How Bad Can Housing Valuations Really Get?

It’s no secret that housing affordability is a hot-button issue across the country and with the recent, drastic increase in home prices,¹ many homeowners and investors may be wondering if things are setting up to repeat the Great Financial Crisis (“GFC”).

The Federal Reserve’s recent monetary policy tightening, which is intended to slow down inflation growth in the wider economy, has started to have very real effects on further housing price appreciation.² Based on our experience and analysis of this housing market, we anticipate the underlying value drivers may be drastically different than they were before the GFC. If true, then there may not be a valuation crisis in housing after all.

Pandemic Pricing & Inflation

Let’s start with the rapid run-up in home values since the Covid-19 pandemic. Home sales were down dramatically during the early months of the pandemic, but as quarantine measures continued and work-from-home and virtual learning evolved, the demand for housing reversed course, causing single-family home sales to grow significantly.³ At the same time, interest rates dropped to historic lows in response to aggressive monetary and fiscal stimulus measures enacted to combat the economic impacts of the ongoing pandemic.¹ The demand for single-family housing, combined with historically low interest rates, led to exponential growth in home valuations and prices paid.¹

Now, with inflation expectations firmly entrenched since early 2022, the Federal Reserve has aggressively raised rates eight times in an attempt to cool inflation.² In response, the average 30-year fixed mortgage interest rate is above 7.00% as of March 2023.⁴ Despite the steep increase in interest rates, home values have largely held onto most of their gains, and according to Oxford Economics, there are far fewer buyers who can afford to purchase homes at current prices with the income necessary to cover a near doubling of mortgage rates. The significant increase in the interest burden has come without a corresponding increase in buyers’ income to support the financing costs.⁵ For example, according to a housing study from Harvard University, in April 2021, a household had to earn $79,600 a year to afford payments on the median-priced home of $340,700. One year later, the income requirement was $107,600, pricing out roughly four million renter households.¹ Based on our experience and analysis, the expected result would be a continued curtailing of housing affordability for would-be buyers and exacerbation of an already tight housing market in many major cities with high demand.

Supply Surge Unlikely

Besides financing costs, there is the supply-demand imbalance, which has been over a decade in the making. For example, according to Fannie Mae, the GFC halted new home development, creating an undersupply of new single-family homes and lagged household formation, and fewer new homes were built in the 10 years ending 2018 than in any other decade since 1960.⁶ New construction remains limited as homebuilders face labor shortages, supply-chain issues, and other constraints.⁵ Despite higher home prices, first-time homebuyers are still driving increased demand.⁷ The Millennial generation entered its prime home-buying age right in the aftermath of the pandemic when robust wage inflation, stimulus checks, and the moratorium on student loan repayments during the pandemic converged, thereby creating a massive surge in demand, and buying power with finite supply to satisfy it.¹ Many of the home sales in the current market are to first-time homebuyers, as evidenced by Freddie Mac having financed 554,000 first-time homebuyers in 2021, up 22% from 2020 and the highest level since tracking began.⁷

We believe a supply surge like the one that occurred in the immediate wake of the GFC is unlikely, when millions of households were forced to sell their homes due to adjustable-rate mortgages resetting and subprime borrowers unable to service the interest cost.⁵ Contrastingly, in the current market conditions, it seems supply-demand dynamics should keep a floor under home prices and historically high mortgage rates may keep would-be-sellers on the sidelines since the new financing environment is expected to erode a significant amount of asset value.⁵

Lending Standards & Locked In Rates

The housing market today appears by some metrics to be in better health thanks to lending regulations imposed following the GFC. Many homeowners’ personal balance sheets are much stronger today than they were during 2007 and 2008, and lenders impose much higher credit standards on today’s borrowers.⁵ According to the Federal Reserve Bank of New York, the typical credit score for a mortgage borrower in Q3 2022 was 768. ⁸

As we described previously, the percentage of adjustable-rate mortgages’ (“ARM”) of outstanding mortgages in the U.S. appears to be considerably low. According to Oxford Economics, ARMs are estimated to be only around 2% of mortgages backed by Fannie Mae and Freddie Mac,⁵ and total only 8.6% of all mortgages in the nation according to Mortgage Bankers Association.⁹ The ARMs originated today are not expected to feature risky characteristics that were offered before the GFC including interest-only periods. Today’s ARMs seem to be predominantly fixed rate for five years before becoming adjustable thereafter.⁵
Lastly, because of the incredible rate at which home values have sky-rocketed during the pandemic, homeowners have record levels of home equity and foreclosure activity is expected to be muted.¹⁰ Simultaneously, the amount of debt a homeowner has against the home’s value has fallen dramatically. 2021 saw the largest annual mortgage origination volume of the last 20 years at $4.51 trillion,¹¹ which means far fewer homeowners with home loans are under financial pressure since they’ve locked in a lower borrowing cost. Home equity may deteriorate on paper, but unless a sale is forced due to a life event, borrowers may choose not to sell in order to enjoy the historically low financing costs they’ve locked in until the economy improves.

Based on our research and experience through multiple market cycles, we do not believe the housing market will see a valuation crisis as it did during the GFC, and we anticipate any correction will be a modest one. While many agree that home prices are expected to fall, we believe a decline as severe as during the GFC is unlikely because the anticipated supply-demand imbalance should buttress values, and stricter lender underwriting standards are likely to result in origination of safer home loans to more credit-worthy borrowers.

Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include, but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.