Rising house prices are supposed to be driven by robust growth of high paying jobs. This drives household formation, and the high wages allows buyers to borrow large sums to drive up prices. This demand creates a shortage in housing as households compete with one another for the available housing stock. This prompts homebuilders into action to provide more supply to meet the demand. Those are the conditions that drive sustained price increases. Obviously, that isn’t what’s happening today. 
Gains in Home Prices Driven by Unsustainable Forces
Despite the Increase in Prices Over the Last Year, Weakness Persists in the Housing Market
The press is buzzing with news of year-on-year gains in housing prices, but a look under the hood raises doubts about whether the gains are sustainable. On the surface, the state of housing markets looks good: the 25-MSA RPX Composite price increased 13.1 percent year over year as of March 21, with all but one of the constituent metropolitan statistical areas posting gains. However, when one digs a little deeper one finds that the conditions that have given rise to these gains differ from those that underpinned past housing recoveries, and are not adequate to drive a lasting appreciation in housing values.
We’ve never had this level of government and federal reserve manipulation of the housing market. Nothing about this market is natural or organic. Perhaps we can transition over to a “normal” market, whatever that is, in time, but sustaining house prices increases during the transition is a daunting task, particularly when faced with serious problems with housing market fundamentals.
1. Limited Supply Tight inventory is perhaps the most significant driver of year-on-year gains in the 25-MSA composite. At the height of the housing boom, in July 2007, 3.4 million single family homes were for sale, according to the National Association of Realtors (NAR). In April 2013, just 1.9 million single-family homes were on the market. …
Looking forward, however, inventories are likely to increase. Current constraints on supply – negative and low equity, seller psychology, and low builder activity – will have less of an effect as home prices rise. As inventories rise, price trends will likely weaken.
2. Negative and low equity The primary constraint on supply may be negative equity on the part of homeowners. According to the NAR, 10.2 million out of a total of about 50 million U.S. homeowners are still “underwater”, meaning they owe more on their mortgage than their home is worth and are therefore unable or unwilling to sell their homes.
(See: Negative equity keeping homes off the market)
As home prices rise, many hundreds of thousands of formerly underwater homeowners will once again be able to sell as their properties are once again valued above the balance outstanding on their mortgages.
(See: Low housing inventory is an indicator of residual mortgage distress)
To the extent that these sellers purchase new homes in different markets and different price points, or decide to rent rather than buy, the homes they sell will add to the net supply available in their current market and price range.
One factor that created the huge supply imbalance during the housing bust was that each foreclosure or short sale was a net negative to the market. The seller did not contribute to future demand due to bad credit and zero savings. This problem still limits demand today.
3. Seller psychology Another serious constraint on supply is reluctance to sell near the bottom of the market, particularly when prices appear to be rising. Such reluctance likely affects many homeowners who, while possessing positive equity in their homes, still feel their mobility constrained by the decline in the value of their homes relative to the purchase price.
(See: Loanowners are in no hurry to list and sell their houses)
This constraint on supply may be the most difficult to quantify and could be the biggest contributor to future volatility. As prices rise, this “shadow inventory” will appear on the market. Such new supply could dampen any sustained growth in prices.
Overhead supply is a concept from stock trading. After a sharp decline in stock prices, many stock owners who are in at higher prices points wait for prices to rise to sell at breakeven. These sellers-in-waiting prevent prices from shooting back up to the previous peak quickly because new buyers must chew through this overhead inventory. Housing markets almost never have issue with overhead supply. First, prices rarely fall, so it’s uncommon for large numbers of owners to have less equity than when they purchased. Second, during a bust when large number of borrowers default, bank used to be required to foreclose on the properties and liquidate them. This capitulatory selling cleared out the overhead supply and allowed for more robust and sustainable price growth off the bottom. The current housing market is very different. First, there has been no capitulatory selling. The changes in accounting rules that allow mark-to-fantasy accounting made this possible. This created a massive overhead supply. The fact that so much supply which ordinarily would be on the market is missing demonstrates how much overhead supply is being suspended at price points well above current market comps. When prices rise, this inventory will return.
4. Builder (in)activity A third factor limiting supply is the slow rate of building activity since 2008. Permits dropped dramatically from 2006 through 2008, and since then have remained well below the monthly rate in January 2010. The low rate of building activity has resulted in record low new-home inventories. While four years of limited building activity helped to constrain supply in 2012, and thereby contributed to the rapid rise in home prices, there are signs that builders have started to respond to price signals. As of April 2013, permits had increased 41 percent from April 2012 and 150 percent from the post-bust low in January 2011. These gains were off a very low base, and permits still have a long way to go to get back to the rates of a decade ago, but building activity appears to have turned a corner. …
Last year I noted, As lenders withhold product, the homebuilders will flourish. Sure enough a few months later, it became obvious that restricting MLS inventory is reviving homebuilding. However, before everyone celebrates the return of homebuilding, it’s worth noting that only recently did new home starts surpass lowest pre-bubble low of last 45 years.
One might therefore expect building activity to continue to increase, which will help to increase the supply of homes for sale in coming months. 5. Unorthodox Demand While the supply of homes for sale has been severely limited over the past year, demand for homes has increased. Unfortunately, this increase in demand has been driven by unorthodox market forces–artificially low mortgage rates and institutional investor activity-which are liable to disappear in the near future. When they do, slackening demand will slow and perhaps reverse current trends in home prices.
The investors will disappear when prices rise above their return thresholds; however, if prices fall, these investors will return for another bite at the apple. In markets like Coastal California where these institutional investors are absent, rising interest rates could actually cause prices to decline, and investors will not step in to save those markets.
6. Artificially Low Mortgage Rates Housing demand is currently being fueled, in part, by low mortgage rates. Unfortunately, the current rates are largely the result of intervention by the Federal Government in the service of loose monetary policy. While the Federal Reserve has indicated that it will continue its current approach for an extended period, it will eventually change course. At such time mortgage rates will likely rise and cease to be a driver housing demand.
Rising interest rates may also have the unexpected effect of increasing supply because surging mortgage rates may scare sellers into action.
7. Institutional Investor Activity During the twelve months ending March 2013, purchases of residential real estate by corporations, partnerships and investment trusts in the 25 metropolitan areas included in the RPX Composite increased 41 percent. To put this figure in context, purchases by all other buyers increased only two percent during the same time period. …
Rising prices will reduce the purchasing activity of investors. When prices rise to the point where the economics of the buy-to-rent strategy no longer makes sense, investors will slow their buying and start to sell. … It should be noted that institutional investor purchases over the last year have been concentrated in seven metropolitan areas: Atlanta, Los Angeles, Las Vegas, Miami, New York, Phoenix and Tampa. One would expect changes in investor behavior to have a particularly severe effect in these markets.
As I noted above, changes in investor activity will stop the buying pressure, but they will remain active support preventing any declines.
In fact, there is recent evidence that the winds have already started to shift in the single-family rental business. It is becoming difficult for institutional investors to purchase homes cheaply. The composite price per square foot paid by institutional investors in 25 of the largest metropolitan area housing markets increased 14.4 percent year over year in March. Over the same period, asking prices for rents have increased just 2.4 percent, according to Trulia, Inc. As a result, yields on single-family rentals are declining.
The window of opportunity to get into this business has past. The existing operators will start winding down their purchases over the next couple of years.
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I like Radar Logic’s reasoning, but I’m less convinced the home price gains will be reversed. As I noted in The long-term negative impact of temporary mortgage interest rate stimulus, The future of home prices will vary by market. In the markets like Coastal California that are quickly approaching affordability limits, rising interest rates will cause a long, slow grindon the way down. In markets like Las Vegas that are still extremely undervalued, rising interest rates will simply make them somewhat less undervalued, and prices there will still go up.
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The post Radar Logic: Seven reasons home price gains are not sustainable appeared first on USA Housing News.