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 is generally caused by unjustified speculation in the housing market that leads to a rapid and unsustainable increase in prices. When the real estate bubble bursts, prices decline quickly — often to levels lower than when the surge in prices started.
There is no doubt that home prices have risen significantly in the Washington area over the past several years, and affordability, especially for first-time home buyers, is a real concern. In such an expensive region of the country, many Washington-area residents are wondering if we’re in a bubble right now. The short answer is no.
From 2002 through 2005, home prices in the Washington area skyrocketed. Demand was artificially high, driven by ridiculously low “teaser” interest rate mortgages. In 2002, prices rose 14 percent over the previous year — and that was just the beginning. Home prices were up 15 percent in 2003, 20 percent in 2004 and 21 percent in 2005. This truly was a period of “unjustified speculation.” Because mortgage underwriting guidelines were essentially nonexistent, 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.
In a market that historically has average annual home price appreciation of about 4 percent, those meteoric home price increases were completely unsustainable, and a consequential adjustment was inevitable. And as many remember, it wasn’t just an “adjustment.” When those artificially low adjustable rate mortgages started to adjust and guidelines tightened, demand dropped. There was a 40 percent dip in the number of home sales in 2009 compared with 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 percent in 2009. Prices only started to head back up in 2012.
None of those demand and supply 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. Low-mortgage interest rates have created an extremely attractive environment for prospective home purchasers, and the region has grown by 1 million residents in the past 14 years.
Yet demand has not exploded. The number of home sales this year in the Washington 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 not being fueled by speculation.
On the supply side, inventory of available homes is at an historic low. Just as buyers are waiting longer, homeowners are staying in their homes 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 areas in the District, annual appreciation rates have been between 6 percent and 8 percent over the past three years. It is less 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, such as Washington and its close-in suburbs, are due for an adjustment because 6 percent to 8 percent appreciation isn’t sustainable forever. In our area’s more suburban markets, the current sub-4 percent appreciation rates align 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. The inevitable market adjustment will come in the form of lower appreciation rates, not a drop in prices.
David Howell is executive vice president and chief information officer of McEnearney Associates.