Since the pandemic began in the spring of 2020, we’ve witnessed an unparalleled explosion of price growth in all forms of housing. Until the peak in June 2022, single family home prices rose 45%. But prospective home owners weren’t the only ones biting their nails. Rents also rose over 15%, peaking in late 2022.
The culprit behind this price shock is fundamental: low supply and high demand. Today we examine the origins of these conditions and whether or not it’s a good time to buy.
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The Economics of the Modern Housing Market
The scene begins in the run-up to the 2008 financial collapse.
In the early to mid 2000s, home builders rode the dark wave of a rapidly expanding housing bubble. This bubble was fueled largely by the practice of subprime mortgage lending. Would-be owners were granted loans at or beyond the margins of affordability. Many of these loans carried adjustable-rate interest structures.
Easy access to historically low-interest credit spiked demand in home ownership, a surge in real estate investment, and most importantly, pervasive speculation. By the end of 2007, the ratio of household debt to disposable personal income rose to 127%, up from 77% in 1990.
A vast array of construction projects were initiated to feed the frenzied and debt-fueled demand. In Phoenix and Las Vegas, tracts of homes were built further and further into the parched desert. In Miami, palm-lined luxury towers rose from the muggy swamps seemingly overnight. If they built them, so they thought, they would come.
Delinquencies Rise, Construction Continues
But they stopped coming. By the summer of 2005, mortgage rates began to climb, automatically resetting the required monthly payments of adjustable-rate loans. In turn, mortgage delinquencies soared for those unable to pay the higher rates. Demand began to soften, slowly at first, while supply continued to steadfastly increase.
A year later, in the summer of 2006, prices for homes peaked, beginning a swift and precipitous decline. US housing prices fell nearly 30% on average. Prices bottomed out over five years later, in late 2011 and early 2012. At the height of the crisis, 30% of homeowners were underwater on their mortgage, meaning the value of the loan was greater than the free market value of the property.
The bursting of the housing bubble decimated the US home construction industry. New home construction starts declined by 78% from January 2006 to January 2009. As a result, the pronounced reactionary slow-down in home construction set the stage for a new supply and demand mismatch.
Demand Up, Supply Down
Millennials, the largest generation group, entered the age of home ownership in the 2010s. As they did, supply no longer kept pace with a growing demand. Home builders, hesitant like scolded puppies, weren’t building new homes at sufficient volumes. Existing home owners were staying put, hoping to regain their dwindled equity. In a supply-restricted market, prices climbed at an above-average rate for much of the 2010s.
Following the initial lockdowns in the spring of 2020, stock values soared and mortgage rates fell to historic lows. A flood of Americans retired or otherwise cashed out from expensive coastal cities and other metro areas; their eyes set on affordable sunbelt cities. Remote workers, able to theoretically work from anywhere, fled to the suburbs or smaller towns. This migration of humanity cashed out on far more expensive homes elsewhere and resettle for a relative bargain in smaller towns. Finally, investors began purchasing high volumes of properties in a supply-constrained market, driving prices higher still.
The Housing Affordability Index, produced by the National Association of Realtors, shows how housing affordability cratered from affordable to drastically unaffordable throughout 2022. Household debt service payments as a percent of disposable personal income rose swiftly and steadily in early 2022 as buyers purchased increasingly expensive homes.
Rate Hikes and Cooling Demand: Prices Begin to Fall
With inflation ravaging global markets of all kinds, the US Federal Reserve stepped in with aggressive interest rate hikes in early 2022. The combination of high prices and rapidly increasing high-interest loans created a cold-water bath for red-hot housing demand. With new mortgage payments doubling nearly overnight, prices for homes peaked in the spring of 2022 and have been on decline ever since.
As of October 2022, Black Knight found that 8% of 2022 mortgages were already underwater. By now, that number has surely grown.
Once again, low-interest credit fueled a frenzied demand. The demand was only curbed by the guard rails of severely restricted supply and federal monetary intervention.
Is Home Ownership Really a Good Idea?
Traditionally, financial independence enthusiasts have eschewed home ownership. Many insist that a primary residence is an inefficient investment at best, often weighted with considerable opportunity cost to building greater wealth. The institution of home ownership, right up there with child-bearing and marriage, is considered by some a flawed pursuit. Critics argue that the desire to own a home is driven more by emotion than the sound logic of a good investment. Much of the negative sentiment around home ownership is surely rooted in the speculative behavior of the mid-2000s housing collapse.
As prices climbed skyward for much of 2021 and 2022, prospective homeowners indeed seemed to exhibit a range of irrational behaviors in pursuit of an accepted offer. Stories began to surface in droves of sight-unseen offers, offers hundreds of thousands of dollars over the asking price, foregone inspections, and even a (failed) pledge to name a first-born child after the seller. These stories lent credence to the emotional narrative around home ownership.
Was Demand Irrational?
Were these actions rooted in the belief that home ownership is an essential part of the American ideal of success? Likely, some were. Prices soared, well over 30% year-over-year in many locations, but demand never faltered. Americans fought tooth-and-nail to secure homes, making drastic concessions and risking personal financial security. But to claim that price increases were driven purely on dark animal instincts of speculation or an ideal notion of class status would be misleading.
Rents were also rising. Dramatically so. With would-be buyers priced out of the market, demand spiked for rental properties, a trickle-down effect of restricted housing supply. With high demand and low supply, vacancy rates fell to a level not seen since 1984, providing landlords the power to raise rates for a restricted number of units. Real Estate Witch reports that, as of May 2022, rent increases outpaced income increases by 325% since 1985.
So, for many, home ownership, at least in terms of monthly payments, seemed to make more sense. Not only were monthly payments potentially cheaper than comparable rent, but home ownership offered the heralded promise of equity, stability, and by extension—wealth.
Home Ownership Worked for Us. But We Were Lucky.
When my wife and I decided to pursue home ownership for the first time in early 2013, we were dealt a hand of good fortune. In the aftermath of the 2008 financial crisis, home prices across America were undervalued and mortgage rates were at all-time lows. While we missed the low of the low in terms of housing prices, which occurred at a national level in late 2011 to early 2012, we couldn’t, with an ounce of hindsight, complain about our timing.
At the time, however, we feared a double-dip crash in housing prices. In Denver, Colorado, where we purchased our first home, prices were already starting to rise at a rapid clip. Multiple offers were being made on homes in the city’s desirable neighborhoods. The elements of hype and bubble behavior observed less than ten years prior seemed to be returning, so soon after the wealth of millions of Americans had been decimated in the housing collapse. We entered into an escalating price war with another bidder, a bloodless battle that ended in our favor. When the dust settled, we agreed to pay about 7% over the original asking price. In 2013.
It felt scary, but we wanted it bad.
Good Timing, Good Place, Changing Demographics
In terms of places and timing, Denver was a great place and 2013 was a great time to buy. The labor market was strong and fast-growing. A range of young, educated, and zealous people were moving into the region, enhancing economic prosperity. My wife and I were part of this influx of young and educated people; we arrived in 2012 with graduate degrees and oil industry salaries.
In hindsight, home ownership was designed to work for people like us. We were the fortunate ones with good incomes, living in popular and growing cities, with more than a pinch of good timing. Buying a first home in 2023 looks much different than in 2013.
Again, with hindsight, it all makes sense.
So, Is Now a Good Time to Buy?
With a few assumptions, the cost to buy our first Denver home today has more than tripled from 2013. But the value proposition probably hasn’t. If someone were to buy that property today, only ten years later, would they live a life three times better than the one we lived? Would they curse the aging home three times less, or feel thirty-three percent warmer on a cold winter day?
Now is not a great time to buy, especially for first-time home buyers. In most cities, renting, at least on a monthly scale, is undeniably more affordable.
The Metrics of Housing Affordability
The old adage states that all combined housing expenditures should not sum to more than about 30% of income. For example, to carry a mortgage, insurance, property taxes, and maintenance costs that sum to $3,000 per month, a homeowner must clear more than $10,000 in pre-tax monthly income. First-time home buyers need sizable incomes and a strong financial cushion to handle not only the higher down-payments and mortgage payments, but increasingly costly maintenance and repair costs in an inflationary environment.
The cost of a mortgage is only the beginning. Many first-time home owners fail to consider the costs of maintenance, which have increased substantially in this inflationary environment. The “1% rule” states that home owners should budget roughly 1% of the value of the property per year in maintenance and repair costs. So, for a home worth $500,000, one should expect and budget for further costs of $5,000 per year, on average. Unexpected one-time costs, such as replacing a roof, can cost in excess of $10,000.
It’s no surprise then that demand, especially for first-time home buyers, has cratered.
Who Can Still Afford Home Ownership?
The market still favors those who can carry large equity holdings from previous properties, assuming those properties can be sold. Those who sell existing properties have the power to make all-cash offers, or may only require small loans for new properties.
Even without large home equity positions from previous properties, buying can still be the more affordable long-term option. This assumes, however, that potential buyers can cough up ever-higher costs of home ownership: high down-payments, higher monthly mortgage payments, and costlier maintenance expenses. This prediction also assumes, importantly, that further price declines will be minimal, with a return to modest growth in home values.
To know if buying is right for you, I enjoy playing with simple rent-or-buy calculators, like this one. The breakeven point is highly dependent on a number of independent factors, including home price, down payment, mortgage rate, comparable rental rates, and potential return of invested cash. One would want to stay in a property for at least five—but in many cases ten or more—years to make buying worth the up-front additional costs.
For more guidance on home affordability and ways to hack it, don’t miss this post.
Let’s Talk More About Renting
Rent prices have fallen, precipitously in some cases. According to the Apartment List National Rent Report, nationwide rents have been on the decline since September 2022, with the largest month-over-month decline observed in November. Many would-be sellers, unable to sell or unwilling to part with their homes at the current free market value, are listing properties for rent instead. As more properties enter the market, prices fall.
The good news is that both prospective renters and buyers have much more leverage than they have since the pandemic began. Falling home prices and rents, alongside a wait-and-see approach by many, are forcing concessions among sellers and landlords alike. Even for those unwilling to move, rents might be surprisingly negotiable.
Conclusion: The US Housing Market in Transition
The prospect of home ownership is a deeply emotional decision. History has shown that those who own land and property tend to rise to the top of social and economic class hierarchy. It should come as no surprise then that the ideal of home ownership is so endearing.
The reality is that the home you live in is, at best, a relatively inefficient investment. Even in the hot real estate market of the 2010s (in a prime location), our return on investment lagged the performance of a good index fund.
But that doesn’t mean I’ve regretted home ownership. On the contrary, I’ve taken great comfort in the sense of stability. No one can raise the rent on us. This simple fact provides a wonderful sense of security and the ability to more accurately forecast future housing costs.
The spreadsheet version of life, however, only captures logic and reason.
Is Home Ownership a Worthy Form of Consumption?
Home ownership might be a form of consumption, but when it comes to value spending, I haven’t regretted a penny. But for all the fortunate reasons discussed above–timing, place, demographics–the narrative of home ownership has been positive for us. Our narrative isn’t necessarily universal.
In terms of opportunity cost, renting is, in theory, a more efficient means to build wealth. The spreadsheet version of life, however, only captures logic and reason. The emotional sense of establishing deep roots in a community, the desire to live in a good school district, or the need to house aging family members will always be drivers of the home ownership economy. It isn’t fair to consider home ownership only as some sort of non-optimized financial mistake.
The Dilemma of Renting
Those who celebrate renting as preferred means to generate wealth will always be at the whims of their landlords, and more broadly, the winds of economic change. Today’s favorable renting market may be tomorrow’s crushing burden. What’s here today is gone tomorrow. The unfortunate reality is that precious few have much of a choice. A growing number of Americans are now priced out of the home ownership market. Many are being priced out of housing altogether.
At the time of writing, renting probably makes better financial sense, at least in the short-term. For a similar property, a mortgage payment and long-term opportunity cost will almost certainly be higher than the cost of rent. That said, for those intent on staying in a property for the long-term, generally five to ten years or more, buying can still be cheaper. The breakeven point is highly dependent on a number of independent factors. These factors include home price, down payment, mortgage rate, comparable rental rates, and potential return on invested cash.
Barring fundamental shifts in the market, I will (probably) always favor home ownership. That’s not to say we wouldn’t rent for a time–we would. Rather, we prefer the intangible benefits of home ownership.
Until supply can be increased, home ownership will continue to benefit those the most who are already relatively wealthy. What intrigues me, in the long-term, is what happens to supply as the baby boomer generation continues to age. Birth rates are declining and restrictions on immigration are increasingly popular. Are we setting the stage once again for a grand mismatch of supply and demand? Time will tell.
Great thorough article! I agree home ownership isn’t always the best option for everyone, but the ability to control your own destiny and not have to deal with someone else’s is sometimes reason enough.
Personally, I wouldn’t buy if you don’t plan on living in a location for at least 10 years, or can’t put at least 30-40% down to make mortgage payments more manageable.
Thanks! I think that guidance is probably pretty solid, at least until mortgage rates and/or prices soften. Some scenarios might put a breakeven at five or seven years, but those are probably the high down-payment scenarios.
Well written Chad, especially with the history of how we arrived here. Crazy to think even in 2013 you were in a bidding war in Denver. I think it’s also many people want to live alone, versus multi-generational family living in the past. Supply hasn’t kept up, and also many people want land and large homes, rather than a townhome or condo. Space is limited and sprawl is what we get.
I don’t see how these prices can continue to be sustained unless like you say more boomers age and supply helps out.
That’s a very good point on supply: The tendency to live alone versus in a multi-generational family has changed dramatically over the last handful of decades.