Housing Prices: How High Is Too High?

It looks as though Wall Street has given up on residential real estate. In 2021 and 2022, investor enthusiasm seemed to know no bounds. They poured billions into the area, eager to cash in on soaring rents. According to John Burns Research & Consulting, large landlords at the height of that boom bought almost 2.5% of all U.S. homes. But since, the tide has ebbed, with landlords taking a mere 0.4% of U.S. homes during this year’s second quarter, the most recent period for which complete data are available. By comparison, individual homebuyers have kept up their interest. The pace of buying has wavered from month to month as home prices and especially financing costs have risen, but any hesitation caused by cost considerations hardly compares with investors’ sudden pullback.

These fundamentally divergent trends naturally raise questions about which group is correct. Has Wall Street’s smart money issued a warning that individuals have failed to receive or do these individuals know something more than the big investors? The question is both natural and informative, but the fact is that these groups are not moving at cross purposes. Big money and individuals are playing almost entirely different games. The calculations of one have little relation to the calculations of the other, and the way it looks now, both are quite rational.

From the investor’s point of view, there is ample reason to pull back. In the last year and a half or so, financing costs have risen almost five full percentage points, while, according to the Census Bureau, the median price of a home sold in the United States has risen almost 8.5%. At the same time, rent increases have slowed markedly. Data provided by iPropertyManagement, shows average rents nationally, after rising a striking 12.1% from 2019 to 2021, actually fell over 9% in 2022, and in 2023 remain below the 2021 highs. The return on residential real estate investments has suffered accordingly, leaving little wonder why real estate investment trusts (REITs) and other investors have lost their appetite for further buying. Indicative of the situation and a general expectation that things might get worse is how shares of single-family REITs now trade at a 20% discount to their gross asset value.

Some of these considerations do matter to individual homebuyers. The National Association of Realtors (NAR) compares household incomes to financing costs and home prices to calculate what it calls an “affordability index.” That calculation indicates that affordability has fallen some 17% over the last 12 months. No doubt these facts discourage prospective homebuyers and may price some people out of the market. But rather than abandon the area, as the big-money boys have done, these increased costs more likely cause people to slide down the price distribution to buy less house in perhaps a less desirable location than they had originally planned. They have stuck as best they can because other considerations – that do not apply to investors – motivate individual homebuyers.

One on those considerations is an ongoing physical need. Over the past 18 years, according to the Census Bureau, the United States has seen family formation increase more than 3%. Because net home construction has not kept up, the nation faces more people seeking a single-family home than are available. These people will pay up if they can rather than continue to share or live in cramped quarters. Related to this is the intangible but nonetheless significant motivation to stive and, if necessary, stretch to give one’s family what it wants and in the eyes of every breadwinner deserves.

Individual homebuyers – sometimes explicitly, sometimes implicitly — also make a crucial calculation that investors do not. In the inflationary environment that presently grips this economy, ownership offers a tremendous advantage even if it involves supporting a high-rate mortgage. Once things are settled, whatever the number, the cost of shelter remains fixed. It is worth a lot to any family to fix the price of a big household budget when all other living costs are rising, some might say unpredictably. It is even worth stretching today’s budget to do so.

This last consideration is no doubt why during the last great inflation in the 1970s and 1980s, a time when mortgage costs were astronomical, that homebuying continued, despite the high costs. Indeed, that buying was sufficient to propel housing prices up even faster than inflation. The Labor Department records that consumer prices rose on average a disturbing 6.2% a year between 1970 and 1990. Housing prices the Census Bureau reports, rose during this time 8.6% a year. It was worth it to fix that budget item even if it meant an initial financial stretch.

Comparisons of behavior in disparate parts of the economy are always dicey. It certainly is in this case. The investors are not necessarily wrong and certainly look rational according to their own calculations. The same is true for individual homebuyers according to their very different valuation calculations.