In these unprecedented times, I find myself reflecting on Rod Serling’s Twilight Zone monologue on travel into an uncharted dimension, “Beyond that which is known to man…It is the middle ground between light and shadow, between science and superstition, and it lies between the pit of man’s fears and the summit of his knowledge.”
We are indeed in a land somewhere between science and superstition, between our fears and the inadequate summit of our current knowledge.
When I am faced with navigating unfamiliar terrain, I tend to fall back on the tried and true method of setting bearings, establishing anchor points in the current environment then projecting a course based on personal experience and/or historical references.
As a thought experiment, I applied this approach to making predictions regarding the effect of the coronavirus pandemic on U.S. home prices.
My working hypothesis for this experiment, to be proven or disproven, is this: One of the economic consequences of COVID-19 will be the collapse of U.S. home prices.
Set Your Bearings:
Before we start making predictions, let’s first set our bearings by reviewing the state of the housing market prior to the encroachment of the pandemic onto American soil.
Prior to March 6, the U.S. housing market was hot. Existing home sales (as seen below) were at a 13-year high.
Meanwhile, purchase application data (as seen below) had eight-straight weeks of double-digit growth, and inventory was down year over year, from 3.6 months to 3.1 months.
Median home price growth was up 8% year over year. Added to this, employment numbers were solid. The last job’s report was one of the strongest in many years, showing a 3-month average of 243,000 hires. We had 23 straight months of having more job openings than unemployed workers, with the last report showing 7,000,0000 openings nationally.
Based on these and other metrics, demand for housing before the crisis was at cycle highs. These market conditions supported potential increases in home prices which could have exacerbated the already widening gap between home prices and incomes in many communities. So that is where we were, some weeks ago.
Establish Anchor Points:
As the second step in my thought experiment, I determined what factors, or anchor points, needed to be present in order for home prices to crash. Here are the three that I will be using:
- Mortgage interest rates: Mortgage rates would need to increase enough to discourage buyers from entering the market.
- Inventory: Inventory would need to expand substantially and quickly.
- Distress sales due to job layoffs: Loan defaults, distress sales, and foreclosures would need to increase significantly.
Use Historical References to Predict Future Behavior:
If we now refer to historical knowledge to make assumptions of how current conditions will affect the anchor points, we can derive an informed prediction of how COVID-19 will affect home prices.
Interest Rates: Inventory increases when mortgage rates increase along with decreased demand. The first part of that equation has been satisfied but only in the short term.
Mortgage rates have increased from record lows recently, but have not exceeded 4.5%, the level needed to have an impact on home sales and thus increase inventory in the existing home sales market.
Mortgage interest rates are in flux now and the spread between the 10-year yield and the 30-year fixed has become less predictable. But in the longer term, meaning the next several weeks to months, the delta between the 10-year and mortgage rates will stabilize.
When this crisis has been resolved enough for investors to start selling bonds to go back into the stock market, the 10-year yield may go up, but for now, expect low mortgage rates to continue. If second-quarter GDP is as awful as we believe it to be, then the 10-year yield should fall below 0.62% and may even go negative.
Inventory: The supply of homes coming into the market will be hampered by two factors.
Some sellers are likely to remove their homes from the market to comply with social distancing and stay-at-home orders, thus reducing some of the natural supply.
Job layoffs may prevent other would-be buyers from moving up, or venturing to buy their first home. I do expect homes to take longer to sell because so many parts of the process from finding a home to closing will be more difficult. If homes sit on the market longer we could see a noticeable increase in inventory. When stay-at-home protocols are taken off, however, I do expect to see a decline in inventory.
Over the next 90 days, we should be mindful of the virus distortion in the data.
Distress Sales: The recent proposals to allow homeowners with Freddie and Fannie loans (about 50% of existing loans) to defer payment up to one year should largely prevent forced sales, defaults and foreclosures due to job loss.
If a homeowner is forced to sell due to job loss, the mortgage deferral programs will allow them to wait out the crisis rather than sell at a discount.
Unlike the previous cycle, when relaxed lending standards created an over-leveraged credit bubble, the loan profiles in this cycle are excellent. Homeowners today have excellent cash flow with a lot of nested equity. This is an extra layer of protection from distress sales that we did not have in the last cycle.
I do not expect a glut of distress sales due to the pandemic, especially if we assume that this will be a relatively short-term event, measured in months rather than years.
If we assume that the U.S. will lose between 6 million to 20 million jobs in the next few months, that still leaves close to 150 million people working. Data from before the epidemic suggests that a respectable number of those working individuals wanted to purchase a home in 2020.
We had the best buyer demand trend going into the spring season with a massive number of Americans ages 26-32 – right at the cusp of homebuying age.
The question remains: How many Americans, even with at least 140 million people still working but with stay-at-home orders in place, will be looking or have the confidence to buy a home? Frankly, I don’t have a model for that.
Where this leaves us:
Our thought experiment suggests that interest rates will not spike, inventory will increase some but should have limits to that process.
Distress sales will not spike with all the government support to prevent that from happening. We will see sellers removing homes from the market and cancelations of current contracts, while we as a nation wait out this virus over the next few months.
Home sales will take a hit during the pandemic for sure, especially working from a cycle high.
With regard to the hypothesis that the pandemic will cause a collapse in home prices, our thought experiment suggests this will not happen.
We should view the next few month’s reports on existing home sales as an episode of the Twilight Zone. These reports will be confusing and will touch the pit of man’s fears and the summit of his knowledge. Once stay-at-home protocols are not part of American life anymore, that episode will be over and we can judge the marketplace with more clarity.