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Where are housing prices heading? Gain, then pain

This scenariowhere the economy is tanking while housing notches new gainsmakes this an unusually confusing moment to weigh whether its a good or bad time to buy or sell a home.

This article is part of Fortune’s quarterly investment guide for Q3 2020.

In his 17 years as a Seattle real estate broker, Sam Mansour had never witnessed a marvel to match the shopping frenzy that took flight in the first days of reopening. “We were shut down by shelter-in-place orders in early March,” recalls Mansour. “When we returned to work, we saw a surge in buyers that continues, with no end in sight. Many customers have condos in the city, but now both husband and wife are working at home, so to get more space and enjoy a backyard, they’re buying second homes. On top of that, we have young renters who are rushing to buy because rates are so low.” He’s putting roughly 10 houses into contract a month, compared with seven this time last year, and his customers are paying record prices––around 8% more for the same ranch or colonial as in 2019. “We’d only seen big spikes when, say, Amazon suddenly hired 10,000 people, but not this big,” he observes. “The joke in the old normal used to be, ‘Where would you be happy living?’ Now it’s, ‘Where would you be happy quarantined?’”

This housing boom that Mansour sees building in Seattle exemplifies the trend that’s sweeping the country from Austin to Jacksonville, from Raleigh to Portland, Ore. In an America where the COVID-19 pandemic has tripled the jobless rate since February to 11.1% and caused the deepest sudden drop in GDP since the Great Depression, it’s the biggest, and most astounding, piece of positive economic news to emerge from the crisis. “The single-family housing market is going gangbusters, though some areas are hurting,” says Ed Pinto, the former chief credit officer at Fannie Mae who heads the American Enterprise Institute’s Housing Center. “It’s fully recovered from the pandemic shock and is back even stronger than last year, when it was showing its best performance in a decade.” On average, prices are rising 7% to 8% nationwide over this time last year, and they’re notching new records by the week. At the same time, data from April shows an alarming spike in mortgage delinquencies.

This scenario—where the economy is tanking while housing romps—makes this an unusually confusing moment to weigh whether it’s a good or bad time to buy or sell a home. Brokers like Mansour, as well as economists looking at the broad macro picture, such as Yale’s Robert Shiller, see several trends emerging. Mansour reckons that 30% of his buyers are families either selling their city condos or purchasing second homes, and most of that demand is new. And Shiller tells Fortune: “What strikes me out of the whole coronavirus experience is that the pleasure of living in a nice city is diminished by the fear of being close to other people. That appears to be causing an outflow to the suburbs and far-flung places even beyond the suburbs.”

Most experts say in the near term they’re expecting to see drops in big cities like L.A. and New York, and declines in Detroit, a metro with persistently high unemployment, and low incomes. According to Pinto, sections of south and southeast Cleveland and the South Side of Chicago, encompassing around 20% of their respective populations, will also get hit. These areas have a high proportion of low-paying service jobs, and will likely suffer from elevated unemployment rates that will last a lot longer than for the nation as a whole, driving down prices. Miami, Phoenix, and Las Vegas, heretofore flourishing metros thrown into recession by vanishing dollars from tourism and vacationers, will see prices fall. Because those declines will be counterbalanced by gains in the Sunbelt areas that will keep roaring, it’s hard to predict how much prices will fall nationwide, if they fall at all.

Research firm CoreLogic takes a pessimistic view, forecasting a decline of 6% on average nationwide in the next 12 months. “We were surprised at how quickly a V-shaped recovery happened, post the stay-at-home orders,” says Selma Hepp, an economist at CoreLogic. But Hepp believes that three factors will turn the rebound into a swift decline. First, she predicts that employment will stay stubbornly in the upper-teens, and cites that the jobless rate is a barometer for the health of housing. Second, the fall in disposable income erodes Americans’ ability to buy homes and make their mortgage payment. And third, the current spike in demand will unleash a bounce in housing starts that will fill building lots with new houses just as buyers are retreating.

In this writer’s view, a 6% fall nationwide over the next 12 months is unlikely, given the market’s current momentum, the super-low rates, and the prospects for continued growth in most of the South and Southwest. What’s easier to predict is the long game, and there, the future looks dark. One reason is that a lot of today’s buying is driven not by new, but by pent-up demand. “People who were planning on buying anyway and didn’t buy earlier in the year are buying now,” says Hepp. In addition, it’s unclear that what looks like the big new source of buying, the exodus from city apartments to suburban houses, will continue. “It’s hard to believe it’s a long-term trend,” says Hepp. “Once we get a vaccine, we may see people coming back to the cities.” Shiller is also skeptical: “People may get over this aversion to the cities faster than expected,” he says.

It’s likely that once the momentum from the decline in rates runs its course, prices will either fall in most markets, or fail to match inflation. The reason is basic: Home appreciation has been outpacing Americans’ incomes for around a decade. Right now, it’s the drop in rates that’s allowing the rise in prices to outstrip the extra dollars in workers’ paychecks. But that can’t go on forever.

Here’s everything we know about the current forces being brought to bear on markets across the country.

Pent-up demand

In late June, the National Association of Realtors announced that sales of existing homes had fallen 17.8% in May, the biggest single-month drop since 1982. That descent brought the total decline since the start of April to a staggering 26.6%, lowering the number from an annualized 5.33 million in May of 2019 to 3.91 million, the lowest reading since 2011. Pending sales of new homes, surveyed by the U.S. Department of Commerce, waned 12.8%, from 665,000 to 580,000, from March to April. Like most of the economy, housing locked down, as states banned agents from showing homes to the few buyers who braved venturing out to tour them.

In an early sign of things to come, new home sales “pending,” or in contract, soared to an annual rate of 667,000 in May, exceeding the previous year’s figure by nearly 13%. But the big driver is the existing home market that accounts for around nine in 10 sales. And probably the best predictor for that dominant sector is the survey of homes in contract that just “locked in” an interest rate with their lender, conducted by the AEI Housing Center headed by Pinto. Those rate lock transactions account for the vast bulk of all future sales. “The lock-in date generally comes 45 to 50 days before the closing or recorded sale,” says Pinto. Hence, the rate locks recorded in May will translate into July sales, and those in June progress to closings in August.

Pinto’s rate-lock data shows that housing entered 2020 in a sprint. For the first 11 weeks through mid-March the number of houses that secured rate commitments averaged 15% above 2019’s already strong levels. The volume of new contracts then entered a corridor of sorrows, trailing the 2019 trend by a wide margin. What followed is likely the most epic leap in the annals of housing. By the first week in April, buyers were getting rate locks on over 45,000 homes, well above the 35,000 from the same week last year. And the total kept jumping week after week, hitting 63,000 in early June before settling at around 50,000, then jumping back to 62,000 for the week ended July 10.

Over the past seven weeks, rate locks have exceeded the numbers from last year by over 40%, at roughly 35,000 to 55,000. In the week ended June 27, contracts jumped 62% ahead of last year’s pace. All told, total volumes for the year are 19% ahead of 2019, despite the falloff in March. “The strong sales pattern from 2019 suddenly got back on track, but with an extra boost,” says Pinto. “That extra boost came from the big decline in rates.” The towering contract numbers posted in June, says Pinto, should send sales on an annualized basis well above 6 million in August, the highest number since 2007.

The Pinto data also tracks the trend in prices. From early 2019 through the start of the lockdown, they’ve been tracing a steady upward trajectory, going from 3.5% annual appreciation to 7.3% at the pre-pandemic peak. The rate of appreciation showed remarkable resilience, falling only to 3.7% at the low point. From there, prices went on a moonshot, passing 7% in mid-June and exploding to 9.2% the week ended July 10, the most recent result.

Fewer affordable options

First-time buyers are typically millennials in their late twenties through late thirties who are moving from apartments, often because their first child is nearing school age. Those maiden purchasers are crucial to a strong market because they power the “daisy chain” that enables owners of existing homes to move up to bigger, pricier properties. The entry-level cohort mostly buys inexpensive used homes, providing a nice capital gain for sellers, who can use the extra cash as a down payment on a more costly, move-up abode.

It’s those first-time buyers that have been driving the bull market in recent years. In peak spring season, they’ve gone from purchasing 130,000 homes a month in 2013 to 190,000 in 2019––and their volumes are probably heading even higher this summer. “Keep in mind that millennials have been powering the market,” says Pinto. “Larger and larger numbers of them have been reaching prime buying age of 33. And their incomes have been increasing steadily in recent years.”

The rub is that the surge in prices that accelerated in 2019, then resumed with even greater fervor in May and June, is eroding affordability for all buyers, but especially for first-timers. Year after year, the outsize increase in what Americans pay for houses has been outrunning the modest ascent in their incomes. “Remember, incomes have been rising nicely at over 3% for the past couple of years,” says Pinto. “But from around 2012 to 2020, prices were increasing many points faster, just below 6%.”

But it’s a tale of two markets. The high end appreciated a lot more slowly, and hence faces less danger. Over those eight years, prices bounced around but averaged gains of about 4.5%. “I’m not worried about the high end,” says Pinto. “The leverage is low; owners have a lot more resources to fall back on; many own their homes free and clear; and those with loans are a lot less leveraged. So the chances of foreclosure or forced sale by the affluent are relatively low.

“Prices are rising fastest for entry-level buyers, and they’re exactly the ones most hurt by the trend,” says Pinto. The relatively low-price entry level that accounts for 27% of the total market has been appreciating far faster than both the 6% average nationwide and 4.5% at the high end, at 7.6%. This continuing escalation means that affordability will hit a wall for first-timers in many markets despite lower rates.

More debt

The affordability problem caused by prices rising faster than incomes is forcing purchasers to take on bigger and bigger amounts of debt relative to their paychecks. New homeowners—particularly low-earning Federal Housing Administration (FHA) borrowers accounting for 20% of the purchasers who get loans, a group forming the riskiest part of the market—are especially highly leveraged. That means their mortgage debt relative to their incomes is extremely elevated. So for prices to keep rising, they’d need to become even more stretched. Pinto says that the FHA could well keep allowing debt to income to spike ever higher and support the trend toward even more unsustainable prices. “That’s why prices still have room to move higher,” he says. But eventually the increase in supply brought on by high prices will push down values, causing the FHA and Fannie and Freddie to tighten credit standards, further chilling sales. That’s what killed the market from 2007 to 2011.

In many markets, from Los Angeles to Denver, homes are already unaffordable for first-time buyers, and for that reason alone, are likely to fall. Even in formerly inexpensive locales such as Charlotte and Dallas, they’re reaching levels that are pricing out new buyers, and hence leaving little or no room for appreciation.

Dearth of new construction

The reason that prices for first-time buyers are rising so much faster than for the affluent is the dearth of construction of inexpensive homes. “It’s new construction that holds down prices,” says Pinto. “But except in markets such as Raleigh and Jacksonville, where there’s a lot of available land and plenty of construction, land is much too expensive for builders to offer the $120,000 or $150,000 homes that young buyers can afford.” Hence, he says, few if any inexpensive houses are coming on the market to compete with the low end of the existing homes. So first-timers are stuck: That fixed supply of older homes, in the lowest-price tier, is practically their only choice. “Since the inventory of those $150K existing homes for sale tends to be lowest of any level, the first–timers bid up the prices a lot faster than for $400,000 or $500,000 homes where in, say, Dallas or Atlanta, you have plenty of construction,” says Pinto.

How have the first-timers kept going when you’d think that fast-rising prices would put homeownership out of reach? First, supercheap rates have empowered millennials to keep paying more and more for the same houses without substantially raising their monthly payments. The second reason is a big increase in leverage. The government-backed lenders such as Fannie, Freddie, the FHA, and the VA, that originate 80% of America’s home purchase loans are allowing low-income buyers to substantially increase the amount of debt they amass for every dollar in income. “That latitude has combined with falling rates to empower them to buy the same houses at much higher prices,” says Pinto.

Prices have risen fast in cities

Pinto and fellow AEI analyst Tobias Peter studied the change in affordability for first-time buyers in 50 metros from 2013 to 2018. The results are arguably the best evidence that prices in all categories, and especially the lower tiers, have been defying economic gravity. When the fundamentals take hold, as they always do, prices will need to fall or go flat in pricey markets, including a number where houses were bargains just a few years ago.

Pinto and Peter measure affordability as the ratio of the average price first-timers pay to their median family incomes. “I don’t consider interest rates, because they can change quickly and in big shifts,” Pinto says. “Keep in mind that the 30-year hit 5% in late 2018.” In 2013, the average price-to-income ratio in those metros was 3.0. In five years, it rose to 3.3, meaning entry-level purchasers nationwide were spending 10% more per dollar of income on their houses.

Most cities became less affordable, many by a wide margin, especially when you consider their big price increases since 2018. The bargain metros are mainly older industrial cities such as Pittsburgh, Cincinnati, and Memphis, and they still offered the best prices per dollar of income in 2018. Metros near the top of the price scale got even less affordable over those five years. For example, Denver incomes rose 31% to $85,000 in that half-decade, versus a 56% bump in median house prices to $367,000. Its ratio of prices to incomes zoomed from 3.5 to 4.2. The pattern was similar in Seattle, where prices rose 40% to $400,000, and incomes rose 28%. Las Vegas became spectacularly less affordable, as prices rose 42% to $265,000, and incomes waxed just 16%.

Even highly desirable cities in the South and Southwest that feature strong job growth and used to be highly affordable, have gotten much more expensive. In Jacksonville, home prices rose 22%, almost three times as fast as incomes, and they’ve jumped another 22% in just the past 18 months. Dallas was the eighth cheapest city in 2013. By 2018, prices had rocketed 40% to $264,000, compared with 9% for incomes, pushing its rank to 20th. Dallas appears to have run out of headroom to keep raising prices. Since the start of 2019, they’ve risen just 5.5%, way below the national average. That’s a sign of things to come.

Prices can’t continue to outpace incomes

For a while, it looked as if a normalization in rates would cool the huge run-up in prices where it matters most, on the low end. The 30-year hit 5% in November of 2018, and the Fed expected a rise to 6%. At that point, according to Pinto, it looked like the house-price boom on the low end especially would have a soft landing. Housing was headed on a sustainable course where prices would more or less track incomes. Then, the trade war and a slowdown in Europe and what looked like a looming bust on the high end prompted the Fed to slash rates once again.

That sent prices skyward at the low end. Then came the current run-up that made the affordability problem, and the correction needed to solve it, even worse. The dynamic of prices rising faster than pay that’s reigned for years simply cannot last, although low rates can keep it going for a while.

In many markets where the gap’s been growing fastest, such as Las Vegas, Phoenix, and Miami, prices will have to fall relatively soon before they can resume rising again. Then they’re likely to increase modestly in tandem with incomes. In those cities, the pandemic will provide the catalyst for the inevitable drop. But the reckoning, meaning flat or declining prices, will probably happen in all but the still-bargain Midwestern metros. We just don’t know how long it will take. The trigger could be that the coronavirus crisis lasts a lot longer than expected, or another unforeseen shock. What’s clear is that perhaps this new and surprising spike makes the already inevitable descent back to normal even steeper.

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