A Look Back at 2022 and Ahead to 2023
Where There is Chaos, There is Often Opportunity
By Rick Sharga
As we prepare to exit one of the most tumultuous years for the housing market in recent memory, there’s a lot to unpack.
The market started the year off white hot, with consumers, and individual and institutional investors competing for limited inventory, driving home prices up another 15% from 2020’s already-high numbers. Housing starts were increasing to levels not seen in a decade, and vacancy rates in owner-occupied and rental properties dropped below 1%.
But the market’s momentum screeched to a stop as mortgage rates jumped from sub-4% to over 7% seemingly overnight, and prospective buyers faced the prospect of monthly mortgage payments that were 40%, 50% or 60% more than they’d been just a few months earlier. Sales fell immediately, along with builder and consumer sentiment.
Weakening demand, worsening affordability, and higher financing costs don’t paint a rosy picture for real estate investors. What’s in store for the coming year?
Will the U.S. economy enter a recession in 2023?
Probably.
The economy has been resilient over the past few years, especially considering the short-term turmoil caused by the COVID-19 pandemic and subsequent government shutdown. Most economic indicators today remain positive — job growth is surging, unemployment very low, productivity high, and consumer spending is strong. Normally, none of this would point towards a recession.
But inflation has been running at its highest rates in 40 years, and the Federal Reserve has taken unprecedentedly aggressive action to get it under control, raising the Fed Funds rate more dramatically and more quickly than at any time in the past 20 years. Historically, when the Fed has taken this kind of action, a recession has usually followed.
Dating back to 1955, the Fed has raised rates 11 times in order to get inflationary cycles under control. In three cases, the Fed was able to manage a “soft landing” for the economy and avoid a recession. In the other eight cases, it waited too long — inflation had either risen too far or become too persistent – and the Fed had to over-correct in order to slow the economy down.
In all eight of those cases, a recession followed, and it seems highly likely that the Fed is driving us in that direction again, given how long it waited to begin addressing inflation, and how difficult it’s been to make any progress.
Another historical trend that suggests a recession is heading our way is the Yield Curve Inversion. This phenomenon, an indication that the bond market is anticipating a recession, happens when yields on short term and long-term bonds invert — yields on long term bonds like 10-year U.S. Treasuries become lower than yields on short term bonds like 2-year U.S. Treasuries. The market has been in this inverted position for months now, and the degree of the inversion has been significant. Equally significant is that each of the last seven times there’s been a yield curve inversion, a recession has followed. There’s little reason to believe that we’ll escape making it eight times in a row.
Most economists and market analysts believe that while a recession is likely, it’s also likely that it will be relatively mild and short-duration, since the underlying economic factors mentioned above are all strong, and household balance sheets are in good shape, with $4.6 trillion in savings accounts across the country.
Will the housing market crash?
Probably not.
This depends, at least in part, on the definition of “housing crash.” With mortgage rates doubling this year — something that Freddie Mac says has never happened before — affordability became a huge problem for many prospective homebuyers, and home sales have declined significantly. According to Lawrence Yun, the Chief Economist for the National Association of Realtors (NAR), existing home sales in 2022 will fall 15% from 2021 and drop another 7% in 2023. In its October Housing Forecast, Fannie Mae projected a drop of 17.9% this year and 21.8% next year for existing homes and 19.6% and 12.6% for new home sales. Sales volume has definitely “crashed,” but prices haven’t followed suit.
Unlike the 2008 market meltdown that led to a 24.7% decline in national home prices according to the Case Shiller Home Price Index, prices have continued to increase on a year-over-year basis, even as the number of homes sold has dropped. According to NAR, as of October, home prices have risen on an annual basis for a record 126 consecutive months. The rate of home price appreciation has slowed down considerably; according to Freddie Mac, national home prices rose by 2% in September, down from 14% increases just a few months prior. More recently, there’s been downward pressure on pricing — according to a report by ATTOM, the median sales price of homes dropped 3% nationally between the second and third quarters, marking the first quarterly decline in years.
But there’s little indication of an impending crash in home prices. Supply remains low at about three months – half of what represents a healthy, balanced housing market — and demographically-driven demand remains, as the largest cohort of young adults in U.S. history marches towards the prime age for household formation and home ownership. There’s still more demand for the few homes that come to market, and the odds are that inventory will remain low in 2023. Homeowners with sub-4% mortgage rates are unlikely to rush to purchase a new home with a 7% mortgage and will probably sit tight and wait for market conditions to improve before listing their homes.
Builders have reversed course since home sales began falling off, with housing starts declining by double digits each of the last three months.
Homeowner equity, a record $29 trillion, gives current homeowners an enormous cushion against home price declines, and a hedge against losing their homes to foreclosure in the event their household finances take a turn for the worst. According to ATTOM, almost half of all homeowners with an active mortgage are “equity-rich,” meaning that what they owe on their mortgages is less than 50% of the value of their homes; even borrowers in foreclosure have some cushion — 92% of those distressed homeowners have equity, a far cry from 2008 when nearly a third of all homeowners were underwater on their loans.
Finally, there’s almost no distressed inventory on the market, and the absence of those properties, which often sell at a significant discount, further protects pricing from major erosion.
Will there be another foreclosure crisis?
Maybe someday, but not someday soon.
The breathless predictions of millions of borrowers defaulting on their loans during the pandemic turned out to be wrong, as did the theory that borrowers entering the government’s mortgage forbearance program would ultimately wind up in foreclosure. Just the opposite has happened.
Of the 8.5 million borrowers who entered the forbearance program, only about 350,000 remain, and only one half of 1% of those who exited did so defaulting on their loans. Over 36% of the borrowers who exited either paid off their loan, had it reinstated, or remained current while in forbearance. Over 45% exited with a deferral or loan modification (and 80% of those have remained current). And most of the remaining borrowers are either working with their mortgage servicer towards a modification or have re-entered the forbearance program.
Meanwhile, ATTOM reports that foreclosure activity is running at about 59% of pre-pandemic levels, and not expected to reach those levels until the middle of 2023. Mortgage delinquency rates, according to the Mortgage Bankers Association, are at 3.64% of active loans, which is below pre-pandemic levels.
To sum things up: unemployment rates are low; loan quality is excellent; delinquency rates have been declining; mortgage servicers are working with distressed borrowers to avoid foreclosure; and most distressed borrowers have the option to sell their home at a profit rather than lose it to a foreclosure auction. A recession could increase unemployment, which could lead to higher delinquency rates and more foreclosures, but another 2008-like tsunami is highly unlikely.
What does all of this mean for investors?
That depends.
Fix-and-flip investors will have a tougher time in 2023 than they’ve had in the past few years, when flipping activity and gross profits hit all-time highs. Limited inventory (especially of distressed properties), higher financing costs and more stringent financing requirements will make the year challenging.
But more challenging times likely means less competition from HGTV-inspired and under-capitalized individual investors. And demand remains strong from prospective homebuyers in most parts of the country.
Single Family Rental (SFR) investors should benefit from an influx of tenants who had planned to become homeowners before being priced out of the market. Since these tenants had been looking to buy a house, they might prefer to rent one instead of a traditional apartment. SFR investors, with their longer time horizons and cashflow-based business models, can also weather short-term home price declines more easily than flippers, since they’re less dependent on home price appreciation.
So, there will still be ample opportunities for real estate investors, especially investors with cash, who will be at a huge competitive advantage over buyers using financing at today’s higher rates. As the old saying goes, where there is chaos, there is often opportunity.
And there’s likely to be plenty of chaos ahead in the housing market next year.
