Collateral Analytics is a company that develops tools and products to help real estate professionals analyze markets and trends. They recently wrote a post titled “Is a New Home Price Bubble Forming” in which they used some of their proprietary tools to analyze many different markets and neighborhoods in the United States. In their post they state that the U.S. as a whole is not even close to being near a housing bubble, but that there are certain cities that may be nearing bubble territory. In today’s post, we will attempt to summarize some of the findings that were discovered in their research.
What factors create a housing bubble?
While there are different ways to define what exactly a housing bubble is, one of these definitions is a trend of unsustainable rising housing prices that is not based on market fundamentals but rather speculation that prices will continue to increase. An example of this speculation is someone buying a home that they cannot afford because they are “sure” that the housing market will continue to rise and that their house will soon be worth more than they bought it for. Rather than home prices rising due to speculation, a healthy market is one in which housing prices are based off of the home’s intrinsic value. One way to look at the value of a home is to compare your mortgage expenses with the market rents in your area. Another way is to look at the local income, local wealth, and the current mortgage rates to determine affordability.
A bubble is created when home prices continue to rise without local market conditions naturally contributing to the increase. For instance, when interest rates on mortgages decrease, less of the homeowner’s monthly payments will be going towards interest and more can be used towards paying down the principal, in essence qualifying them for a higher mortgage. Home prices increasing due to this would be an example of a healthy market. Likewise, if a well-established, reputable company were to open a home office in your town that necessitated the hiring of thousands of people, this would add more income to your local area and could lead to a fundamental rise in housing prices. However, when prices continue to rise quickly without any of these factors contributing to the rise, the fundamentals are not there and the local market may be in store for a correction.
The authors of the article believe that there are a few reasons that an upcoming housing bubble is unlikely. The first reason is that most people buying homes will be obtaining a mortgage with a fixed rate. Because the rate is faxed, their monthly payment will remain the same (assuming that they don’t refinance at some point) throughout the life of the loan. Back when Adjustable Rate Mortgages (ARMs) were more common, some homeowners were hit with much higher payments once their rates adjusted after the fixed-rate period. This led to many people not being able to afford their mortgage because they did not realize how high the payments would become. Also tied to mortgages is the fact that potential buyers must be able to qualify for the loan. If lending institutions are doing their job correctly, they should not be issuing loans that people cannot afford. Lastly, the authors argue that the appraisal process adds another set of eyes to help ensure that the house itself is worth the amount of the loan.
Collateral Analytics state that they have created computer models that use many different variables to analyze the intrinsic value of homes throughout the country. Using these intrinsic values, they can more accurately determine if property values are at a healthy level, overvalued, or undervalued. Using their models, they have concluded that most of the United States shows signs of a healthy real estate market and that there is no immediate fear of a housing bubble. Out of almost 400 different areas that they analyzed, they believe that only seven areas show signs that might be nearing bubble territory, three of which are in Northern California. While the authors do not state that a bubble will or will not happen in these regions, they suggest that potential home buyers and investors pay attention in those areas to try and understand if prices are rising due to market fundamentals or merely speculation.
While Collateral Analytics specializes in analyzing real estate markets, I am sure you can find other experts who can provide data to support their case that a national housing bubble is just a matter of time. We believe that one of the main takeaways from this article is that residential real estate is localized, so it is more important for homebuyers to understand what is happening in their city than on a national level. While we are nowhere near experts on this subject, we will note that mortgage rates are still near historic lows. While no one can say for sure when interest rates will rise, I think that most people will tell you that they are certain to rise at some point in the near future. What direct impact this will have on the housing market remains to be seen and will also depend on how high interest rates rise. Lastly, I always try to tell people that just because someone can qualify for a certain loan amount, doesn’t mean they necessarily can afford it. While loan approvals are pretty thorough in analyzing your reoccurring income and expenses, they don’t really take into account your other spending habits. Just because on paper it looks like you can afford a $2,500 monthly mortgage payment doesn’t necessarily mean that you are not spending most of your discretionary income frivolously. I am always cautious when articles bring up that lending institutions are only lending to people who “qualify” for their loans, as this does not always tell the whole story.