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3 Reasons The 'Bubble-Like' Surge In Home Prices Won't Last

This article is more than 10 years old.

(Image credit: Getty Images via @daylife)

The "bubble" word has reentered the real estate conversation and with it, much worried comparison between current market conditions and those of the mid-2000s housing bubble.

It's easy to see why the word has been resuscitated: thanks to low inventory levels coupled with burgeoning buyer demand, many markets are indeed becoming frothy. Bidding wars have erupted in the most desirable neighborhoods and some buyers have started adopting pre-2007 tricks to win those face-offs including worrisome non-contingent offers at full asking price or higher.

In turn home price indexes have jumped. The S&P/Case-Shiller Home Price Indexes reported that nationally home prices grew 11% in March from a year earlier -- the highest rate of appreciation since 2006. Among the hottest markets were Las Vegas, Phoenix, and San Francisco, all of which posted about 20% annual price growth. It followed 9% year-over-year growth the month before and is expected to show similar gains in this week's April report.

Earlier this month, another report posted similar findings. Nationally, the median sales price of previously owned homes shot up more than 15% in May from a year earlier, according to the National Association of Realtors, in the strongest yearly price gain seen since October 2005. It marked the sixth straight month of double-digit price increases and the 15th consecutive month of year-over-year price increases. And the last time the existing home sale price climbed that steadfastly was from March 2005 through May 2006.

Economists warn that the dramatic price surges of the past several months aren't sustainable. NAR chief economist Lawrence Yun, for example, warns that price growth is "too fast."

If home prices were to continue growing by such leaps and bounds, the possibility of a bubble would truly need to be taken seriously. But use of the B word is still painfully premature, especially as some states like New York and New Jersey continue to wade through a mound of foreclosures.

Real estate is cyclical, the new cycle commencing about two years ago according to economists. And prices are still rising off of extremely depressed bottoms. Large housing-related gains are not uncommon or unexpected-- be it the triple-digit runs of homebuilder stocks on the NYSE or the huge percentage jumps logged in new construction.

But before we start worrying about unsustainable home prices and the future bubble they could inflate, let's take a look at several factors emerging now that will likely make that worrisome run-up in home prices slow down in coming months.

1. Inventory Levels Won't Stay Tight

Nationally, inventory levels have been incredibly tight since last year -- even leading to nascent housing shortages in some markets. Thanks to both a dearth of new home building during the downturn and the fact that 9.7 million homeowners still owe more on their underwater mortgages than their homes are worth, the supply of available homes is down by 10% since last year.

But inventory is slowly starting to ease. As prices increase more owners become right-sided on their mortgages, a financial factor that enables them to more easily list and sell their homes. Confidence among prospective sellers is rising, with 40% of Americans believing now is a good time to sell, according to a Fannie Mae survey, up from 30% a month ago and 16% a year ago.

It's all beginning to manifest in the marketplace. Listing inventory has grown 25% since the start of the year, according to a recent report  from Realtor.com, an uptick that outpaces seasonal increases historically associated with the Spring/Summer selling season. In May inventory levels grew by nearly 6%  from April, to about 1.85 million homes for sale.

Other real estate companies have found similar results. Zillow , for example, recently reported that the number of listings on its national platform on June 2, 2013 were down 12% from the same day a year earlier. Yet, despite that decline, the total represented an increase from the 17.5% decline logged in six months ago, in January.

Another factor beginning to positively affect supply: new construction. Home builders are starting to roll out projects again. In May housing starts rose nearly 29% from a year earlier to an annual rate of 914,000 units, according to the Commerce Department, and building permits climbed 21% to an annualized rate of 974,000. Apartment housing has led the residential construction rebound thus far but new single-family homes are beginning to materialize as well: builders broke ground on homes at an annualized pace of 599,000, representing a 16% increase over last year. While that's still markedly lower than the 1.3 million homes per year considered a healthy pace, it's 50% higher than it was at the worst of the downturn.

"Inventory will likely remain below year-ago levels for a while yet, as builders ramp up capacity and sellers wait to squeeze every drop of equity from their home before listing. But a corner has been turned," Stan Humphries, chief economist of Zillow, recently asserted. "Going forward, as this new supply makes its way to market, we expect the pace of home value appreciation to slow down from unsustainably high annual levels of 5% or above to more moderate levels closer to historic norms of 3% or 4%."

2. The Mix Of Homes Is Changing

It's important to remember that a median sales price represents the middle price point of all homes selling in any given market. The larger the geographic sample size, the more generalized the price.

In the case of median sales price for previously owned homes, as reported by the National Association of Realtors, the national-level price hinges in part on the markets that have welcomed the most sales activity. So states like California, Arizona and Florida, where the volume of sales has surged, have an outsized effect on the national number.

Geographic size plays a large role in home price averages as well. This is the case with the S&P/Case-Shiller home price indexes, for example. It tracks metro area which includes cities and their surrounding suburbs. And since it only tracks the top 20 metro areas, the national-level number misses whole swaths of the nation's housing data.

It's also necessary to break down the types of homes selling. Many of the most active markets have been fueled, at least in part, by a substantial investor base. In the downturn, markets like Phoenix. and  Las Vegas led the country in terms of foreclosure activity and consequent home price hemorrhages, ultimately over-correcting to values lower than the local economies could sustain --  lower even than the cost of replacement. As foreclosures contributed to a burgeoning renter base, investors began snapping up distressed homes, converting them to single-family rentals. Institutional investors armed with Wall Street capital began pouring billions into the hardest hit markets which in turn has helped drive up prices among the lowest-priced tiers of homes.

This flood of capital has helped discounts to shrink between distressed and nondistressed homes, narrowing the spread between the two inventory classes and pushing the base price point of the market up. That in turn has raised the median on home prices overall, creating double-digit rates of appreciation that are not necessarily indicative of the entire market's growth. It's one of the biggest factors contributing to the 20%-plus yearly increases reported in places like Phoenix, Las Vegas, and Atlanta -- and a major reason that, despite those robust numbers, Fitch Ratings says these metros are either correcting  (as is the case in Phoenix) or still undervalued (as is the case in Las Vegas and Atlanta) relative to local income levels.

Both that dwindling supply and the subsequent rise in prices have led to a decrease in distressed sales. The Realtors association says these sales comprised just 18% of the overall sales of existing homes in May, the lowest level since it started tracking them in 2008.

Simultaneously, as distressed activity ebbs, luxury sales have surged, also pushing median prices higher. "Part of the steep rise in the median home price can be attributed to a change in the mix of homes that are selling. Sales of homes priced below $100,000 were down 9% from a year ago, while sales of homes priced at more than $500,000 were up 33%," Lawrence Yun, chief economist of the National Association of Realtors, recently told CNBC.

3. Mortgage Rates Are Rising

Thanks to speculation that the Federal Reserve will begin tapering its $85 billion-per-month bond-buying program as soon as September, mortgage rates have spiked in recent weeks. On Wednesday, after the central bank's chairman Ben Bernanke reaffirmed plans to wind down that stimulus program by the middle of 2014 dependent on economic growth, the 30-year fixed mortgage rate inched up further to 4.25%.

Economists expect those rates to continue growing, albeit at a slightly slower, uneven pace throughout the year. The National Association of Realtors projects the 30-year fixed mortgage will continue to rise but modestly, hitting 5% in 2014. While that's still low by historic standards, it's markedly higher than the 3.5% rate logged in early May. It means the cost of borrowing is  beginning to get more expensive. Compared to early May, that 4.25% rate translates into roughly $40 more per month for every $100,000 borrowed. As the dollar amount of interest increases, home buyers qualify for less in terms of the principal amount.

While those rising rates will do little to actually derail housing's recovery, they will put downward pressure on the dramatic run-up in home prices. Goldman Sachs expects to see a "slowdown in price growth" as those rates continue to rise. In a recently released report, the investment bank found that a 100 basis point increase -- meaning rates rise by 1% -- would reduce the equilibrium house price level, or the sustainable price level economic fundamentals can support. It also forecasts that home prices will likely appreciate 4-5% over the coming years --  lower than the 10%-plus annual price increases seen recently.

Some markets may even see a slight decrease in home prices, though just how likely this scenario is depends greatly on how fast rates rise relative to income levels. Fitch Ratings worries that some hotspot markets like Washington, D.C. and California's Los Angeles, San Diego and San Jose could be overvalued could be vulnerable to further price corrections since these areas didn't correct to levels that, adjusted for inflation, were in line historically relative to their local economies.

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