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Are we heading for another real estate bubble burst?

by Ryan Zimmerman

The real estate market has been on fire since completely bottoming out between 2011 and 2012. Investors started the trend by realizing that prices were low, and they pounced. Investors with deep pockets were grabbing up as much real estate as possible at a steep discount. At the time, cash was king, with nearly 25 percent of sales being purchased with all-cash.

With many people losing their homes due to default, there was a swarm of new renters looking for places to live, and the investors drove the real estate market in those early recovery years.

During the recovery, financing was tightly regulated. It became more difficult for buyers to qualify for a mortgage, compared to the loose qualification criteria lenders had set before the crash. However, the 2012 market was perfect for buyers to enter as interest rates at or below four percent were incentive enough to get would-be buyers off the fence.

Fast forward to 2016, where the average price of a home in Claremont is only $10,000 shy of the absolute peak of the market in 2007, and the year isn’t even finished yet. Spring and summer are typically when markets see the biggest growth, and I predict that 2016 will see prices on par with the market peak, and quite possibly, surpassing it.

Prices have rebounded so much, that we are now seeing a slow down in investor purchasing, with cash purchases of Claremont homes dipping to 19 percent of transactions. This is due to “cheap money” access, as well as higher entry barriers for cash investors.

So what does this all mean for the future of the housing market? With prices likely to exceed the highest peak in history, are we on the brink of another bubble burst? It’s hard to say for sure, but factors surrounding the housing market today are very different than they were leading up to the crash.

Here is a condensed version of how the first bubble was created: The housing explosion that took place in the early-to-mid-2000s was largely due to banks essentially throwing caution to the wind when it came to qualifying buyers for a loan. They were giving loans to buyers who had terrible credit, poor job histories and, at times, no jobs at all. They were loose with their debt-to-income ratios to qualify and, on top of it all, were doing whatever they could to ensure the appraisals came back at or above value on any purchases. If that sounds bad, it gets worse.

 

If all of those loans were set as 30-year fixed rates, perhaps the crash would have been more like a bad fender bender, but the majority of those “sub-prime” loans they were giving had adjustable rates, which nearly ensured that the borrowers would default when the rates would inevitably jump well beyond their ability to afford them. So the rates jumped, borrowers defaulted left and right and the market crashed. Hard.

The recovery, however, has been quite different. Lenders’ credit requirements shot back up. Regulations on the banking industry were put in place, and those horrible sub-prime mortgages with adjustable rates and loose-to-non-existent criteria went away. So we aren’t going to see millions of homeowners default on their adjustable rates like we did after 2006 and 2007. This means we’re out of the woods, right? Well, not exactly. The problem now is that interest rates have been too low for too long.

Money is still so inexpensive that buyers have been wanting to take advantage of that before rates inevitably go back up. Lending requirements have also loosened up a bit again, and more loan programs keep coming out all the time. Buyers can now get loans with as little as 3.5 percent down for an FHA loan, and many lenders offer conventional financing with as little as 5 percent down. So we are putting a lot of buyers into homes who have very little skin in the game. This works fine as long as people keep their jobs and the market keeps moving upward, but what happens when the economy turns around for other reasons?

It is becoming increasingly more difficult to afford a home as prices continue to rise. Interest rates will be going slowly upward, which will put even more pressure on affordability. If interest rates move up too much, affordability goes down—and so do prices. The other issue is incomes are not keeping up with the same rate at which housing prices are rising.

In addition, the world is a very volatile place right now, with increasing tensions in the Middle East and Asia, oil volatility and many other global factors that could cause a downturn in the economy. If that happens, it could mean a loss in people’s incomes, or their jobs.

When lenders used to require 20 percent down, borrowers had enough built-in equity that they could often weather the storm if prices declined. They had enough equity to likely prevent them from being “underwater” on their mortgage. But what happens when prices trend downward, the real estate market turns and people find themselves needing to sell their homes, and they only had 3.5 or 5 percent equity to start with? This could cause another large string of defaults on homeowner’s mortgages.

So what does all this mean? Without a crystal ball, it’s really impossible to say what exactly will happen. The last bubble—and eventual burst—were directly the result of unscrupulous activity by the big banks and lack of regulation. We don’t appear to have that anymore, so a more global economic issue is really what would have to happen to cause some trouble for the housing market in the future.

As things stand now, the economy seems to be doing well, and interest rates are expected to only gradually increase without making shocking jumps. So there are no major indicators of a “bubble burst” any time in the foreseeable future. There are some signs that do point to a possible slow-down in the real estate market, but then again, maybe not. Economists have been wrong before.