Market Volatility Could Impact Housing Values When Rates Fall
You’ve probably heard the old adage that extremely low supply across the U.S means home prices can only go up. But hold on a second—what if I told you that even with low inventory, there’s a significant risk that prices could go down? Let’s unpack this together.
The Low Supply Dilemma
It’s no secret that housing supply is at a historic low. Fewer homes are on the market, and new construction hasn’t kept up with demand for various reasons—rising material costs, labor shortages, and regulatory hurdles. The immediate thought is that low supply + high pent-up demand = skyrocketing prices. And that’s been true to an extent. We’ve seen home prices surge over the past few years, leading many to believe this trend will continue indefinitely when interest rates drop.
The Hidden Volatility
But here’s where it gets interesting. When demand is also low because prices have shot up too high, the market enters a phase of extreme price volatility. High prices are pushing potential buyers out of the market, reducing demand. This mismatch between supply and demand can lead to unpredictable price swings, rather than the steady increase many expect when rates decline.
Imagine this scenario: a condo building has ten units for sale, but they’re all priced at a premium, 30% above where they traded just a few years ago. If buyers can’t afford these prices, the units sit on the market longer, and sellers might have to lower their asking prices to attract buyers. This creates downward pressure on prices, despite the low supply.
I experienced this firsthand. Since 2021, I have sold off 60% of my STR portfolio and now hold only six of my best doors. I recently sold two condo units in the same building below market value. Why? Because I made my money when I bought the deals seven years ago. I already enjoyed six years of incredible cash flow and still made significant equity gains on each property, even when selling below market value. Money is made when you buy (buying for the right price, at the right time in the real estate cycle), not when you sell.
However, by selling at these discounted prices, I effectively reset the condo building’s market values 20% below the previous highs. When the next buyer comes along and gets a loan, they (or their lender) use my lower sale prices as comps, thus reducing the appraised value of other units in the building. This challenges the narrative that low supply always means rising prices.
Real Wage Growth: The Elephant in the Room
Another crucial factor is real wage growth—or the lack thereof. If wages aren’t growing at a pace that keeps up with housing prices, fewer people can afford to buy homes. This is especially true in urban areas where housing costs have outpaced wage increases significantly. When people can’t afford to buy, demand drops, which can lead to price reductions, even in a low-supply environment.
Real wages (adjusted for inflation) have been stagnant for many workers, and this is a big deal for the housing market. If people aren’t earning more money, they can’t afford higher mortgage payments. This affordability crisis can force prices down as sellers try to find a price point that buyers can actually meet. It used to be that the average $100k income family could buy in the $300k range (3x wages). Today, it is not uncommon for that $100k income family to have to pay $500k to $800k for the same type of home.
This situation is unsustainable. Either rates need to drop back to 2.75% to increase buyer purchasing power, or real wage growth needs to triple to support current price levels. Likely, neither will happen with the impact AI will have on the job market.
Interest Rate Impact
Many assume that a drop in interest rates will automatically trigger a new boom in buyer demand and lead to rising home prices. However, this isn’t necessarily the case. Even if rates fall, other factors like stagnant wages, economic uncertainty, and high home prices can continue to suppress demand.
Lower rates might make mortgages more affordable, but if buyers are still priced out due to high home costs or lack of job security, the expected surge in demand may not materialize as the mainstream media suggests.
The Risk of a Downward Spiral
When high prices, low demand, and stagnant wages combine, it creates a perfect storm for potential price drops. Here’s why:
- Affordability Issues: If homes are too expensive, people will rent longer or move to more affordable areas. This lowers demand for overpriced homes and affects STR and Airbnb investments, which are feeling revenue, occupancy, and ADR pressures.
- Economic Factors: Economic uncertainty or downturns can exacerbate these issues. Wars around the world, a potential U.S. recession, and stock market volatility add layers of risk and liquidity credit challenges needed to fuel the housing fire. Rising unemployment rates are starting to show cracks, making job security a concern and further reducing the pool of potential homebuyers and investors.
- Interest Rates: Rising interest rates can also play a role. Even with lower rates, the other factors noted here can weigh down the fundamentals that fuel housing demand.
- Investor Retreat: Investors who were driving some of the demand might pull back if they see lower returns on investment, decreasing property values, leading to an increase in supply without corresponding demand, even in a lower rate environment. If prices are falling, do you buy now or wait?
Case Studies and Real-World Examples
Look at some of the hottest markets over the past decade—places like San Francisco, New York, and even smaller cities like Austin. These markets saw explosive growth, but now they’re starting to show signs of cooling off. High prices have pushed many potential buyers out, and wage growth hasn’t kept pace. The same is true in Austin and a growing number of COVID boom markets.
In San Francisco, for example, the tech boom led to astronomical housing prices. But as the market matured and salaries didn’t rise at the same rate as housing costs, the market started to cool. More homes stayed on the market longer, and we’ve seen price adjustments as a result.
The STR Investor’s Perspective
As a short-term rental (STR) and Airbnb real estate investor, understanding these dynamics is crucial. Low supply might make a market look attractive at first glance, but you need to dig deeper. Assess the affordability of the market, look at wage growth trends required to support current price levels, and consider economic indicators that could impact demand, revenue, cash flow, and future equity growth. Cash flow and equity growth are dependent on price stability and the economic capacity from consumers’ discretionary income for travel and vacations.
Investing in a market with low supply but also low demand due to high prices can be very risky today. The volatility could lead to sudden price drops, affecting your investment’s value, and an equity cushion could evaporate in a matter of months.
We are net sellers today, but also scouting every day for lowest-risk opportunities globally. It’s essential to have a comprehensive understanding of the local economy, tourism demand, inventory trends, list-to-sales price, DOM trends, real wage growth, and demographic trends.
Strategic Moves for STR Investors
So, what should you do if you’re looking to invest in this volatile market? Here are a few strategies for STR and Airbnb investors to think about:
- Diversify Locations: Don’t put all your eggs in one basket. Consider investing in multiple markets to spread risk. This includes looking at international destinations and emerging low-cost/high-quality of life destinations that offer both quality-of-life experiences, cash flow, and potential equity growth.
- Focus on Affordability: Where can you live better for less? Where can you travel to and vacation better for less? Look for markets where housing prices are more aligned with local wage growth. These areas might offer more stable long-term returns and stronger cash flow.
- Stay Informed: Stick with STR Scout and keep an eye on economic indicators, market trends, and real estate trends in STR destinations of interest. Being proactive about changes can help you make timely decisions.
- Value-Add Investments: Consider properties where you can add value through renovations, additions, mid-term rentals, room rentals, lock-offs, or improvements that matter most to guests. This can help you compete better and command higher rents or resale prices, providing a buffer against market volatility.
- Flexible Strategies: Be prepared to adjust your investment strategy based on market conditions. Whether it’s shifting from short-term rentals to long-term leases or selling when the market is high, flexibility is key.
- Make Money When You Buy: “You make money when you buy,” meaning buy at the right time in the cycle, and buy at the right price. Be selective, find the right market, be conservative with projections, negotiate the right price, or don’t buy it.
The housing market is a complex beast, and while low supply might seem like a surefire way to ensure rising prices, the reality is far more nuanced. High prices, low demand, an uncertain economy, and stagnant wage growth can create significant volatility and potential price declines, even if rates fall. As an STR and Airbnb investor, staying informed and being strategic about where and how you invest is crucial.
Understanding these dynamics will help you navigate the market more effectively and make smarter investment decisions. Keep an eye on the bigger picture, and don’t get caught up in the media hype that low supply means prices will just go up, up, and away. Consider the broader economic context.
So, the next time someone tells you that low supply means prices can only go up, you’ll know the story isn’t that simple. Stay savvy, stay informed, and happy investing!
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