Is that a bubble we spy in the sky? Or is it just home prices, floating up into the stratosphere on the now-depleted gust of low interest rates?

A housing bubble happens when home prices rise faster than can be supported by housing market fundamentals for a sustained period of time. During a bubble environment, the expectation that home prices will continue to rise to ever-greater heights is irrational. In fact, it’s often irrational expectations and behavior that cause asset prices to rise into bubble territory in the first place.

How does a bubble end?

Due to the rapid pace of price increase during a bubble, asset prices tend to contract quickly, as in a pop.

The last time the housing market popped was the infamous crash following the Millennium Boom. During the early 2000s, deregulation of the mortgage market allowed homebuyers to qualify despite lacking the support of savings or even incomes. Lenders also pushed risky mortgage products which injected further instability into the market.

When asset prices crashed in 2006-2009, homebuyers were trapped, unable to refinance or sell. They were forced to accept default and foreclosure, generating a downward spiral for home prices which bottomed first in 2009, followed by a dead cat bounce and a second bottom in 2012.

Economists can never be certain they are in a bubble until after the pop — but there are some tell-tale signs to watch for.

60% of housing experts polled by Zillow believe the housing market is not in a bubble as of the second quarter (Q2) of 2022. Their reasoning included:

  • price growth is supported by fundamentals like low inventory and demographic shifts;
  • the low risk of default due to high credit standards has created a stable housing market; and
  • the likelihood of a crash is low.

On the other hand, 32% of respondents do think the housing market is in a bubble, supported by historic home price increases and the lack of ongoing support from low interest rates, according to Zillow.

Even so, most respondents believe the next economic recession will hit soon — likely in 2023 — they just don’t think the coming downturn will have a significant impact on the housing market.

firsttuesday has some thoughts.

Recession talk

The next recession is already here, though as yet, undeclared. Essentially characterized by two quarters of declining gross domestic product (GDP), the economy already fits this definition following the recently released second consecutive negative GDP report, according to the Bureau of Economic Analysis (BEA).

However, as we see it, 2022’s undeclared recession is not a brand new economic event. Rather, it’s an extension of the recession which began in early 2020, briefly interrupted by government intervention.

The government blocked the 2020 recession in response to the global pandemic, which coincided with a recession that was already long in the works. In an effort to keep people in their homes during the pandemic, and to keep the economy from completely failing, the government pumped stimulus money into businesses — and individual’s wallets — while the Federal Reserve (the Fed) dropped their benchmark interest rate to zero.

Then, rapid inflation took the economy from embers to a full-on wildfire, which the Fed is still struggling to put out.

In an intense effort to combat the highest inflation experienced in the U.S. since the 1980s, the Fed began bumping up interest rates in March 2022. It most recently increased their benchmark rate by 0.75 percentage points in July 2022, marking an increase from essentially zero at the beginning of 2022 to 2.5% in July 2022. The impact on buyer purchasing power has been swift and devastating — and the Fed has assured us they are planning even more rate increases for 2022.

Related article:

Behind the curtain of the Fed’s latest rate hike

Higher interest rates not only decrease borrowing by business and consumers, they also take the winds out of asset price increases — particularly in real estate.

In response to a firsttuesday poll conducted at the end of 2021, just over half of readers believed California’s housing market was in a bubble, and that they expect it to pop in the latter half of 2022. A scant 22% of readers believed there was no housing bubble.

We just checked our calendars, and based on this forecast, the bubble is primed to pop at any moment.

However, the latest reports show California home prices continue to rise (albeit, more slowly in recent months). How long will the increase last in today’s environment of high inflation and rising interest rates?

Prices will fall in 2022

Home prices today have become far removed from the mean price trendline, the historical equilibrium to which home prices cyclically return. This means fewer homebuyers are able to qualify due to prices rising significantly faster than incomes. Here in California, home prices are more significantly removed from the mean price trendline than the national average — meaning they have further to fall.

The Fed fueled record-low mortgage interest rates during the pandemic, which temporarily relieved this homebuyer purchasing power crunch. However, now that interest rates have fully risen from their historic lows, the support for home prices has disappeared. Without fuel from low interest rates and absent the support of a full jobs recovery, home values are now only being inflated with hot air.

firsttuesday expects home prices to fall in the second half of 2022, not to find a bottom until 2025, when prices will reach the mean price trendline. This timeline may be complicated by global events and any further (unlikely) government stimulus which may occur during the recession. Still, the downward pull represented by the mean price trendline means all price tiers need to drop — it’s simply a matter of when.

In the meantime, agents with an eye to career survival will prepare their financial strategies to endure the coming downturn today.

Related article:

Stay ahead of the next recession