Have you logged on to Zillow recently to check the price of your home? There is an uncanny pleasure in seeing your home value tick up over 20% since 2020. However, if you are an aspiring homeowner, rising prices are not a source of comfort. Understanding how home prices work is essential to making a sound decision in your largest investment. Realtors run 'comps' or a comparative market analysis (CMA) when pricing a home for sale. They create and average of 3-6 recent sales in the immediate vicinity based on property similarities in size, age and amenities.
The CMA is akin to the comparative sales method used by appraisers to value a home. The other two approaches used by appraisers to triangulate home values are the cost method and the income approach. The cost method looks at the value of "land" and "built-up" structures separately. The income method uses potential rental income to value the home. All three approaches come up with a number, but none of these approaches cover the macro economic dynamics that have dominated home pricing in the last two years. We offer a customer friendly paradigm to think about macro pricing trends. Let's peel back the onion starting with monetary policy, fiscal policy, inflation, and end with the structural imbalance between housing supply and demand.
- Monetary policy - in the context of housing refers to the interest rates set by the federal reserve for long term borrowing. Mortgages rates were already at historic lows of below 4% before the pandemic started. The fed lowered rates even more in 2021 and we saw the 30yr mortgage rate drop below 3% for the first time in decades. Low interest rates increases the borrowing capacity of homeowners and make prices trend up. A 0.5% decrease in interest rates translates to 6% more purchasing power. That's roughly $30,000 more borrowing capacity on a $500k loan. If borrowers can take bigger loans while keeping their monthly payment fixed (because of the lower rate) they will accept higher priced homes. Mortgage rates have climbed well above 4% in 2022, but home prices will not come down as fast as they went up, because no one likes to sell their home at a loss.
- Fiscal Stimulus- the govt. created more than $6 trillion dollars of COVID related new money for support programs. US GDP is approximately $22T, but the economy did not grow by $6T with the infusion of cash. Instead the excess money went chasing for fewer goods and services, which leads to our next issue: Inflation
- Inflation - consumer price inflation (CPI) reached 7 percent in Q1 of 2022 and housing accounts for 30% the CPI calculation. Housing inflation causes rents to rise and the prices of homes to go up. The value of a home can be divided into two parts a) value of a the land and b) the value of the structure. The value of land is primarily driven by demand, relative to its supply (which is fixed). The value of the structure is primarily driven by the inflation in materials, labor and supply chain costs like transportation. COVID-19 is in its third year of disrupting global supply chains as the bottleneck shortage moves from lumber and paint to the more obscure, like garage doors.
- Housing supply - is short because there is insufficient labor engaged in the construction of new homes. Delayed timelines due to material and labor shortages has been further exacerbated by people not selling their homes. Rising interest rates creates a "lock-in" effect where people stay put to keep their mortgage rates low and thereby disrupt the natural ebbs and flows in home sales.
- Demand - COVID-19 and work from home (WFH) have also created a structural increase for housing demand with more people spending more of their waking hours at home. A home also doubled as school, office and everything in between. The jump in home prices of ~20% in the last two years may seem like a housing bubble, but it has also been driven by a perfect storm of tight supply and increasing demand. Since the total amount of land is fixed, price is relatively inelastic. An unforeseen increase in demand for land has spiked prices.
While fears of a housing bubble may be warranted, it does not appear that people are buying homes with the expectation for price exuberance to continue. People just want a place to live and feel safe. While the macro forces at play may not be great news of price relief to aspiring homeowners, understanding them should help in your discernment for a home purchase. We believe in the adage: if you love it, and can afford it, then buy it!