SAN DIEGO, CA – “Buy low, sell high” is a well-known adage attributed to the legendary billionaire investor and philanthropist Warren Buffett. Looking at today’s super-hot residential real estate market is hard not to wonder how much longer this buying frenzy will continue. Buyers are in bidding wars to buy homes, multiple all-cash offers with no financing, no contingencies, sale prices tens or even hundreds of thousands of dollars above asking prices, double-digit annual home price appreciation, and a very low inventory of homes for sale.
According to the Case-Schiller Home Index, the average annual home appreciation in the 20 major metropolitan areas was 14.6% year-over-year as of this past May. Phoenix had the highest annual price increase of 22.3%, followed by San Diego’s 21.6%, and Seattle at 20.2%.
I vividly remember that back in 2005-2006, at the peak of that last super-hot residential real estate market, many were saying that the market would continue to thrive and prices would go up for at least another ten years. Yet, by 2007 the home prices started to deteriorate and by 2009-2010 a wave of short sales and foreclosures dominated the previously super-hot markets. The hardest hit places like Phoenix and Las Vegas had property values depreciated in some cases by over 50%.
But this time it will be different… not. If there is one thing certain about real estate (and life in general), it is that it is cyclical. Every boom is followed by a bust, and every bust by eventual recovery and then another boom, etc. In case of real estate, cycles are usually much longer than those of the general economy and they last, on average, about 15 years. In this particular case, it is important to note, that we are discussing a residential (homes) real estate market, which can be quite different from a commercial (investment properties) real estate market, although they are interconnected.
So, where are we today? The interest rates, including those on mortgages, are at ultra-low levels. For example, recently our sister mortgage company closed a 15-yr fixed rate loans as low as 1.99%. This is quite remarkable given that the inflation rate is sky-rocketing. Just this past June, the inflation jumped by 5.4% year-over-year, which was the largest increase of inflation rate since 2008. At this pace the U.S. is on the trajectory to have a double-digit inflation by 2023. Compare that to annual inflation rates of just 2.4% in 2018, and 1.8% in 2019, and 1.3% in 2020.
Money supply, government debt, and the public spending by the Federal Government are enormous. It seems that not too long ago, when the politicians were arguing about the federal budget, they were talking about millions, or at the most billions of dollars. Now if it is not a trillion, it does not seem to be a big deal.
The U.S. unemployment has been steadily improving since its peak of 16% in May, 2020. As of early June, the unemployment rate was around 5.9%. However, these figures can be misleading as they don’t include folks who are “under-employed,” e.g. went from a full-time to a part-time jobs, or those who earn less now than pre-pandemic. Additionally, they don’t count workers deemed “permanently unemployed” (unemployed for more than six months), and those who “stopped looking for work. “The “real,” or the so called U6 unemployment rate, is around 9.2%.
So, how all of this translates into the residential real estate market? The current real estate cycle is about 15-16 year old, which is worrisome, but basically, as long as the money is so cheap, buyer demand so high, and supply of available homes for sale so low, the “music is still playing.” Furthermore, we should not underestimate the “Covid-effect” on housing. One of the reasons why homes became so valuable was because of the lockdowns and the resulting work-at-home, teach-at-home, play-at-home, and eat-at-home paradigm shift. But this will change too.
If the cycles are one of the immutable laws of the universe, then it is safe to assume that this cycle must change too. But when? Nobody knows for sure, as we realize that the cycle has changed only after it already did. However, in my estimation, the catalyst for the change will be an increase of the short-term interest rates by the Federal Reserve, which sooner or later will have to happen given the rapidly escalating inflation.
Our real estate brokerage receives lots of inquiries from buyers and investors wanting to purchase properties. In our opinion, real estate buyers should proceed with extreme caution in such an over-heated real estate market. The double-digit annual price appreciation is absolutely unsustainable as the real wage increases are in the low single-digits. It is important to understand that real estate is not a very liquid asset and there are substantial costs associated with selling it.
For most residential property owners, real estate should be a long-term game and buyers should take that under consideration when considering purchasing properties. When the inevitable market correction comes, home equity can be greatly reduced or even wiped out in case of highly-leveraged homes. In such instances, property owners can find themselves “upside down” on their mortgages, meaning they will owe more than the values of their properties. Short-sales and foreclosures will become familiar terms again.
On the other hand, the lucky residential property owners who currently own highly-appreciated real estate assets, maybe in a perfect position to cash out on their equity now when the market is hot and the prices are high (remember what W. Buffett said). They can also consider alternative ways of liquidating their equity such as: cash-out refinancing loans, home equity lines of credit, and reverse mortgage products.
Residential home builders, especially those who build in the lower price ranges with projects that are already going, or about to go vertical and are scheduled deliver completed homes in the next 12 to 24 months, should be in good shape because the current buyer demand far exceeds the available supply. However, past that time frame, it is anybody’s guess. Exorbitant prices of building materials, high costs of land and labor, and onerous government fees and regulations make it hard for builders to deliver affordable houses and make a profit.
There could be another important consideration for selling sooner than later: Uncle Sam. The current administration openly talks about increasing taxes and in spite of their election promises, it is not going to be affecting only “the rich.” For example, according to their latest tax proposals, the home-owner exemption from the capital gain taxes when selling primary residences, may be greatly reduced or even entirely eliminated. Oh, by the way, the capital gain tax rate is also going up.
Another significant tax change on the horizon for those who own any investment properties, even if it is a small rental house or condominium, is a proposal to reduce or eliminate the so called “1031 Tax Exchange” under which capital gain taxes can be deferred on investment properties, including small and large rentals.
Each situation is unique, but our general advice for Clients who want to buy real estate now is that there needs to be a compelling reason for them to do so. We recommend being patient and not buying into the frenzy, which sooner or later will pass. Again, let us remember what W. Buffett says about buying low and selling high, and he certainly has a track record (and the bank account) to prove that he knows what he is talking about.
For Clients who own real estate and want to hold it for a long-term, we recommend that they review their mortgages and interest rates (if they have any loans on their properties). If beneficial, they should look into refinancing them, with or without a cash-out, to take advantage of these extremely low interest rates, which at this point are way below the inflation rate, which makes them practically a “free money.” Owners who are 60 or older, may want to look into reverse mortgage products, which can give them tax-free income from their home equity and a payment-free mortgage.
For Clients who are considering selling or have shorter term ownership plans, this might be a great opportunity to review their properties’ values and determine if selling now, while the market is super-hot and the prices are ultra-high, is a good idea.
In conclusion, nobody knows what the future has in store for us, but a couple of things are certain: real estate is cyclical and the change is inevitable. The current residential real estate market cycle is mature, prices are very high, and thus it is reasonable to expect a downward shift.
Robert W. Dudek, MSEL is the President and Broker Associate of The Blu Summit Real Estate Group at KW. He has over 30 years of experience in real estate sales, marketing and finance. Robert can be reached at 619-280-1400, firstname.lastname@example.org or www.blusummit.com .