Real estate cyclical downturn projected for 2017

BofA analyst projects falling house prices due to rising mortgage rates.

I_want_to_believeHouse prices rose rapidly from early 2012 through mid 2013, and although the rate of increase has slowed, prices are still rising rapidly by historic standards. But does that mean prices will keep rising rapidly forever?

Most investors assume prices will continue to rise rapidly. It’s the same phenomenon that caused people to buy at the peak of the housing bubble or a the peak of the first bear rally in 2010, a phenomenon known as recency bias: People project short-term price movements to infinity.

The tax credit stimulus of 2009-2010 made house prices rise quickly, which in turn prompted many potential buyers to accelerate their plans to purchase homes to take advantage of the tax credits and appreciation. When this stimulus was removed from the market, housing demand collapsed, prices rolled over, and we had 18 consecutive months of falling prices. This surprised many buyers who believed housing was going to appreciate at double-digit rates again forever.

In 2011 and 2012 in response to the lack of demand, the federal reserve launched Operation Twist to drive down long-term rates with hopes of lowering mortgage rates further to stimulate housing demand. As a result of this temporary manipulation of mortgage rates, housing demand did increase, and when combined with lender can-kicking from loan modifications, the housing market bottomed, and house prices rose rapidly once again, prompting more foolish optimism.

bears_were_rightA few analysts mentioned the manipulation of the housing market was unstable, and most notably, Mark Hanson pointed out that the removal of the interest rate stimulus was likely to result in a collapse of demand similar to the expiration of the tax credits in 2010.

In the post The case against another catastrophic housing market crash from April of 2012, I made the following observations:

Three factors will weigh on the market going forward. First, the overhang of supply is enormous. Lenders will be disposing of distressed inventory for another decade. Their sales will dominate the market for at least three to five years, and these sales will linger for much longer as this crisis will have a long tail.

At the time I didn’t understand that lenders were transforming their shadow inventory into cloud inventory. The overhang is still there, but rather than liquidating these bad loans through foreclosure from 2012-2017, they reflated the housing bubble to delay their liquidations from 2015-2020 to obtain a better price (See: Mortgage and Foreclosure Crisis 2.0).boomerang_missed This overhang coupled with the likelihood of rising rates makes future home price appreciation suspect at best.

Second, demand will be weak for a decade as those who have already gone through foreclosure and those yet to go through foreclosure rebuild their credit. …

(See: Stunning proof boomerang buyers do not exist)

And third, rising interest rates as the economy improves will increase the cost of borrowing and reduce loan balances. Hopefully, borrowers will be making more money to counteract this problem, but with persistently high unemployment dogging the market, wage inflation is years into the future.

That was written more than three years ago, and we still await meaningful wage inflation. (See: Will rising wages boost house prices?)

In September of 2013 in the post realtors lament low demand, low supply, and collapsing first-time homebuyer market, I made the following observation:yellen_raise_rates

We will likely see a very brief drop in mortgage interest rates due to the fed no-taper, but in my opinion, it won’t take long before the market starts worrying about when the taper will finally happen, and mortgage rates will resume their upward drift. The direction of mortgage rates will likely determine the strength of demand going forward because future housing markets will be very interest rate sensitive.

Interest rates actually fell since mid 2013, but that merely delayed the inevitable market worries about what will happen when rates do rise. As talk of an imminent rise in rates intensifies, investor worries about what will happen intensifies as well.

Supply will continue to come onto the market, but this will be can’t-sell cloud inventory rather than must-sell shadow inventory, so there will be more selection of houses nobody can afford. I believe that’s a recipe for low sales volumes and gently rising prices.

We have experienced gently rising prices and endured low sales volumes since mid 2013 despite mortgage rates falling from 4.5% to near 4% today. While these rates make high prices financeable, these prices aren’t necessarily sustainable.

I recently argued that the Price-to-rent ratio suggests housing is 30% overvalued and may be due for a correction.


Back in 2013 I wrote the Housing market impact of 25 years of falling mortgage interest rates. In that post I noted, “House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.” The chart above is confirmation of my calculations.home_price_appreciation_fairy

What are the paths forward to correct this price-to-income imbalance caused by super low mortgage rates?

1. House prices can come down to match underlying fundamentals.

2. Fundamentals can catch up to current house prices.

3. Magic appreciation fairy can make house prices go up faster than wages in the face of rising interest rates forever confirming everyone’s recency bias.

While I think rapid ongoing appreciation is nearly impossible and that flat pricing is most likely, an analyst for Bank of America suggests that perhaps home prices might come down to match fundamentals, particularly in the face of rising mortgage rates.

Bank of America: U.S. Home Prices Set for a Fall in 2017

by Jody Shenn, June 1, 2015 — 11:33 AM PD

Americans will face falling home prices in a matter of years as personal income gains fail to keep pace with the recovery from the financial crisis, according to a Bank of America Corp. analyst.

Chris Flanagan predicted in a report Monday that starting in 2017 the U.S. housing market will experience three straight years of “modest” declines in property values.

The petering out of a reflation rally is not without precedent. In Great Britain, they inflated a massive housing bubble in the 1970s, then they stimulated a reflation rally, probably to bail out their banking system like we did. That rally failed to reach the previous peak, and prices drifted back down to fundamental values. It took 15 years to get back to peak pricing (See chart below).


Of special interest is the period from 1980 to 1982 when house prices drifted lower when their reflation rally fizzled. As you may recall, the early 1980s were a period of high and rising interest rates, not just in the US but in Great Britain as well. Their reflation rally died because higher mortgage rates reduced borrowing power, the same effect predicted here in the US.

Flanagan’s projection offers a substantial divergence from most forecasts, as he acknowledges. The majority of market observers expect to see continued home price appreciation, though at a slower pace than the surges of recent years.

lemmingsI give this analyst kudos for having the courage to stand out from the crowd and point out what the herd doesn’t want to see. The rest of the herd succumbs to their optimism bias and prefers the safety of failing with everyone else rather than risking ridicule for believing and expounding their personal analysis.

Housing prices have jumped 25 percent from their trough in 2011, which followed their worst slump since the Great Depression. They now sit just 7.6 percent below their 2007 peak, according to S&P/Case-Shiller index data.

Providing fuel to Flanagan’s call is the size of the recent gains in housing prices amid a job market in which unemployment has declined but worker pay has barely improved.

“We do not see income growing fast enough to keep up with the past few years of rapid increases in home prices,” he wrote.

Lowing mortgage rates from 6.5% to 3.5% can do wonders to make up for weak wage growth.misfortune_teller

Flanagan, who in 2007 offered prescient warnings over the “very bleak” conditions in the subprime mortgage market, said that the downward path of prices would depress housing activity, the economy, and interest rates.

In other words, he was a Cassandra back in 2007 and he is a Cassandra again today. The last time he bucked conventional wisdom, he was proven correct. What will happen this time?

His forecast calls for home values to rise 3.7 percent this year and 0.8 percent next year, before declining 1.7 percent in 2017, 2.1 percent in 2018 and 0.8 percent in 2019.

Among the firms that are more bullish on the sector is JPMorgan Chase & Co., where Flanagan worked before joining BofA in 2010. JPMorgan analysts led by John Sim expect home prices to rise by 3.4 percent this year, 2.6 percent next year, 2.4 percent in 2017 and 2.3 percent in 2018, they wrote in a report last week.

One of our astute observers, Mellow Ruse, has this to day about the analysis:blinded_economists

This is a surprisingly realistic outlook from a mainstream economist. The only thing I would take issue with is his percentage declines look to be a bit conservative. I would at least double his numbers if I was going to rely on this prediction in deciding my next course of action.

His cumulative decline is 4.5% over 3 years. I think if we actually experience another nationwide decline in price it will be at least 2-3x that amount because once prices start to decline, the psychology will change and it will build momentum, as people once again become fearful. The price decline will take on a life of its own.

I think a cumulative 9-14% decline would be more realistic as people have flashbacks to 2008 and react accordingly. Buyers will sit the market out for awhile and sellers will become a little more desperate. The Fed would step in to stop the carnage if things got too far out of control, so I wouldn’t expect the percentages to go much higher.

I am less bearish than Mellow Ruse!

I believe this analyst’s predictions are a reasonably good estimate of what may happen when mortgage rates go up. This will also be accompanied by a major decline in sales volumes.

The reason I don’t believe the declines will be as significant as Mellow Ruse suggests is because lenders will still kick the can, and the decline will have little or no must-sell inventory. When house prices are controlled by discretionary sellers, prices are very sticky on the way down because most people aren’t willing to sell for less than recent comps if they don’t have to.

Perhaps this is all wrong.

Perhaps house prices will still go up.

Perhaps house prices will still appreciate rapidly.

I have a difficult time imagining a scenario where house prices rise rapidly in the face of rising mortgage rates. For each 1% mortgage rates go up, incomes must rise 12% to make up the loss in buying power. I don’t see incomes rising rapidly enough to make up the difference. Mortgage rates will rise, and incomes will rise, but rising house prices seems like a long hard slog.


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