Housing Market May be Experiencing a "Bubble within a Bust"

Wells Fargo Bank's Economics Group has issued commentary on housing which updates concerns it says it has raised over the past few month "that the influx of investors into the housing market may be exaggerating the extent and magnitude of the recovery in home sales and home prices."  Much more has been made of this issue in recent weeks, the commentary says, "and some headlines have even raised the specter of another housing bubble."

While some markets and submarkets have a bubble feel to them, a more likely outcome, the commentary says, is a "bubble within a bust that supports a temporary spike in home prices."  As interest rates move up the risk-adjusted returns for investors who convert single-family homes to rentals will diminish as will investor purchases. 

Wells Fargo cites a number of reasons why, while it does see the housing recovery remaining on course it does not see its bubbly aspects continuing and points to the cooling of overall economic activity at the end of the first quarter.  Most key economic indicators such as retail sales, non-farm employment, and consumer confidence slowed growth or even declined and economists have scaled back projections for the second quarter.  The recovery, however, does remain on track.

The report cites housing specific indicators that are showing signs that suggests that the housing recovery will continue to proceed in periodic fits and starts.

The spring home-buying season has gotten off to what the Commentary calls a "mediocre start."  While March housing data is holding up relatively well and builders and real estate agents are busier than they have been in several years it is apparent that there will not be a smooth transition to a normal or new normal housing market.  "Too much of the financial infrastructure related to housing finance and new construction remains impaired to clouded to allow sales or new construction to get ahead of themselves." 

Despite the high affordability of homes, traditional homebuyers face tight mortgage underwriting guidelines and a large proportion of homeowners have little or no equity in their current homes, constraining attempts to move up in the market.  Consumer finances, while helped by the rebound in the stock market and the recent rise in home prices, are still fragile and gains have not accrued evenly across the country.  The government's efforts to push mortgage interest rates still lower have only partially offset other drags.

The National Association of Home Builders (NAHB)/Wells Fargo Home Builders Index, a measure of builders' confidence in the market, has slid recently.  The commentary says the frustration expressed by builders likely reflects the shortage of available approved building sites, sharply higher materials costs, and a shortage of skilled workers.

Despite slipping builder confidence, single family construction is improving due partially to an increase in household formation at the labor market improves.  Wells Fargo says it expects single-family starts to pick up perhaps by as much as 25 percent this year and 24 percent next. 

Rental apartments have seen a huge influx of investment and surge in both demand and supply in recent years."  The economists say they expect this to be another good year for apartment developers but then supply will begin to catch up with demand and construction should taper off considerably next year.

Housing affordability remains high with home prices well below their peak and interest rates at record lows. 

After a jump in January sales of new homes lost ground in February, slowing in every region except the Midwest.  As some volatility is to be expected in the winter months the report says it expects sales will remain on an overall upward trend this year and will probably rise nearly 20 percent this year. 

Sales of existing homes also appear poised for stronger gains this year.  The uptick of 0.8 percent in February sales came entirely from condominium and townhome sales but single family sales should pick up as the market moves into the spring buying season.  Inventories are higher than a year ago and the recent rise in home prices should encourage more owners to put their homes on the market.  Fears of rising rates if the Federal Reserve eases its efforts in the financial markets may push more people to purchase.  Investors will also remain active although institutional investors probably won't continue to raise as much capital and their influence on the housing market may wane later this year, probably slowing the pace of home price appreciation. 

The Fed said its monetary policy is likely to remain on track for some time but there is now more speculation that the monthly MBS bond-buying program will begin to taper by the end of the year removing some of the downward pressure on mortgage rates.  While the low rates have encouraged refinancing, the idea the era of ultra-low rates may be ending should increase the rate of purchase applications.

Home prices continue to move upward but there is concern that much of the increase is being driven by investors.  This, the report says, is partially true, but inventories also remain tight and household formation is increasing.  With all major indices showing an increase in home prices over the past year, buyer confidence should continue to improve.   Well Fargo says it expects price gains to moderate later this year as inventories rise and the investor share of home sales declines.