A decline in housing affordability may be considered a leading indicator of potential stress in the market that could lead to a market correction. Simply put, as housing affordability diminishes, households begin to experience greater stress in covering their housing costs. In such a scenario, the demand for housing declines, inventory levels increase, and home prices trend downward.
From this perspective, relative affordability would act as a gauge on the extent of a housing bubble. With home affordability already at a multi-year low, the following factors will further support the thesis that the U.S. is in the midst of a housing bubble in 2017:
- Supply glut in high-end housing, as well as in high-end multifamily housing.
- 85% of 189,000 multifamily rental units completed in 2016 were in the luxury category.
- 378,000 new apartment units are expected to come online in 2017 across the U.S., and “banks are retreating from making apartment loans in traditionally strong markets.”
- Foreign all-cash buyers have elevated high-end home prices beyond local economies' price ranges.
- Spread between premium and trade-up homes constrained medium-tier housing supply.
- Shifting labor trends likely dampen demand and exert downward pricing pressure.
MECHANICS OF A HOUSING BUBBLE
By establishing a definition on “housing bubble,” recent data of cooling demand in high-end housing following years of brisk price growth would qualify as a concern. At the same time, home price appreciation turned middle-income neighborhoods into premium destinations to squeeze potential buyers into an ever-shrinking area of periphery with dwindling low-cost home inventory.
This distortion can be seen in the following chart—premium homes initially led the price growth as foreign all-cash buyers dominated premium home purchase, and home builders reacted predictably by concentrating activities within top-tier markets. Atlanta Fed highlighted the following:
Since the recession, new home construction activity has been more selective, with many homebuilders shifting away from entry-level price points in favor of move-up price points while concentrating activity primarily within top-tier submarkets. As a result, today only 28 percent of all newly built homes are priced below $250,000 according to data provided by Metrostudy, a national new home data provider. This level is down from 43 percent before the crisis.
As top-tier markets’ prices move beyond the price ranges of ordinary buyers (including affluent middle-class workers), the sector becomes reliant on foreign demand, which is now being negatively impacted by PBOC policy changes.
At the same time, competition amongst low- and medium-income buyers continue to fuel the rise in starter and trade-up homes (including buyers who were priced out of the premium market), which also pushed up prices to decrease affordability and exacerbate limited supply. A March 2016 blog post on Trulia highlighted factors that resulted in the supply crunch:
- Institutional and buy-to-let investors bought many foreclosed homes during the recession and turned them into rentals (removal of housing supply).
- Larger share of lower-priced homes are still underwater compared to premium homes.
- As premium home prices outpaced trade-up homes, their owners would be less likely to sell their existing homes to fund a premium upgrade.
The last point was especially noteworthy:
In fact, there is a strong correlation between growth in the premium home price gap and a drop in the inventory of trade-up homes. In other words, housing segments are intertwined. The more premium prices rise, the less likely existing trade-up homeowners will put their home on the market.
The end result is the worsening of home affordability in recent years. Housing prices exhibit vulnerability to potential shocks at their current level.
CHANGING LABOR MARKET DYNAMICS
The U.S. labor market is steadily changing, and “mediocre growth in high-paying jobs” was blamed for a decline in high-end multifamily housing demand in some sectors:
- Working professionals living near urban hubs contributed to the demand for high-end multifamily housing developments (although St. Louis Fed researchers warned that “there is a risk that investors’ expectations for future demand are unrealistically high” amid overbuilding).
- As corporations continue to focus on outsourcing and on-shoring low-cost consultants, existing workers’ would face greater hardship to save for a new home or afford to live in prime rental locations (low-cost housing are in hot demand for this reason).
- Job polarization had contributed to the on-going political changes in the U.S. and abroad, and “retooling” will take time and create a temporary negative demand shock.
In essence, the buildup in high-end housing and supply constraint in the low-end sector are two sides of the same coin. Growing income inequality is forcing workers to fight over the limited supply of low-cost housing, and expected demand for premium dwelling was briefly met by foreign buyers and renters (which is now under pressure). Given current valuation and the lack of affordability, it will be difficult for domestic buyers to “step up” to fill the void left vacant by foreign demand, thus illustrating the risks of a housing bubble.