BiggerPockets’ Dave Meyer prepared a thorough presentation on the root causes that pushed housing price to a peak in the US in 2022 and why prices has started to decline. Figures provided focus on the US market but the logic is the same for Europe, even if the magnitude is not as strong.
From February 2020 to June 2022 : Extreme growth supported by sound economic reasons
- Supply was low with a structural shortage estimated between 3 and 7 millions homes. Even if construction has picked up since 2020, a deficit has accumulated since the Great Recession (2007-2009) when many home builders went out of business.
- Inventory was low which created competition among buyers (seller’s market). Listings did hit the market but went under contract quickly due to extreme demand.
- Demand, as the combination of both desire and ability to buy a home, was fueled by demographics: Millennials are the largest generation in the US population and have reached the peak age to purchase a house.
- Mortgage rate, pushed below 3% during the pandemic more than offset the impact of rising pricing. In the meantime, median income increased a bit, impacting positively affordability too.
- Inflation, with money printed as never before during the pandemic creating “too much money chasing too few goods.
- Geopolitical factors such as the invasion of Ukraine impacted the price of all sorts of materials.
- Other asset classes like stocks and crypto soared creating a “wealth effect” leading some investors to put some of their profits into real estate. In the meantime, usual bond investor came to chase higher returns as bond yields were falling.
- Rents also increased as the results of all the factors above (+15% YoY)
From June 2022 to present : the correction begins following the decision of the Federal Reserve to raise interest rates to fight a persistently high inflation.
- Mortgage rates consequently increased and more than doubled up to 7% and negatively impacted affordability
- Demand has fallen off due to the shrinking affordability (mortgage applications down 41% YoY and virtually no refinancing applications)
- Prices usually fall after the summer (seasonality) but in 2022, the downturn was sharper and longer
- Rents also became less affordable as wages stopped keeping pace with inflation
- The economic picture has deteriorated with many layoffs announced in some industries
2023 Outlook : how big will the correction be and what will happen until the end of the year?
- For Meyer, all eyes should be on affordability as prices are currently too high in this interest rate environment
- Moody’s Analytics is predicting a declines between 10 and 15% and up to -20% in some markets
- Freddie Mac is calling for a more modest decline of -0.2%
- Markets that should be impacted the most are the ones which saw the largest increases recently (Boise, Reno, Las Vegas) or the ones with low affordability (Denver, Seattle, San Francisco)
- On the other hand, markets in the Midwest, North East and South East are less likely to decline
- Inflation vs. recession. The Fed is likely to keep raising interest rates, maybe at a slower pace following the recent liquidity issues at some banks. Though, in case of a recession, long term yields as mortgage rates tend to decrease
- 7% 30-year mortgage rates seem the normal but ATTOM’s predicts a fall in the 5.5%-6% range.
What to do and how to invest in uncertain economic times?
- Keep in mind that this environment creates a buyer’s market with opportunities for investors even if the market is set for short term declines.
- Most experienced investors remain active or increases activity and stick to the fundamentals:
- Buy deep well bellow asking price
- Pick hybrid cities which offer both solid cash flows and modest appreciation (Birmingham, Philadelphia, Madison)
- House hacking to build equity faster for a low down payment and preferred rate
- Flip with caution as holding costs will increase due to higher interest rates and longer selling period
- Short term rental risk due to increasing supply (+17% in one year) which can lead to decreasing revenues for hosts especially if demand slows
- Use creative financing to avoid bank loans (“subject-to” or seller financing) to negotiate better terms
- Hold on to your portfolio especially if it cash flows, no need to panic
- Use cash whenever possible as high interest rate is dilutive
- Become a private lender to benefit from the higher interest rate
- Never try to time the market, you’ll miss opportunities.
What to watch for in 2023?
- Will there be a recession? The US job market is still strong and announced recent layoffs are limited to some sectors.
- GDP growth and inflation to monitor closely
- Mortgage rate and the broad bond market as a flight to quality, if a recession materializes, will push rates down
- Commercial real estate has a different risk profile than residential. Loans have a shorter duration and have variable rates, so some operators may face issues and defaults can push valuation down (higher cap rate)
- Geopolitical conditions may escalate further
- Watch institutional investors, they are not likely to exit the market now as they are long term investors. However, if they get more involved, housing and rent may become less affordable.
Conclusion
- The real estate market will still be a place of opportunities and risk
- Risk of a recession and of poor performance of metropolitan areas
- Though, opportunities may arise with potential (or fear of) declining home prices and buyers are now in charge.
- That doesn’t mean you should buy anything and anywhere, you have to understand the dynamic of your target market and apply a strategy that works with the current conditions.
- As Warren Buffet says “be greedy when others are fearful, and fearful when others are greedy”