History Lessons from the Housing Market
Jul 19, 2022
Summary
If the housing market worries you today, we urge patience—there will likely be a wide array of opportunities tomorrow.
The residential real estate boom of the last few years may give people of a certain age a sense of déjà vu because it’s somewhat reminiscent of the 1970s. For one, after several years of steady home price gains, many people fear they’ll miss out on further appreciation if they don’t buy a home right now. At the same time, rising inflation and interest rate fears have clouded the future economic outlook. Of course, predicting housing prices and interest rates is challenging for even the most seasoned real estate experts. Our suggestion is to avoid making any hasty decisions based on the latest headlines. Instead, turn to history for clarity and perspective.
When I began my career in 1980, older colleagues were almost unanimous in advising me and my contemporaries to buy a house immediately. The 1970s had seen rapid inflation, and home prices in our city had boomed. The notion was that if we didn’t jump to buy a house, then we would fall permanently behind existing homeowners. This was my first experience with an important emotional hurdle to successful investing: the fear of missing out (FOMO). As it turned out, the FOMO was unjustified, and there was no need for prospective purchasers to rush. There were plenty of homes to purchase at reasonable prices years later.
The advice seemed reasonable then because it was based on experience. After World War II, a unique set of circumstances favored home ownership for decades:
- Government assistance. Federal government programs supported home ownership, such as the Federal Housing Administration insuring mortgages and the U.S. Department of Veterans Affairs backing home loans to veterans. Meanwhile, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) expanded the secondary mortgage market.
- Favorable tax treatment. The federal income tax structure was tilted to benefit homeowners through the deductibility of mortgage interest and property taxes as well as the exemption of at least a portion of capital gains after the sale of a house.
- Post-WWII boom and focus on suburbia. A combination of the post–World War II boom and persistent, if uneven, inflation led to substantial appreciation in home values, particularly in new suburban communities. The American Dream became a house in a good neighborhood with the best schools.
- Cultural status of housing combined with leverage. Most home purchases depended on substantial mortgage financing. The mortgage payment was sacrosanct; failing to pay it was the last desperate consideration in tough times. This discipline made homes a forced–savings vehicle.
- Protection from the psychology of price changes. Unless you were selling, the only information you typically received regarding home value was the imperfect assessment in your annual property tax bill. In other words, unlike today, few people knew or thought much about short-term fluctuations in home prices.
These factors formed the foundations of the “You’ve got to buy a house now” mantra of 1980. Times have changed. Consider how the experience of and reaction to the 2008 global financial crisis changed each of those long-standing factors:
- Increased skepticism of the value of government assistance. Leading up to the crisis, financial institutions purchased mortgages, bundled them into new forms of securities, and created exotic derivative speculations based upon them. The ability of mortgage lenders to sell a loan soon after origination fundamentally changed the ethos and calculation of mortgage issuance, leading to a deterioration in credit standards. Remember subprime debt and NINJA (no income, no job, no assets) loans? In the downturn, Fannie Mae and Freddie Mac failed and then passed into government conservatorship.
- Reduced tax incentives. A substantial increase in the standard deduction for federal income tax, coupled with limitations on the interest deduction for higher-priced homes, reduced the number of taxpayers benefiting from deductions for mortgage interest and property tax.
- Greater uncertainty regarding housing location and the economy. Rather than suburbia being the dominant focus of new home construction, factors such as the ability to work remotely and expansion of mass transit have increased the attractiveness of inner-urban and rural/small town living. Now, changes in attitude resulting from the pandemic creates uncertainty about where people will live in coming years. Future economic growth is also in doubt.
- Changed moral/cultural status of mortgage debt. The sheer number of foreclosures during the global financial crisis reduced the stigma of failing to pay a mortgage. Foreclosures also showed the negative side of leverage.
- Greater liquidity and availability of price information increase the risk of suboptimal behavior. Home equity lines of credit and refinancing became widely available prior to the global financial crisis. Homeowners could get current home price estimates online through services such as Zillow and Redfin, and could use their home equity as a piggy bank. The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index (Case-Shiller Index) fell 26% between 2007 and 2012. Is it a coincidence that the most severe decline in home prices since the Great Depression occurred soon after current price information became more available and tapping into home equity for spending became easier?
The Case-Shiller Index of nationwide home prices has increased almost 50% in the past four years without a single monthly decline, even when COVID-19 shut down much of the economy¹. If anything, the ability to work from home during lockdown may have increased consumer desire to upgrade living spaces. Recent year-over-year increases exceed even the high points of the housing market bubble that preceded the global financial crisis and the ebullience of the late 1970s.
Recent inflation has increased the psychological appeal of making an investment in a home and helped create the FOMO mindset. The homeowner vacancy rate is at an all-time low, and total mortgage debt exceeds its high before the global financial crisis. On the other hand, the era of super-low mortgage rates appears to be past. Conventional mortgage rates have more than doubled from early 2021 lows. Combined with rising home prices, the payment for a 30-year mortgage on an average home has increased 86% in just the past year and a half².
Our advice?
- Do not listen to advice from last century. As detailed above, the old rules about tax advantages, forced savings, and psychological comfort of home ownership as an investment either no longer hold or have changed substantially.
- Watch out for adjustable-rate mortgages (ARMs). Nobody knows the future direction of mortgage rates, but the past year has demonstrated that rates can increase quickly. As depicted in the movie The Big Short, a major cause of distress during the global financial crisis resulted from initial teaser rates on ARMs expiring and borrowers discovering they neither could afford the higher rates nor obtain refinancing.
- Do not rush to buy a home because of FOMO. We make no prediction about the future of either interest rates or home prices, but history shows that markets tend to correct excesses. The year-over-year change in the number of homes listed for sale is strongly positive for the first time in years. The number of new privately owned housing units under construction is the highest since at least 1970. In other words, recent high prices and low vacancy rates are leading to increased supply.
Buying a home is an important and often emotional decision. Yet history shows that hasty decisions based on FOMO or outdated advice can result in disappointment and regret. Instead, we suggest prudent consideration of both where you want to live in the post pandemic world and what you can afford. Today’s conditions will inevitably change, and there will be a wide array of choices for you tomorrow.
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Footnotes:
¹ Ned Davis Research, Inc.
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