"The four most dangerous words in investing are: 'This time it's different.'" - Sir John Templeton
The last time home prices crashed was during the Great Financial Crisis. Average US single family home prices dropped over a 4-year span ~30%. It took until about 2013-14 for existing home prices to again reach comparable levels as 2007-08…roughly 7 years. A comparable drop of ~30% for average single family home prices from current levels would bring them to ~292k. However, as discussed by many, the current economic storm we are in is possibly much worse than in 07-08. Based on the above chart, existing home prices would need to correct to ~230k to bring them on par with their long-term mean values. That means we could potentially see an astonishing drop of over 40% for average single family home prices over the next 3-5 years! If it sounds too crazy to be true, continue reading.
While this may seem like it would take a complete meltdown of the US financial system to achieve, this is actually one goal of the Federal Reserve - aka the FED. If home prices continued gaining in value, it would mean the FED failed to do their job and sent the US into a period of severe hyperinflation. The illustration above from the Federal Reserve Bank of Atlanta depicts the national home affordability. Due to the rise in interest rates and the current valuation of home prices, affordability is now lower than it was during the Great Financial Crisis of 2007 to 2008.
Despite the severely low affordability, home prices have inexplicably continued climbing higher along with interest rates. Affordability within some local areas, such as New York, New Jersey, and Pennsylvania, is even worse than the national average. As you can see from the illustration above from the Federal Reserve Bank of Atlanta, the percentage of income needed to afford a home in these areas is over 12% more than the national average. With home prices at such an astonishing unaffordable level, it would be hard to imagine home valuations increasing further into 2024. To realize why a major correction is likely, you must first understand the relationship between interest rates and home prices.
Typically, interest rates have an inverse relationship to home values. To understand this better, let's start with the basics:
Interest rates are the cost of borrowing money. When they are low, it's more affordable to borrow funds for purchasing a home. Conversely, when interest rates are high, the cost of borrowing increases.
When rates are low, it is more attractive for people to take out mortgages to buy homes. With lower monthly mortgage payments, prospective buyers can afford larger loans. This increased demand for homes often leads to higher home prices. In other words, low interest rates make homeownership more accessible and desirable, which can drive up demand, causing prices to rise. Low rates = higher demand = higher prices.
On the other hand, when interest rates are high, cost of borrowing increases. This results in higher monthly mortgage payments for homebuyers. As the cost of homeownership rises, demand for homes typically decreases. The decrease in demand often leads to a decline in home prices as sellers may need to adjust their prices to attract new buyers. Essentially, high rates = lower demand = lower prices.
In addition to rising interest rates, another factor which could affect real estate prices are the new laws passed in New York regarding AirBnb which cuts down on short-term rentals. Other cities are looking into implementing similar laws of their own as well. Those who own these properties will likely need to change their operating strategies or sell. Listing their properties will increase supply of new units, thus decreasing the price. Higher supply = lower prices.
There are several other factors to additionally consider when it comes to a possible housing market correction. One of which being commercial real estate. Since 2020, only about half of the workers who previously occupied commercial offices have returned. If the new normal is to have many corporate positions filled on a work-from-home basis, many commercial offices will be left vacant. Again, lower demand = lower prices. The illustration above depicts the Commercial Real Estate Price Index. Based on its long-term mean value, a correction of ~40% would be needed to bring it on par with its mean. Roughly the same percentage as single-family home prices.
So, what do you do? Well, one option is to hedge your investments against such a scenario. And if you recently purchased real estate since 2021, don't panic! In my personal opinion there is a strong likelihood of a correction, however there are options for you if it were to occur. Because markets generally move in a higher linear progression over time, eventually your home or investment value will return and possibly go higher. Hopefully, you did not over-extend yourself and can afford to remain patient until that time comes. As you can see from the illustration above, despite how bleak the future seemed during the Great Financial Crisis, even those that bought at the top still almost doubled on their investments since then!
As the possibility of a real estate market correction looms, it's imperative for both seasoned investors and aspiring homeowners to remain vigilant and proactive. While any correction is unpredictable, being informed and prepared can significantly mitigate potential risks and ensure your financial future. Diversification, thorough market research, and financial discipline are key. By staying informed about market trends and seeking guidance from experienced professionals, you can safeguard your investments and identify unique opportunities that may arise during uncertain times. Be sure to follow and subscribe to stay informed on financial information that affects you and your family most!
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