3 months ago • 4:59 mins
US homebuyers have been in a buying frenzy since the Covid recovery, with homes in formerly hard-to-sell markets drawing fierce bidding wars. But with a recent push higher in mortgage rates and more to come, it begs the question: should you jump in while borrowing costs are still relatively low, or hold off till home prices start to slip? Let’s take a look.
It’s not been pretty: US mortgage rates have just seen their biggest three-month gain since 1987, with the 30-year fixed rate – the most popular among US homeowners – rising from just above 3% in February to 5%.
The impact on household budgets is real: new homeowners have to shell out $420 more a month for a median-price home (roughly $405,000), at a time when food and gas prices are already pushing budgets to the brink. And it’s not just house prices that have increased, with landlords upping rent to make the most of a red-hot market.
The issue is, it might well be burning too hot. In a recent paper, researchers at the Federal Reserve Bank of Dallas argued that for the first time since the global financial crisis that there are signs of “abnormal” market behavior. Looking at key ratios, including price-to-rent and price-to-income, they created an “exuberance indicator” that reflects confidence in the housing market. When prices exceed the upper confidence bound of what fundamentals could explain, the indicator turns red. That’s when prices can be said to be in a bubble, and it’s what’s happening right now.
More worrying still, the US isn’t alone: an earlier paper found similar signs of a bubble in about half of the 25 countries they track.
Well, no, probably not. First, the underlying fundamentals of today’s housing market are strong: people paid down debt and saved money during the pandemic, making them better qualified buyers. And the labor market continues to show signs of strength. What’s more, the market is supported by strong demographics, with millennials – the largest generation group in the US – in their prime home-buying years.
Second, the rise in home prices isn’t because of some massive speculative bubble like it was back then: it’s down to an extreme shortage in new-build houses. The trade war and the pandemic have wreaked havoc on the supply chain, and this is just another way that it’s caught up with us.
Third, the quality of mortgages is much higher now, with tougher underwriting and down payment requirements than there were in the lead-up to the 2008 crash. The financial condition of banks and homebuilders is much better too: they’re better capitalized, and subject to stricter stress tests.
Let’s face it, prices aren’t likely to fall in the near term – not with the acute shortage in supply that’s still out there.
But price increases are likely to fade: the rise in mortgage rates will push a lot of potential buyers out of the market, with some deciding they can’t make the higher monthly payments, and others falling short of their lender’s strict debt-to-income ratios. Early signs of a cooldown are already showing: demand for new loans and refinancing have declined over the past few months, and homebuilders’ stock prices – which usually move hand-in-hand with house prices – are down 30% from their January highs.
And looking slightly further out, the market is likely to cool off as inflation and interest rate increases continue to erode buying power – particularly as mortgage rates rise above this 5% mark. Higher costs also mean less cash on hand at the end of month, which will force new homeowners and rents to spend less, in turn dragging on economic growth and leading to slower wage growth and rising unemployment. And that will amplify the shock on disposable income and shrink demand even more.
If you look even further out, you’ll see new housing coming onto the market, both as supply chain disruptions ease and as several states relax restrictions to make room for more housing. And if the economy falls into an outright recession (which I think is likely), the demand shock might be larger than the market is expecting and house prices could fall significantly – although we’re unlikely to see a repeat of 2008.
If you’re looking to enter the real estate market, being patient and waiting a bit to see how the situation evolves may be the smartest thing. Sure, you could miss out on lower mortgage rates, but there are few good options and you’ll have to pay a massive premium to fend off competition. When the market is driven by a shortage in supply as much as it is now, it’s probably best to play defense and wait for things to settle a bit.
But while buying a property doesn’t seem the best option in this market, there are few ways you could still profit from the real estate market. If you think the market is as strong as ever, you could buy a cheap and diversified ETF like the Vanguard Real Estate Index Fund ETF (ticker: VNQ, expense ratio: 0.12%). The SPDR S&P Homebuilders ETF (ticker: XHB) is another option, and currently presents you with a much-improved entry point after the recent fall in price.
If, on the other hand, you think the housing market is headed toward the basement, you could either buy put options on the REITs and homebuilders ETFs, short them (if your broker allows you to), or bet on them using contracts for difference. But my recommendation is to neither buy nor short sell at these levels. Patiently waiting on the sidelines for better fundamentals and a better entry price might be worth its weight in gold.
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