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When prices fall

Today’s real estate professionals are well acquainted with rising prices — but that environment is now behind us. What can agents and brokers on both sides of California home sales transactions expect going into 2023?

Think back to last year’s sky-high home prices, supported by rock-bottom mortgage interest rates. For reference, California home prices rose over 20% year-over-year in all tiers in July 2021.

In 2022, with the Federal Reserve (the Fed) steadily hiking interest rates, home prices have nowhere else to go but down. Agents watching their local listings dry up are beginning to recharacterize 2021’s boom as a windfall rather than a pattern.

In tandem with the Fed’s aggressive interest rate increases, the U.S. economy experienced two consecutive quarters of gross domestic product (GDP) decline in the first half of 2022, signaling a recession — though still undeclared.

California home sales volume has already fallen back in 2022 for four consecutive months. It is highly unusual for home sales to plunge mid-year; this is typically when home sales peak. In accordance with this cycle, home sales and prices will likely remain low through the remainder of the year.

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In the second half of the Millennium Boom, circa 2005, real estate participants viewed the housing market with a profound level of irrational exuberance, believing the only way housing prices would go is up — indefinitely. Of course, history taught otherwise. [See RPI e-book Real Estate Economics, Factor 12: Pricing]

When housing prices are on an upward trend — the norm for the past decade — real estate participants on both sides of a transaction can expect to earn (and spend) more money. The seller profits more on a sale. The buyer pays more for the purchase. The lender lends more and takes greater risks. Money abundantly circulates through the economy.

But when housing prices are on a downward trend — the cycle the housing market is now entering — owners and sellers lose net worth as their real estate is worth less than it was in the peak market cycle.

Read on for a breakdown of how each real estate participant will fare as prices descend gradually and extensively through the next few years.

Buyers benefit from diminished prices

For prospective first-time homebuyers, a period of falling home prices is a welcome change.

Through the last decade, home prices have increased at a much faster pace than incomes. As a result, many first-time buyers struggle to qualify for financing.

A period of declining or flat home prices improves the home price-to-wage ratio in buyers’ favor. This is good news for younger homebuyers who have long experienced stagnant wages and typically carry significant student loan debt.

Additionally, buyers during a recession will be more likely to find:

  • sellers who are willing to lower their asking prices;
  • short sales from mortgage defaults; and
  • banks offloading foreclosed properties.

Each of these scenarios bring lower purchase prices than those experienced during the robust pandemic housing rush — a huge payoff for patient buyers.

As the market shifts its focus to buyers, agents are closing ranks with their industry contacts. Important corollary groups associated with buyers include the support services which enable buyers to perform their due diligence on the property they wish to buy. This group includes escrow companies, title companies, home inspectors, document preparation servicers, home appraisers, sales-sign companies and builders.

These support services will also be affected by the recession since many are operated by small companies, which are the most vulnerable to negative economic shocks.

Sellers struggle against diminishing prices

For owners and sellers, falling home prices hurts consumer confidence and spending in the local economy since owners see a reduction in their main wealth-building asset.

As more consumers pull back from spending, economic growth slows in tandem. This marks a shift in consumer behavior from spending to saving.

Worse, during a period of faltering home prices, some properties can become trapped in negative equity — which is when the value of the real estate falls below what the owner paid for it. Negative equity status significantly heightens the risk of foreclosure when combined with a household income shock (e.g., loss of job, divorce, loss of health, death, etc.). Altogether, these factors can push a homeowner’s regular mortgage payments beyond reach.

As of July 2022, 1.8% of California homes were delinquent on their mortgage payments, according to Black Knight. This also marks the first decline in home price growth after 31 consecutive months of growth.

Home values have hit their peak. As a result, the number of underwater homeowners is expected to level out and begin to rise, picking up speed going into 2023. [See RPI e-book Real Estate Economics, Factor 4.2: Negative equity and foreclosure]

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Lenders cut losses against price cuts

For lenders, falling home prices mean the lender will lose money when owners default on their mortgage payments. These lender losses lead to lower bank lending and lower investment initiatives.

Refinancing will become untenable for owners, and banks are preparing to lose on that too. When interest rates rise, refinancing loses its appeal among owners. By contrast, when interest rates are low, such as during the 2020 recession, refinances explode in popularity.

At the end of 2020, refinances in California made up a whopping 79% of all mortgage originations. Over twice as many refinances occurred in 2020 than in 2019. As the Fed remains steadfast in raising rates to level out inflation, expect refinances to suffer.

Many owners who default on their mortgage during the recession will choose to undergo a short sale instead of foreclosure. Others will be foreclosed upon, and their property will become real estate owned (REO) property owned by the mortgage holder, which the mortgage holder will sell at a loss.

Real estate agents will become REO specialists to accommodate this growing share of the real estate market.

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Preparing for the shift

Since the financial and housing market crash of 2007-2009, real estate pricing has remained on an upward trend. On a significant or elongated downturn in prices, all real estate market participants need to make a dramatic shift in their thinking and practices.

A contraction in the money supply circulating through the market is a much-needed correction, but an uncomfortable one for most real estate participants.

Real estate professionals who enjoyed 20% year-over-year price jumps at the outset of the pandemic will find the drop back down to the mean price trendline a complete shock. This is especially true for those who did not experience the 2008 financial crash firsthand as a licensee.

Consumers have also grown accustomed to an upward path on prices. But this dramatic upward swing was an anomaly from the start. 2019 was the last normal year for prices, and home prices will have to return to reality for the real estate market to regain stability.

Are you and your clients prepared for the drop?

Stay ahead of the yet undeclared recession by subscribing to Quilix, the firsttuesday Journal’s agent- and broker-focused real estate newsletter.

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Want to learn more about California’s upcoming economic landscape? Click the image below to download the RPI e-book cited in this article.