Bubble or No Bubble?

As we near the end of the summer selling season our housing market continues to march forward. Every month since February has brought a record high average home price in the metro Denver area, with average prices approaching an astounding $425,000. Amazingly, half of all Denver's new homes for sale sell in six days or less, which is the fastest in the country. The latest Case-Schiller report says we have the highest 12 month price increase of any of the Top 10 Cities it tracks (Denver 10 percent price increase, San Francisco 9.7 percent and Dallas 8.4 percent). The strength in the market has been so pronounced that logical, informed people are beginning to ask whether we’re setting ourselves up for another bubble. Good question. While no one can ever predict the future with certainty, I see no evidence that we’re heading for a dramatic downturn in the real estate market any time soon. Here’s why: 1. Even with the increase in metro Denver home prices the Housing Affordability Index is still well above the rate it was during the last upturn in the market between 2002 - 2006. The HAI is the median price of a home compared to the median income, taking into account the prevailing mortgage rate. So, given that homes are still relatively affordable given median (and, by the way, increasing) wages and low interest rates, we haven’t entered bubble territory. 2. The number of transactions relative to the population of metro Denver is just about at the 25-year average. At the peak of the bubble in 2006 the number of deals was about 20 percent percent above the historical average. When we see the number of closed transactions well above our historical average that’s an indication to me of an overheated market, as it was in 2006. We’re nowhere close to that. 3. As we led up to the last bubble in 2006, many of the deals were closed with low or no documentation ("liar loans” or “no doc loans"). Today, mortgage underwriting standards are the toughest they’ve been in decades. This prevents unqualified buyers from purchasing property, which mitigates the chance of the market overheating (fewer buyers means fewer purchases means less chance of the market frothing into bubble territory like it did in the past). 4. Because of reasonable home affordability it’s still cheaper to buy than rent in our market, especially at the lower end. This would not be true in a bubble. For housing price affordability to return to the average level that we saw in the years between 2002 and 2006 either home prices would have to increase an additional 24 percent or interest rates would need to reach 6 percent. Neither is going to happen any time soon. 5. The imbalance between buyers and sellers we’ve seen recently in our housing market is due to a lack of inventory, not illogical/unrealistic/unsustainable demand from buyers. "Much of the price increases we are seeing are the result of rising demand among investors and homebuyers for a still-limited supply of homes for sale," said Anand Nallathambi, president and CEO of CoreLogic. This imbalance is a logical correction from the past downturn years when we had too FEW buyers in the market. This is how markets are supposed to work, moving in cycles and always regressing to the mean over time. 6. Rising mortgage rates will help to temper the possibility of a bubble as well. "History shows that a rapid rise in interest rates tends to have little correlation with home prices. Rather, rising rates are more likely to contribute to a decrease in home purchase volume," wrote Mark Palim in a Fannie Mae commentary. So the positive side of a rise in mortgage rates is that it will reduce the number of buyers and therefore reduce the chance the market will rise out of control and end up collapsing in a bubble. Here are a few metrics I watch closely to look for signs of a weakening housing market: 1. Housing inventory. When the inventory of homes for sale rises, supply will begin to balance with demand and slow the price increases. We’re still at record-low inventory so I don’t expect to return to a balanced market for several more years. 2. Number of homes sales. If we see a spike in homes sales (most likely due to increased inventory of homes coming on the market) we can expect a slowdown in the housing market to follow just as we saw after our home sales spiked in 2006. At this time, we are right at the 30-year average of homes sales/year/capita which tells me the market is not overheated. 3. The economy. Metro Denver has a booming economy which is contributing to our strong housing market. If the economy begins to falter that will affect housing. I see no sign of that happening anytime soon. 4. Interest rates. Low interest rates have contributed to relatively high home affordability, continuing to help the housing market. If interest rates spike that will decrease affordability. But if you’ve been reading this newsletter for years you know that no one can predict interest rates and trying to do so is simply a waste of time. Some day if interest rates move upward we may see an effect on the housing market but there’s no reason to believe that’s going to happen any time soon. For these and many other reasons I believe our market will continue to be strong for the foreseeable future, but of course it can't grow indefinitely. Since the inventory of homes for sale is still extremely low I think the demand will still exceed the supply for the next 24-36 months and prices will continue to rise for at least the next few years. No bubble on the horizon yet. Stay tuned!