Whether real estate investors realize it or not we are looking at an uncertain economic future. Specific to real estate, there are three primary variables likely to play a heavy hand over the next year or so. These factors are the stability of residential real estate prices, inflation, and wage growth. That doesn’t mean other factors such as the global economy or politics won’t also have a big impact. But we are less able to predict or account for those.
Today’s reality is inflation is rising, house prices are rising, and wages are rising. But not all at the same rate. The most recent data for inflation shows is up 2.9% (U.S. Labor Department). Wage growth is up 3.2% (Federal Reserve Bank). And home prices are up 6.9% (S&P CoreLogic Case – Shiller). While inflation and wage growth are running close to parallel, it is starkly clear that home prices are rising more than twice as fast.
Many months ago (if not years), the price of homes stretched beyond the purchasing power of many Americans. Hence the dilemma of whether real estate is a potent hedge against inflation or if it is pushing the edges of a bubble? This could play out in several different ways.
Bubbles do have characteristics that can be seen in advance. Most notable in the early stage are when market watchers start sending up warnings that real estate is becoming expensive. Early adapters begin wondering if they should aggressively be in on the price spike? Or if they should wait for prices to retreat? The second stage is when prices begin retreating gradually. This is at least partially caused when buyers are financially over stretched (income can’t support expenses). Another cause is investors who bought at the bottom of the cycle begin selling at the top of the cycle. But the biggest factor is that home prices have exceeded the purchase power of most retail buyers.
The best outcome here is that the market stabilizes for a lengthy period of time. That supply and demand come into balance. People begin selling for maximum profit. It remains a stretch for many buyers but an ample number are able afford buying to maintain an active market. This is only going to happen if price increases more closely align to wage increases. Inflation also plays a role because higher food and gas costs leaves less income available for a home purchase.
An economic shock could have a very different result. The Feds raise interest rates against inflation. Of course, higher interest rates make it more difficult to finance real estate. Interest rates are expected to rise gradually for at least the next nine months. For real estate to remain stable, price increases need to slow to be closer in-line with both inflation and wages increases. If they don’t, home prices will soon be forced to retreat. This triggers stage three of the bubble. More and more people will realize the bubble is bursting and flood the market with houses. Prices will spiral down until equilibrium is reached with wages. Should unemployment begin increasing, the downward pressure on house prices will increase and accelerate. The bubble cycle will be complete.
However, this isn’t limited to the U.S. economy. U.S. real estate is a security haven for foreign investors. If global or major regional (China and Canada) economic changes happen there will be an impact to U.S. real estate markets. These can first be expected to appear in major investment cities like NYC, Miami, and LA. Key changes to watch for are big fluctuations in currency values and government policy changes such as tariff and trade wars that we now see developing. Domestically, this includes reducing mortgage interest and property tax deductions on federal tax returns.
Traditionally, real estate is viewed as one of the most solid long term investments and a hedge against inflation. Supporting this are charts showing home prices increasing faster than inflation over the past 10 or 20 years. As it has for the 10 years since the previous real estate bubble burst. But that probably isn’t good current thinking. The bottom line is now is a time to watch short term changes in all three metrics. Common predictions are for an annual inflation rate of 2.5%, wage growth at 2.8%, and home prices increasing 4.3%. This is good for the overall economy because wages are expected to outpace inflation. And home price increases are expected to move closer to both. This should at least lengthen the period of market stability. However, these numbers will change month to month and quarter to quarter.
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Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 10 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. With the Pacific Ocean a couple of miles in the opposite direction.