The Housing Bubble Discussion (Part 2)

Over the past few months I have asked the question, “Do you think Nashville is experiencing a housing bubble?” to several respected individuals involved in real estate. After talking to a banker, appraiser, commercial broker, realtors, wholesalers, and other investors, the responses have been quite varied. Some seem to think that Nashville is just beginning a growth transformation that isn’t going to stop anytime soon. They believe that with continued population growth continued housing demand will follow. And as long as there is steady demand, prices will justifiably appreciate.

While Nashville’s economy appears to be healthy, others I talked to are concerned that the national economy isn’t very strong and will eventually weaken Music City’s real estate. Many of the home buyers are moving to Nashville from California, New York, and other higher priced areas. Their money goes farther in the mid-south, buying bigger and better houses than coastal options. But any type of dip in the national economy could impact the out of state dollars that have added fuel to Nashville’s housing fire. Even if Nashville’s local market sustains its growth, it isn’t immune to unfavorable outside forces.

More than anything, most of the real estate insiders that I talked to are excited. They are pumped up about the record numbers of sales, the incredible amount of new construction, and the piles of profit resulting from the boom times. This excitement can be fun and harmless, but it can also breed and contribute to the facade of never-ending optimism. Some Nashvillians may believe that Music City is in a magical world of rising equity where no harm can touch our housing market, but our city is simply not that special. Every other city that has risen dramatically eventually levels off. Barry Nielson with Investopedia describes how it doesn’t last forever:

"Too often, homeowners make the damaging error of assuming recent price performance will continue into the future without first considering the long-term rates of price appreciation and the potential for mean reversion. The laws of physics state that when any object (which has a density greater than air) is propelled upward, it will return to earth because of the forces of gravity act upon it. The laws of finance say that markets that go through periods of rapid price appreciation or depreciation will, in time, revert to a price point that puts them in line with where their long-term average rates of appreciation indicate they should be. This is known as mean reversion. Prices in the housing market follow this law of mean reversion too – after periods of rapid price appreciation (or depreciation), they revert to where their long-term average rates of appreciation indicate they should be. Home price mean reversion can be rapid or gradual. Home prices might fall (or rise) quickly to a point that puts them back in line with the long-term average, or they might stay constant until the long-term average catches up with them."

It seems that at some point Nashville’s housing prices will need to slow down, flatten out, or even decline in order to revert to the long term average. The question is at what point will that occur? It is often hard to tell when the market is at its peak until it has already started to descend.

Another question I frequently raise is, “What about interest rates?” For an unprecedented length of time, the Federal Reserve has maintained artificially low interest rates. With a 15 year mortgage at just over 3.1% and a 30 year term only 3.8%, borrowers can buy about as much house per monthly payment as ever before. These nearly historical low rates cannot last. Once they also revert closer to average, housing prices may stall as buyers are forced to come to terms with having less buying power.

But until interest rates change, many buyers want to take advantage of cheap money and buy as much house as they can. Likewise, investors are flocking to Nashville for easy profits while lenders are loosening some of the requirements. Investors typically pay a minimum down payment of 20-25% of the purchase price for investment property. However, I just heard of a local bank who is only requiring 10% down of a project’s total price for a renovation or new construction. This lowered entrance barrier has allowed more beginning investors, builders, and developers to enter the market, as well as more volume for those already involved. These extra buyers are simply increasing demand for land and housing of all types. Yet again, the prices rise as a result. What are the eventual effects of the rising costs?

If prices in Nashville’s core neighborhoods continue elevating, some buyers will elect to head to the suburbs. Why settle for an old 1,000 square foot house with one bathroom and a small kitchen in Sylvan Heights, when the same dollar figure can buy a newer subdivision house in Mt. Juliet that features a massive kitchen and master suite with a five piece bathroom and double walk-in closets? Some buyers have already made that selection, as well as Nashville residents who have chosen to sell their in-town houses while the market is up and take a chunk of cash with them to live in a surrounding county.

If Nashville’s surrounding counties become too expensive, some individuals and families may choose to leave middle Tennessee altogether. I wrote about Housing Prices in Other US Cities, where it is quite clear that Indianapolis, Louisville, Cincinnati, Memphis, and Knoxville all have significantly cheaper housing.

At some point, the type of residents that Nashville wants to keep may not be able to afford to stay, and prices will fall when there are less buyers and more inventory. Until that time comes, enjoy the ride. Buy smart, invest smart, cash out if desired, and be prepared for an eventual correction of the market.