Home prices are rising faster than market forces would suggest and are being “snapped out of fundamentals,” according to a new blog post by researchers and economists at the Federal Reserve Bank of Dallas. Until recently, the possibility of a bubble was not widely supported. But after looking at US housing markets, the Fed researchers said new evidence is emerging.
“Our evidence points to abnormal behavior in the US housing market for the first time since the early 2000s boom,” the researchers wrote. “Concerns are clear about certain economic indicators … showing signs that house prices are increasingly out of step with fundamentals in 2021.”
Many Americans are still scarred by the last housing crisis in 2007, which was fueled by cheap credit and lax lending standards that left millions of homeowners with more debt on their homes than they were worth.
But this time economists said they are concerned about a different scenario.
Just because house prices are rising sharply doesn’t always mean the real estate market is in a bubble. And there are many reasons why home prices have risen steadily over the past decade — and even more so over the past two years — including supply and demand imbalances in the market, rising labor and construction costs, and how high or low Interest rates are related to a mortgage, the researchers pointed out.
But they said prices could rise to a point they call “exuberance,” where prices are increasingly misaligned with the market’s economic fundamentals.
One possible reason, they suggested, is that buyers may believe prices will continue to rise and fear they are missing out on a lower price on a home now and have to pay more later.
This fear of missing out, or FOMO effect, can drive prices higher and raise expectations for higher prices in the future. That can create a self-fulfilling prophecy, researchers said, where price growth can become exponential.
Consequences of housing exuberance may include overpriced housing, investments based on distorted expected returns, and a slowdown in economic growth and employment.
The cycle will be broken when politicians intervene, urging investors to be cautious and cutting off the flow of money into housing. This could result in a case fix, or possibly even bankruptcy, according to the blog post.
The researchers recommended that policymakers and market participants closely monitor local markets for price booms to better respond “before misalignments become so severe that subsequent corrections lead to economic disruption.”
blistering
The behavior of home buyers and sellers over the past two years has been anything but normal, the researchers emphasized. Prices are at record highs and continue to rise because inventories have been at record low levels. Still, homebuyers keep buying. Interest rates fell to record lows during the pandemic, but that alone doesn’t explain the housing market frenzy, they wrote. Other factors have played a role in pushing the market into bubble territory, the Fed researchers wrote, including pandemic-related stimulus plans and Covid-19-related supply chain disruptions and related policy responses. The researchers particularly highlight the role of investors aggressively buying up homes. Investors are now buying 33% of homes in the US, which is 5% more than the average over the past decade, according to John Burns Real Estate Consulting. The business of iBuying — where a company buys a home for cash to easily repair and resell it — accounts for just 1.7% of the national housing market as of the final quarter of 2021, according to Zillow. But in some cities, the percentage of properties that go to ibuyers is as high as 11%.
The researchers found that as prices rose, signs of exuberance emerged. The U.S. housing market has been showing these signs for more than five consecutive quarters through the third quarter of 2021, they found.
Fed researchers also examined the relationship between home prices and rents. They noted that since 2020, home price-to-rent ratios have risen rapidly beyond what market fundamentals can explain and began to show signs of exuberance in 2021.
Another indicator the researchers examined was the ratio of home prices to disposable income, which is closely linked to affordability. That home price-to-earnings ratio is rising fast, but not yet effusively, the researchers said.
silver lining
Much has been learned from the last real estate crash, leading to better early detection and warning indicators of real estate bubbles, the researchers wrote. If these worrying trends continue, banks, policymakers and regulators should be better equipped to react quickly and avoid the most severe negative consequences of a correction.
Furthermore, they wrote, there is no reason to expect any resulting correction to affect homeowners or the economy as badly as the last housing crash. Americans are generally in better financial shape, homeowners have stronger equity positions, and excessive borrowing is not as prevalent as it was in the mid-2000s.