Tim Thomas has given permission to republish this excellent post on predicting a housing market crash.
Following the dotcom times, the value of real estate began to rise, thereby fuelling a rise in homeownership.
Extreme low-interest rates and a lack of stringent lending standards pushed people to buy homes who would have otherwise not been able to purchase.
Home prices began to soar, reaching all sorts of new-high. Soon, mortgage-backed securities were sold off in large volumes, and mortgage defaults and foreclosures rose to record-breaking levels.
During this time, many speculative investors decided to pull out as the market was turning out to be very risky, so what happened next?
Potential housing market buyers felt the financial strain and postponed or canceled their home purchases. This overturned the economy and subprime borrowers found themselves paying high monthly mortgage rates.
The 2007 crash was one good example of housing market prices reaching all-time highs before dropping to more reasonable levels.
Unlike stock investors who frequently experience stock price falls or even crashes, housing market crashes are less common but they do happen. Swing trading can help protect stock investors from price falls, hedging against a housing market crash is more difficult.
How to Predict a Housing Market Crash
1) When Interest Rates Are High Enough, Homeownership Is Put Out Of Reach
Interest rates and the spread of credit play a crucial role in the availability of credit to build houses. Most homebuyers do not pay capital upfront, mainly because they don’t have half a million dollars to invest in real estate.
They usually finance the cost with the help of a financial institution.
These financial institutions make a profit by borrowing short-term bonds while they lend them out to customers over a long period of time at higher interest rates.
Suppose the difference in short-term and long-term finance interest rates is flat or negative in such cases. In that case, it makes it difficult for financial institutions to remain profitable.
Margins for net interest matter to the housing market because if financial institutions can’t lend to customers or other banks, credit availability gradually decreases, and interest rates drastically increase – thereby affecting the supply of new housing loans.
Today, housing prices are 30% higher than in 2008, indicating that even more credit has been pumped into the economy. When the next crash occurs, there could be a severe decline in house prices.
2) Observe Leading indicators
Identifying housing market indicators is key to predicting housing market crashes. Indicators like building permits, housing starts, and new home sales data are released once every month, available for free download.
At the start of every month, the building permits predict the number of new housing starts while the new housing starts predict the number of new home sales in the region. This cycle is almost always on repeat.
Combining these three indicators, we clearly understand when and why the housing market can crash. Once these indicators start to trend one way for an extended period, housing prices will stall and then immediately reverse in the opposite direction.
3) Compare Rental To Capital Values
One of the most proven ways to identify signs of a housing market crash is to compare rental values to capital values. When the underlying properties of the economy change, the rental, and capital values simultaneously change.
During a housing market crash, investors raise capital values expecting even more capital gain, while rental prices do not rise as the tenants do not see a change in value. Such disparities between rental and capital values can be considered a sure shot sign of a housing market crash in such markets.
The underlying logic is that the high price could result from an investor-driven housing market, and the average person is only a tenant.
4) Analyze Housing Linked Commodities Market
The commodity price of lumber could be a great indicator of a housing market crash. When the prices of lumber crash, it usually coincides with peak house prices.
Wood products are created on the manufacturing side of the supply chain. It takes time for the lack of demand to reach manufacturers. This is witnessed in almost all industries.
If there is a decrease in construction demand, housing prices will fall to counteract the excess inventory. If there is no demand for any wood products, it becomes strikingly clear that the market is in for a severe demand shock.
5) Utilize the Stock Market as an Indicator
The S&P 500 Index is the main measure of the US’s economic health, made up of the top 500 blue-chip companies – some of them being housing-related. Investors often use global stock markets to express their opinions on real estate.
For example, if investors think that a housing market crash will happen, they will start to sell stocks related to the American housing market.
Stocks that makeup ETFs follow the same housing indicators; prices begin to rise and fall when there is a demand and supply shock in the market.
6) Gauge Housing Inventory
Housing inventory indicates the total number of unsold homes with developers in the housing market. In a usual market scenario, the housing inventory can be seen to remain stable.
This is because housing developers have a fair idea of supply and demand. However, when the market is bullish, there is a sudden shortage of houses. On the other hand, during a bear market, there is a sudden influx in housing inventory.
Thus, keeping an eye on housing inventory can really tell an investor what stage of the cycle the market is currently in.
7) Compare Wages to Capital Values
Another primary metric of affordability is to compare the annual wages of an average person in a particular neighborhood with the capital values observed in the neighborhood. This will give us the number of years a person has to work to buy a house in the area.
Numbers between the range of 5 to 10 imply affordability. This is because if a person can afford to buy a house in 5 to 10 years with 100% of their wages, they can afford a 20-year mortgage.
However, if the number goes above 20, this signifies a housing market crash.
Final Word on Ways to Predict a Housing Market Crash
There are various ways one can predict a crash in the housing market. Above are the seven simple ways to do just that.
Factors such as mounting losses, tighter credit standards, difficulty in mortgage borrowing prevailing, and Increasing demand with a decrease in the supply – all these factors will force the investors to quit the market, thereby leading housing market prices to fall.
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Disclosure: The author is not a licensed or registered investment adviser or broker/dealer. They are not providing you with individual investment advice. Please consult with a licensed investment professional before you invest your money.
Tim Thomas has investments in real estate.
Featured image credit: Shutterstock.