Champagne, baths – and real estate

Bubbles are great to have in champagne, baths, and a host of other things, but they are not good for the real estate market.

A real estate bubble generally is caused by unjustified speculation in the housing market that leads to a rapid and unsustainable increase in prices. When it bursts, prices decline quickly – often to levels lower than when the run up in prices began. The whole country experienced a painful bursting bubble almost a decade ago, and its impact was felt far beyond the real estate market.

There is no doubt that home prices have risen significantly in the metro area during the past several years and affordability, especially for first-time homebuyers, is a real concern. But are we in a bubble? The short answer is no.

From 2002 through 2005, home prices in the Washington, D.C. metro area skyrocketed. Demand was artificially high, driven by ridiculously low “teaser” interest rate mortgages. Prices were up 14% in 2002, 15% in 2003, 20% in 2004 and 21% in 2005. Since mortgage underwriting guidelines were essentially non-existent, more and more buyers rushed into the market to buy homes they could not afford, with the expectation they could cash in their gains later.

When those artificially low adjustable rate mortgages started to adjust and guidelines tightened, demand plummeted. There was a 40% drop in the number of home sales in 2009, compared to the peak in 2005. At the same time, the market was flooded with new inventory as homeowners rushed to sell homes they could no longer afford. With the enormous drop in demand and the jump in homes on the market, prices dropped almost 15% in 2009. Prices only started to head back up in 2012.

None of those supply and demand conditions exist today.

Let’s take a look at demand. There are three basic ways to increase the desire for housing: an upturn in economic activity, an increase in population and generally low interest rates. To a large degree, all three of those exist today. The region’s economy is doing pretty well, especially in The District. Further, the region has grown by one million residents in the last 14 years. Finally, low mortgage interest rates have created an extremely attractive environment for prospective home purchasers, and yet, demand has not exploded. The number of home sales this year in the metro area will be virtually identical to the number that sold in 2003. There have been significant demographic shifts – people are waiting longer to marry and form households, and student loan debt makes it harder for many to buy their first home. And despite those low interest rates, it is harder to qualify for a loan. In short, demand is reasonable, and it not being fueled by speculation.

On the supply side, inventory of available homes is at a historic low. Just as buyers are waiting longer, homeowners are staying put longer. Nationally, the median number of years sellers have been in their homes has risen from six years in 2000 to 10 years today. New construction isn’t keeping pace with household formation.

Low inventory has certainly contributed to increasing home prices, but even in the hottest market area in The District, annual appreciation rates have been between 6% and 8% during the last three years. It is far lower in the suburbs. If demand were greater, the lack of inventory would have pushed prices much higher.

Markets seek balance over time, as long as they are not artificially stimulated or restricted. The hottest areas in our region are due for an adjustment because 6% to 8% appreciation isn’t sustainable forever. In our more suburban markets, current appreciation rates are in line with historic norms. And we know that eventually, mortgage interest rates will climb, and that will ease some of the upper pressure on home prices. We believe the inevitable market adjustment will come in the form of lower appreciation rates, not a drop in prices.

— David Howell, McEnearney Associates Chief Information Officer

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