement might make the market look a little bubbly, there are multiple solid fundamentals underpinning the appreciation.
First, the Federal Reserve’s massive response to the COVID-induced recession of 2020 helped push mortgage rates to exceptionally low levels by historical standards, as shown below. As most Americans are far more sensitive to monthly payments than outright cost, low mortgage rates have bolstered the affordability of housing.
Second, supply has been weak for several years. Numerous homebuilders went out of business during and after the financial crisis, leaving the industry ill prepared for an uptick in demand driven by household formation.
Real home prices and the housing inventory-to-sales ratio tend to be negatively correlated, as shown below. The blue line represents the year-over-year change in housing prices, as illustrated by the FHFA Purchase-Only House Price Index (adjusted for inflation). The dotted black line shows the housing inventory-to-sales ratio (inverted). Currently, we’re experiencing record low inventory and record high price gains. In essence, when housing inventory declines and is not replenished by new building, real house prices tend to rise.
The following chart provides additional historical context, especially in relation to the peak of the previous housing bubble. There has not been an inventory-to-sales ratio this low in more than 40 years! We find this to be very noteworthy. Is the ratio low because of COVID eviction moratoriums, or because people don’t want prospective buyers entering their homes during a pandemic? If these are the reasons behind the depressed inventory-to-sales ratio, then supply could soon return to the market.
Does the trend have staying power?
We believe it might take a number of years for the market to re-balance toward historically average levels. In the near term, we have some concerns around the level of price appreciation and expectations for this growth to continue. During the COVID-induced lockdown of the past 12+ months, many people stayed in their homes for extended periods of time and had the chance to carefully assess what they want most out of their primary residence. People then began to seek out different qualities, such as a home office, more square footage, bigger yard, etc. These adjustments in preferences combined with more money to spend (likely due to a lack of other places to spend it) allowed for upward movement in residential real estate. We believe this spike will be reassessed in coming months.
In addition, housing prices are, once again, beginning to look expensive relative to income. The chart below illustrates median single-family home prices and median family income. The bottom portion shows that home prices relative to family income are currently almost two standard deviations above the mean, a level only seen around the peak years of the previous housing bubble.
Looking ahead: A return to normalcy
We are concerned that, despite the solid fundamentals underpinning the housing market, prices might have gotten ahead of themselves in the last 12-18 months, especially in some of the more expensive markets and areas that experienced positive migration due to COVID lifestyle changes. The question is: Will the recent appreciation—or even a pause in the appreciation trend—combined with a return to normalcy begin to lure investors off the sidelines to part with their homes at record high prices?
We believe investors should manage return expectations in the residential real estate space, as future returns could have been pulled forward into the last 18 months thanks to excess liquidity, low mortgage rates and pandemic-related lifestyle changes. As things get back to normal, more supply could help balance the market, causing appreciation to slow or perhaps stall. For now, we think the market looks a little bubbly.