Housing will no longer cycle like it has over the last 40 years
Dodd-Franks limitations on affordability products ensure housing cycles won’t see raucous rallies and devastating declines.
A time to build up, a time to break down
A time to dance, a time to mourn
A time to cast away stones, a time to gather stones together
The Byrds (and Ecclesiastes 3)
Prior to the 1970s, there was no housing cycle. There were periods where housing did well and periods when housing did poorly, but this was generally in response to larger economic cycles. Starting in the 1970s many jurisdictions began restricting housing type and location, leading to shortages and the first major cycles of boom and bust that weren’t correlated to broader economic events.
Once housing supply was limited by regulation, these shortages would occasionally cause brief price rallies where home values departed from buyers’ incomes. This sparked enthusiasm among ordinary citizens, and they responded by buying more real estate, causing prices to rise even faster. Thus the housing cycle became synonymous with the stages of a financial bubble.
Commercial real estate and even multi-family residential exhibit cyclic behavior mostly due to the delay between when the market provides a signal to developers and when they can actually deliver product. Builders and developers build too late, and they continue beyond the point when the market reaches its capacity to absorb new product. This is a systemic problem due to the long lag times for product delivery and the extreme difficulty of stopping a large project once it starts.
Residential homebuilders generally don’t face these issues because it’s far easier to start and stop housing production. That doesn’t stop homebuilders from foolishly acquiring too much land in anticipation of future gains, but it demonstrates that the housing cycle in residential homes is more a psychological problem than a systemic one.
Response to affordability is the key
In the past, whenever affordability became a problem, lenders “innovated” with toxic loan products that allowed people to buy homes. This natural reaction to a common business problem seemed harmless at the time, but it began the cycle of boom and bust based on financing that typified the first three housing bubbles in California.
It took three cycles and 40 years, but legislators finally grasped the problem. They passed Dodd-Frank, which contains the restrictions of qualified mortgage rules and the ability-to-repay rules. These two rules effectively ban the toxic mortgage products used in the past to make unaffordable house prices temporarily affordable.
So what happens when prices get too high and toxic mortgage products are unavailable? Home sales volumes decline, and prices stop going up until wages catch up. While some may still consider that a “cycle,” it looks more like a temporary adjustment. We left behind the era of exciting price rallies and epic crashes. Good riddance.
Rick Palacios Jr, September 22, 2016
Where are we in the housing cycle? This, by far, is the question we get asked the most. … To better answer the cycle question, we examined all of these influences across the 20 largest new home volume markets. I break down our findings below.
Phase 1: Cycle Bottom / Early Recovery
Declining to flattish home price and sales trends remain the norm, and investors can still find distressed opportunities. …
Phase 2: Expansion
Capital investment picks up in the Expansion phase, accompanied by rising home values and sales trends. Affordability is good, and construction activity has reached healthy levels. …
Phase 3: Exuberance
Capital has flowed freely for several years now in these markets. Prices and sales volumes have surged, and smart money is now investing more cautiously. … Already we are beginning to see signs that look eerily familiar to prior boom/bust cycles. …
Phase 4: Contraction / Early Downturn
… Construction activity has pulled back, particularly in apartments. Higher price point homes have felt the brunt of the downturn, while lower price points have held up remarkably well. …
Phase 5: Full Downturn / Recession
Capital losses are the norm and are typically unavoidable at this point in the cycle.
One of the reasons housing markets didn’t cycle prior to the 1970s is because homebuilders simply stopped building when affordability became a problem. They waited until the economy picked up and buyers could afford to buy homes again, which seems the proper response.
It wasn’t until lenders “innovated” that the low points in the economic cycle didn’t cause a low point in home construction. Affordability products helped lessen the pain for homebuilders during economic cycles, but these products spawned their own monster that ate builders alive in what became the housing cycle. Affordability products made the booms more euphoric and the bust more devastating, which is why legislators banned them.
The housing cycle may not be truly gone, but it will no longer resemble the manias of the last 40 years. The ebbs and flows of housing will go back to mirroring the economic cycle, and while sales volumes will vary quite a bit, house prices will be much steadier, and that is good for everyone, including homebuilders.