Given how hot the housing market currently is, let’s look ahead to see what bad things might occur to derail the trend. This post looks at the cities most at risk of a housing downturn so you can better invest your real estate capital.
In brief, here are the things that could cause a national housing downturn:
- Interest rates go up too much too quickly
- Overly loose lending standards
- A virus that negatively affects fertility rates
- New oppressive real estate taxation laws
Real Estate Supply And Demand
One of the reasons why it took me until 2016 to invest aggressively in the heartland was because I was always worried about supply. If you can build an endless number of homes due to an endless amount of land, that doesn’t bode well for price appreciation.
Here in San Francisco, it is extremely difficult to build new housing. The city is only about 49 square miles and it is surrounded by water on three sides. Further, a large part of the city is zoned for single-family homes. And most homeowners won’t vote to build in their backyard (NIMBY) due to noise, density, blocked views, blocked sun, less parking, more traffic, and potentially more crime.
Our city’s bloat, corruption, and inefficiency have ironically been a boon to homeowners as well. For example, it has taken me over one year to get a permit to remodel a rental property partly because the Department of Building botched a multi-million dollar online permit system. They ultimately had to scratch it and start all over. As a result, fewer property owners could get permits to build new units.
Once I decided there would be a positive demographic trend towards lower-cost areas of the country, I decided to first invest $260,000 in the heartland. Then I invested another $550,000 after selling my SF rental home in San Francisco in 2017.
I bet the growth in new people and new jobs into the heartland would more than outweigh the potential for new supply. So far, the bet has mostly worked. However, there’s now a growing risk of a housing downturn since prices have risen so much and a lot more supply is coming.
Heartland Cities May Be The Most At Risk Of A Downturn
Take a look at this fantastic chart by John Burns R.E. Consulting. The vertical Y-axis shows the price of the Burns Home Value Index. The horizontal X-axis shows Single-Family Permits. Both figures are relative to the prior peak.
As a real estate investor, you want to be investing in real estate in cities that are up the least versus the prior peak and have the largest decline in permits versus the prior peak. The lower to the bottom left, the better.
In other words, investing in cities such as Chicago, Las Vegas, and Miami look relatively attractive. These cities are all in the green box. However, do note that cities such as Chicago and Minneapolis have been dirt cheap for a while. Perhaps the inclement weather for four months a year is too hard to structurally overcome. Or maybe it’s the high taxes and mismanaged local government.
On the flip side, you want to stay away from cities that are up the most since the prior peak and also have the highest single-family permits issuances versus the prior peak. These cities are all in the heartland: Austin, Dallas, Nashville, and Houston. Raleigh-Durham isn’t looking too hot either as an investment.
Based on the enormous housing price gains in Texas cities, I no longer am excited to buy there. The supply is coming and will put pressure on home prices. Instead, cities such as Philadelphia, Charlotte, Las Vegas, and Orlando look more interesting due to fewer permits issued.
The Artificially Constrained Cities
Cities in the top left quadrant, where prices have risen, but permits are still way below peak are very interesting. Artificial forces are at work to limit permits, despite healthy price increases.
Artificial reasons should be considered a risk because we have the power to change. However, cynically, it’s hard to believe some city governments will ever become more efficient. We also must believe that homeowners will always act in their best self-interest. Therefore, the possibility of a housing downturn in such cities may be lower.
Today, New York looks like the most interesting big city for investors. Not only are prices up just ~20% from their previous peak, but permits are also down ~35%. More people are returning to big cities for opportunity, and NYC is clearly back.
Real Estate Boom And Bust Cycles
Real estate tends to go through boom and bust cycles because developers cannot time their acquisition of land and construction perfectly.
As home prices rise, more developers are willing to build given their profit margins will expand. Although building costs (material and labor) have risen as well, building costs are almost always lower than home sale prices. If they weren’t, builders wouldn’t build.
For example, with Austin real estate prices 160% higher than the previous peak, some developers might only now be motivated to acquire land and build. However, by the time the finished product is ready to be sold or rented two or three years from now, there might be Hypersupply (Phase III), which ultimately leads to a downturn.
Single-family permits are FORWARD-LOOKING indicators. You can get the permit, but you’ve still got to go through multiple phases of inspection to have your construction finally approved. As I’ve said before, to get rich, you must practice accurately predicting the future.
Taking Forever To Get A Permit Approved
As I said, it has taken me one year to get a permit approved for a ~600 square foot remodel. I’m just talking about remodeling within the envelope and not an expansion. I’ve decided to reclaim about 250 square feet of wasted garage space, while still leaving enough space for one-car parking.
After a year of waiting to get the plans approved, we now have to spend 1-2 months doing the rough. The rough is the plumbing, electrical, and mechanical with open walls. It also includes installing the windows without covering with stucco. Only after these items are approved can you cover up the walls. The inspector will then come out and make sure everything is properly installed.
Then, if we’re lucky, we’ll have to spend another month, installing the finishes (tiles, fixtures, mirrors, cabinets, floors, etc). However, with my luck, I’m sure I will not have enough of at least one product, which will end up being on backorder for months. Therefore, let’s call it two months to do the finishing.
In other words, the project I started at the beginning of 2020 likely won’t finish until 1H2022, or one year later than anticipated. If I had wanted to sell the property in 1H2021, delaying for a year would cut significantly cut into profits. As of now, my loss is the opportunity cost of not renting out the space.
This difficulty of getting a permit and then getting through the approval process with multiple inspectors is why so many property owners elect not to get a permit. Not only can you get construction done quicker, you also get to save on higher property taxes. In cities where building restrictions are highest, the demand to remodel without a permit is also the highest.
The irony is that the harder it is to get a building permit, the better it is for existing home prices. It is next to impossible to build an ADU in San Francisco, which helps boost supply. I tried!
A Housing Downturn Will Not Be Uniform
House price appreciation will slow no doubt. But I don’t believe there will be a national housing downturn for years to come.
Just be careful about investing in cities with tremendous upcoming supply after already massive price increases. I would be looking elsewhere if your real estate portfolio is already very heartland-heavy.
With the country slowly going back to normal, I suspect incremental capital will go back to where job opportunities are the greatest and prices have lagged the most. Then again, the cities that have gained the most in price could keep on going for years due to growing network effects.
When it comes to forecasting a potential housing downturn, forecasting supply is paramount. If you are investing in real estate today, I would look to surgically invest in cities with lower upcoming supply and lower price appreciation so far.
Readers, which cities do you think are at risk of a housing downturn and why? Do you believe real estate in Texas is at greatest risk of declining? Which cities are you looking to buy real estate today? For more nuances personal finance content, you can join 50,000+ others and sign up for my free weekly newsletter.