After an intense two-year bull market, the real estate market is showing signs of an imminent collapse. Mortgage applications dropped for the seventh straight week for the week ending April 22, and mortgage rates are up more than 200 basis points on the year.
What does that mean for prices in May and beyond? Let's go over the possibilities.
A full-blown collapse
The case for a price drop is clear: Rising interest rates reduce demand, and for the first time in years, demand falls below supply. Flippers and other short-term real estate investors see the tide breaking and try to get out of the market as quickly as possible. As they sell for less than market value, it changes the comparable prices in the appraisals for other sales, and the whole market starts to fall.
Eventually, increased interest rates also make it so investors and homeowners with adjustable-rate mortgages can no longer make their payments. They either have to sell to a market with low demand or face repossession. If the banks start to get hold of houses, they will be trying to sell as quickly as possible -- and not necessarily for the best price.
This type of perfect-storm worst-case scenario is certainly bleak. We've seen it before in housing back in 2008, and it's the same type of emotion-driven selling that we see when high-flying growth stocks collapse. The market has been propped up on easy money for a while, and the Federal Reserve just kicked the stool out.
Of course, it's probable that this type of collapse is more of a black swan-type outlier event. More likely, May will be a transitional month, either to a long-term downtrend or to a more range-bound market.
A range-bound market
While it seems certain that housing prices are overvalued, that doesn't mean they need to revert to the mean all at once. The S&P CoreLogic Case-Shiller Index, which measures changes in sale prices of single-family homes across the U.S., was up 34% from February 2020 to February 2022.
The Case-Shiller Index isn't perfect, but that sort of growth in real estate prices is unheard of over two years -- especially when part of it came during a recession.
What caused that level of growth? It started with inflation in housing materials. Lumber prices were up 400% at one point. Steel prices were up 67%. Pair that with supply chain shortages and pandemic-related work stoppages, and you get a supply shortage. Even if demand stayed consistent, prices likely would have gone up more than general inflation.
But demand didn't stay consistent. The increase in work-from-home opportunities led many Americans to move out of big cities into more rural areas. However, the exodus probably wasn't at the level you'd expect. Cities like Los Angeles (176,000), San Francisco (116,000), and Chicago (91,000) all lost residents from 2020 to 2021, but none of them lost millions of people. Regardless, any level of increased demand paired with the supply shortage was sure to increase prices.
What does that mean for May? Builders have gotten used to quick sales on spec homes. In Utah, where I live, it wasn't unusual as recently as a few months ago for new houses to have 15 or more bids on the first day they were listed. Houses routinely went for tens of thousands of dollars more than their list price.
That type of demand doesn't fall off in an instant because mortgage rates are up 2%. And builders also have a budget constraint. They can stop pricing in as much margin as they were, but prices will only drop so far before they're losing money. Meanwhile, don't be surprised if some sellers were waiting for the market to peak and start to list their homes now, before it's too late.
I would guess there will be a slower tapering of demand than the doomsday scenario above would require, and that supply will remain constrained for the foreseeable future.
All that would spell a range-bound market. In stocks, a range-bound market is when prices remain within a specific range for a prolonged period. They may go up 10% over a few months and then back down 10% over the next few, but they don't break through into a new long-term uptrend or downtrend.
So where are we going?
Smart, long-term-focused investors may be hoping for the market to cool off a little. It's hard to build wealth when you're in a bidding war for every new purchase. Good investing often comes from an edge, and there's no edge if you and 17 other people are bidding up the price of the same duplex that was built in 1977 and needs a new roof.
If you don't want to engage in these bidding wars, the best advice right now might be to simply hold steady. Keep collecting passive income from your existing properties and build up capital so you can strike when demand does fall.