What Happens When Home Prices Fall?

The real estate market has been on the rise for a while, but are the good times about to slow or reverse?

It’s not an unreasonable question. Though home values rise and fall over time, they have primarily gone one way in most markets for the past decade, and that way is up.

We all like winning streaks. Football teams, baseball players, and musicians have become immortalized thanks to their hits. And now the National Association of Realtors (NAR) is also in the record books.

According to the Association, “the median existing-home price for all housing types in February was $357,300, up 15.0% from February 2021 ($310,600), as prices grew in each region. This marks 120 consecutive months of year-over-year increases, the longest-running streak on record.”

It’s been a fantastic time for most real estate investors and property owners for ten years. Not always, not everywhere, but just like sports players and musicians, you can’t ignore the accomplishment – it is impressive.

You also can’t ignore this: while year-over-year prices have consistently increased, monthly prices have not. For instance, in June 2021, existing home prices stood at $362,900, according to NAR, but by February of this year, they had fallen to $357,300.

Home Prices and the New Challenges

“Rapid economic recovery, fiscal support, and high saving rates amid negative real interest rates explain part of the strong housing demand,” expand economists at the Bank for International Settlements. “Pandemic-induced demand for space, structural supply constraints, and increased demand from investors provide additional support for house prices.”

While that’s been true, things are changing. Interest rates are rising. Mortgage rates are low by historical standards but higher than in January 2021, when rates hit 2.65%, the record low.

The impact of higher rates can already be seen. Even as prices continue to rise, pending home sales – a useful measure of future activity – fell in November, December, January, and February, according to NAR. Given the rate spike seen in March, it follows that additional sale declines are on the way.

With rising mortgage rates, soaring gas prices, inflation increases, and war in Eastern Europe, the current market may be entering a new phase.

Will highly-leveraged owners be able to make their monthly house payments when faced with a steeper overall cost of living? For example, in the fiscal year 2021 – the period that ended September 30th – 23.71% of all new FHA borrowers had 50% or higher debt-to-income ratios. That’s considerable debt when everyday costs aren’t rising.

Good News on the Real Estate Front

While circumstances are changing, there is also good news.

First, American homeowners have an enormous amount of equity in reserve. For example, in the third quarter of 2021, homeowners had equity valued at $25.3 trillion. According to the Federal Reserve, that’s an increase of $4 trillion in just one year.

It may not be a positive thought, but if home prices stall or decline and owners run into financial difficulty, most can sell for far more than they paid. No less important, because of rising values, most can easily pay off mortgage debts if they sell.

Second, most homeowners aren’t concerned by rising mortgage rates. Why? They knew a good thing when they saw it and bought for cash or financed with fixed-rate financing while rates were low. So if rates go up, the monthly principal and interest payment remains unchanged for millions of homeowners and investors.

“One of the reasons so little inventory has been available for sale concerns the low interest rates seen during the past few years,” said RealtyTrac’s Executive Vice President, Rick Sharga. “Owners look at the financing they have and simply don’t want to lose it as a result of selling.”

Third, according to the Urban Institute, over a third of all homes – 37% – were mortgage-free as of 2019.

Fourth, the use of home equity lines of credit (HELOCs) has substantially declined. In the first quarter of 2009, the value of HELOCs amounted to $736 billion, according to the Federal Reserve. By the end of 2021, the balance for such accounts dropped to $324 billion.

Fifth, while inflation has caused prices to increase for many products and services, it is also true that many employees have seen wages increase. According to the Bureau of Labor Statistics, wages and salaries increased by 4.5 percent in 2021.

Although the wage increases seen by many workers help, they have generally not kept pace with the 7% inflation rate in 2021.

Sixth, Americans have stashed away vast amounts of cash. Banks had $18.2 trillion in deposits as of mid-March, up from $12.6 trillion three years ago. This money allows households to face higher prices and bouts of unemployment.

Seventh, it remains possible that the inflation surge we are now seeing is temporary. It may fall as supply chain issues are straightened out, the chip shortage becomes less severe, and the Ukraine war ends. The Mortgage Bankers Association expects the inflation rate to drop to a more-tolerable 4.6% by year-end.

Lastly, suppose real estate price increases slow or reverse. In that case, there’s little of the dread that accompanied the last mortgage meltdown when millions of owners faced foreclosure. Much of the risk in the mortgage marketplace a decade ago is gone, resulting from tighter lender regulations and stronger borrower protections.

A price slow-down will happen at some point – prices cannot rise forever without interruption – this time around, most local markets are likely to see a gentle softening and not a gut-wrenching decline. That is something for which to be grateful.