US new-home sales drop 9.4% in July

Uh oh! Is the new housing bubble beginning to deflate? My thought is yes, but let’s not move to hastily to that conclusion before walking through some facts:

1: Many lenders were / are offering mortgage down payments from 1-3% (sometimes as low as 0%). This means that even if a buyer is not able to save money such that they can make a reasonable down payment (or have money set aside if they lose their job, have to make a major repair, etc) they can still be granted a mortgage to buy a property that they make default on.

2: Home values have reached levels near or beyond the highs of 2007 (depending on which region one examines). This means that for most working people buying a home is not something that they can reasonably afford. And if they can they do so under extreme financial stress, making debtors who acquire a mortgage on a property more prone to defaulting.

3: The millennial student debt bubble has grown to over $1.4T. These poor souls who were overcharged for an education that may not lead to better income prospects have little chance of obtaining a mortgage for a home if they are hamstrung by so much debt, poor job prospects and potentially low credit scores. In addition, many millennials have opted to downsize and live in smaller spaces (micro apartments, studios, pods in the parents’ backyard, etc).

4: Many people whom are intending to buy a new house must also sell their existing property. It is more and more difficult to do so with prices on the rise. Somewhere either demand must rise to the higher prices or the supply must fall to more reasonable prices. I suspect the latter will happen given the current macroeconomic environment (final stages of current business cycle).

5: A lot of quasi-affordable housing stock is being leveled and replaced with gaudy, poor quality McMansions by rabid speculators. These housing units tend to have shorter lifespans before major repairs are necessary since builders prioritize quantity over quality. As a result, housing stock that is the most desirable to middle class buyers is being eviscerated while unaffordable, low quality and undesirable housing stock is growing. This is a large, and mostly unrealized problem as of yet.

Without near zero interest rates, and the Fed holding an enormous amount of defunct MBS (mortgage backed security) notes there would be no housing bubble right now. But because we are in an artificially low interest rate environment with massive stimulus in the mortgage market, there is likely a large bubble in real estate valuations that is extremely perilous.

It may be the worst time in US history to buy real estate

The prevailing belief that helped to spark the last housing crisis was that homes are an investment.  That price will keep going higher.  We’re now 8 years out of the peak of the last housing bubble.  But have we formed a brand new one with reckless monetary policy?

US home prices rose 35% in the last four years

CASE SHILLER

The S&P Case Shiller housing index (above) shows an ominous chart of home values.  The first take away is that even 8 years after the previous housing crisis, prices have not returned to their previous highs, despite a large increase.  And this is with the backdrop of the most accommodative monetary policy in US history — with specific support for mortgage backed securities to help lower interest rates on borrowing.

Adjusted for inflation that gain is muted

Prices, when adjusted for purchasing power, are not responding to stimulus as policy makers may have hoped.  This means that while housing prices have gained in notional value, the purchasing power of the dollar has weakened during that period enough to offset much of that gain. So much for being a promising investment.

Cheap debt is the key to this bubble

The largest support mechanism in place for the current housing market’s uptrend has been very, very low interest rates. Some would say this presents a fantastic opportunity to buy a home with a lower monthly mortgage rate.  But what’s not factored in to that logic is everyone else has the same idea — and thus there is an extremely high amount of artificial demand pushing prices up from borrowers who otherwise could not afford to take out a mortgage on a property that is overpriced.

rates

The normalization of interest rates would turn this support mechanism on its head and begin to drain excess demand from the housing market.  Whether that happens because the Federal Reserve begins a tightening cycle or because mortgage backed security holders become nervous and begin to sell their assets remains to be seen.

Knowing that the primary support mechanism for the current housing price boom is entirely artificial, and has been for the better part of the last decade, is an important foot note at the very least.  It may even prove to be the signal that tells us when this latest housing bubble may pop.

Once more, the housing market is entirely dependent on the stability of and confidence in global financial markets.  Any market meltdown will have a profound effect on the housing market.   And every financial market is interconnected to such an extent that a problem in Shanghai can become a problem on Wall Street very quickly.

In conclusion

Prices are artificially high because of monetary stimulus, not a booming economy.  Affordability is near all-time lows for similar reasons.

These gross distortions have created an unsustainable paradox: Houses priced beyond the reach of most Americans — while wages stagnate, labor force participation is at multi-decade lows and the next generation of consumers has an enormous student debt load preventing them from buying a home.

If you are selling a home, this is probably the best time in recent history to exit the real estate market to reduce risk.

If you are buying a home, be extremely careful.  And be prepared to lose a good chunk of that home’s value (or wait until prices normalize and buy in at what will likely be a much lower price).