The Four Horsemen of a real estate bubble: Why 2013 is not the start of a new bubble.
In just over a year since the real estate market hit the bottom the bounce back has been dramatic. Double digit price appreciation across the board and many areas seeing 20+% jumps. At first, the return to a positive market was a relief from the long grinding crash that lasted for years. Now as we reach the half-way point to the second recovery year there is talk of a new bubble. At first look this makes sense; buyers are in bidding wars on homes which are routinely selling over asking price and sometimes at huge margins over asking price. Homes sell before the sign even hits the yard and the inventory is at lows not seen since the peak of the last boom. Despite the fact that the velocity of the recovery has many people worried, we are not in a new real estate bubble. In a real estate bubble there are four horsemen that tell of a coming crash: Affordability, Rents, Vacancy, and Easy Money. To show why there isn’t a bubble about to burst let me illustrate the difference between 2007 and 2013.
The cornerstone of the current market strength is affordability. This factor alone shows the remarkable difference between the real estate bubble of 2007 and the current recovery. Affordability is simply a measure of how many households with median income can afford the mortgage on a median home both nationally and in a given city. Affordability is currently still close to historic highs which is a good thing for the market. Why is affordability so high? Three things affect affordability: home prices, interest rates and median income. At the peak of the market in 2007 homes had largely become unaffordable for many families in America. Prices are now 20%-30% less than in 2007 and interest rates would have to go up 50% to match the interest rates of 2007. Anecdotally, my first mortgage in 2006 was 7.25% and my current mortgage is at 3.5%. For a 30 year fixed rate loan of $200,000 in 2006 that means you’d be paying $1,364 a month. How big is the effect of lower interest rates on that same loan today? At 3.5% the monthly payment drops to $898 a month, a savings of $466 per month. Now if you assume that this average loan is now based on a lower purchase price which is 20% less than at the peak you arrive at a loan amount of $154,000 and at 3.5% the monthly payment is $691 that’s a savings of $673 or, to put it more simply, an average mortgage is now almost half the monthly cost it was at the peak of the market.
The increased affordability has also dramatically strengthened the investment market which was the first card to fold in the crash. Not only are investors able to get loans at roughly half the monthly cost of the peak of the market but rents are up significantly. Lower cost, higher income and increasing market values mean that there is no way an average investor is going to be a foreclosure risk today. For many first time buyers now, buying a house saves them money instead of being an increased monthly expense. Rentals cash flow better for investors and renters are motivated to buy due to low ownership costs.
In Portland, Oregon apartment rents in 2008 averaged $0.86 per square foot but by 2012 they were at $1.03 per square foot, an increase of 20%. Luxury rentals and newer buildings have reported rents from $2.25-$2.85 per square foot.
At the peak of the market home building was far exceeding actual demand. In cities hit the hardest by the crash they were building 2 units for every one that was actually needed to take care of population growth and migration. Vacancy therefore went up to new highs. Housing vacancy according to the Census Bureau hit a high in the West in 2008 when it got to 2.9% as of the first quarter of 2013 is now 1.5%, almost half the vacancy we saw in the height of the crash. Even in 2006 it was an average of 2.1%. The higher vacancy was driven by building oversupplying the market and that building frenzy was driven by speculation and easy money.
If you or someone you know has bought or refinanced a home in the last 5 years you are aware that the process is significantly more cumbersome than in 2004-2006. Gone are the exotic loans and the no income verification loans. In today’s market lenders want to know everything about a borrower’s credit and all of their finances. Gone also are the days of zero down investment loans on properties with no income or not enough income to even cover the mortgage. While the rates are low on today’s loans, buyers need to have real money down and a clear ability to afford their mortgage. These more stringent requirements for borrowers ensure that the market growth is sustainable and that homeowners and investors alike can afford to make the payments. In 2006 this wasn’t always the case and if an investor had no money invested in a property and the market goes south there is no motivation to try to make it through the hard times. Simply put, borrowers in 2013 have to actually be qualified and able to afford their loans.
The intent of this article is to highlight the major differences between the bubble market of 2006 and the recovering market of 2013. Today’s market, across the board, is more fundamentally sustainable. Affordability is very high, Rents are up, Vacancy is down and Easy Money is gone. These four horsemen of a real estate bubble are the factors you need to consider when looking at the health of the real estate market. Right now all the indicators are pointing to a healthy and appreciating market.