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
- Oversupply
- Overly loose lending standards
- A virus that negatively affects fertility rates
- Stagflation
- 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.
Here is my 2022 housing market forecast. Overall, I'm bullish on real estate. However, it's important to be aware of upcoming supply.
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 because it restricts supply. It is next to impossible to build an ADU in San Francisco, I tried! And when demand for housing is high, and supply is limited, as a homeowner you might just be able to make more money from your homes than your salary.
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.
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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.
Posting on this older because I just saw a Consumer Affairs article entitled, “Smaller cities may be among 2022’s fastest-growing real estate markets” https://www.consumeraffairs.com/news/smaller-cities-may-be-among-2022s-fastest-growing-real-estate-markets-120821.html and it says, “Concentrated in the Mountain West, the Midwest, and New England, 2022’s top 10 housing markets are predicted to be” consistent with what you have said.
What kind of cap rates are you typically looking for now days? Been heavily invested in Las Vegas for a while but cap rates are getting difficult. Would you suggest to wait out for them to return to 6+? or are those days over? Also, curious to hear how has your fundrise portfolio been doing vs investing in heartland or other cities? I’ve traditionally one SFH but am really interested in throwing 200k into fundrise lately.
We just went to Houston to check out investments in single family homes (~250K, renting $2K, for cap rate ~4%). Every home we looked had multiple bids, and although the cap rate is still reasonable, the high end homes in Houston area (>$2M) are sitting on the market for months. If interest rate goes up then things will look very interesting.
Would love to hear your thoughts on Denver?
I bought a house in Austin while the prices sky rocketed. It was the toughest decision my wife and I have ever had to make.
We sold our home in August of 2020. Moved our stuff in storage to travel across the country visiting National Parks for a few months. It was amazing, I highly recommend it.
We both work remotely and could live anywhere. We talked about London, Miami, California, Arizona, Austin, and Dallas. In the end we ended up deciding Austin was the place we wanted to be.
When we returned, houses were selling sight unseen for $100K – $200K over asking. A house that was worth $500K in October was selling for $700K in February. After losing so many bids we had to make a decision. Buy, rent, or move cities?
We both work in tech. Although we are remote and can work anywhere, companies are more attracted to seeing Austin, TX on your profile. For example, I was recruited by a headhunter who couldn’t find a candidate in New York and moved their search to Austin.
The X factor for us ended up being tech moving to Austin. Tesla and Apple are the big ones, but many more small and medium sized are coming or already here. The tax benefits are too good.
I read your article about the 30 30 3 rule and some other housing articles. We decided we could make it work if we both were working. So we decided to buy even though it was painful. We are happy in Austin, and happy with our home. Although it was distressing to see our previous home valued 80% higher 6 months after we sold.
My prediction is prices will drop, but not to previous levels. My guess is a 15% price drop, maybe more. But I think it will go on the upward trend again within 5-10 years.
There are many people that were priced out of the market, so there is still some pent up demand that is building under the surface. I’m betting that California will continue to squeeze the life out of the businesses there. People and businesses from California and New York continue to move to Austin and I think that will continue for a long time. I definitely overpaid for my house, but hoping it will come around within 5-10 years. If not, we still love the house.
Congrats on your house, and I understand the pain. Long term, I think Austin is going to do great. It might see some dips here and there, but the trend is clearly there. And this is the trend that I’ve been talking about since 2016 when I wrote about investing in the Heartland of America.
Further, given you guys are making tech money, don’t the prices still seem pretty reasonable? Where did you sell your house in August 2020?
Salt Lake City is interesting to me… What most people don’t realize it is like San Francisco the land area is very limited. There are the Wasatch Mountains on one East Side and the Great Salt Lake on the West. So you can only really get land going North and South. Going far North or South is very time consuming because there is only one interstate to handle the traffic which makes for long commute times. I think Salt Lake has potential to continue going up due to the land limitations and high population growth (highest birth rate in the country) and low unemployment.
The entire Salt Lake Valley has been growing like mad that past decade now. A lot of old farms are being subdivided into dozens of properties, and new communities are springing up left and right. A number of real estate conglomerates have been buying up the small apartment complexes left and right, or simply taking over management.
It’s going to be interesting to see what it looks like in thirty years. San Francisco will not be the same city is was before Silicon Valley arrived, and Salt Lake will likely be bearing the moniker of Silicon Slopes for decades to come.
My dad used to tell me real estate was always a good thing because they weren’t making it anymore.
I live in town in Westchester County, just outside NYC. We have a lot of single dwellings. We also have a lot of formerly single dwelling that have been converted into apartments. And we have apartment buildings (mostly under stories or so) and condos. There is no appreciable crime, you can walk anywhere at any time of day or night and be fine. You can catch the train from two blocks away and be in Grand Central Station in less than half an hour. We have cars and many of us have garages. There is some bus service. Property taxes are insane.
What there is not is empty lots. There are no empty lots in the entire town. On a given day, there is also next to nothing for sale. When we retire and move I don’t know how we are going to price the house, as everything that goes up for sale tends to sell almost same day.
I don’t know how the situation will change or when. No one is allowed to convert any more single dwellings to multi, nor is there likely to ever be any large scale clearing to build big apartment buildings because, even if the expense didn’t promise to be monstrous. Zoning would never approve it as roads and infrastructure are pretty much peaked out.
Hopefully you guys are accumulating or have accumulated multiple single-family homes for future generations? Here in San Francisco, so much of the city is built out. In 20 years, our children will thank us for buying today. And if there really is elevated inflation, then they will really thank us.
St. Paul MN and Minneapolis just passed (tuesday) rent control measures. St. Paul’s is now one of the strictest in the nation. Another example of government meaning well, but ultimately causing divestment from housing.
It will be interesting to see that play out.
Fascinating. With rent control, the supply of housing will go down, and rents and property prices should go up in the medium-to-long term.
What are your thoughts on Columbus Ohio? I have a duplex and a SFH as investments, and I am looking to buy more. But might hold off.
In January 2022, Intel said it is spending $20 billion on two chip fabrication plants, or fabs, near Columbus, OH. The new “megafab” site eventually could house eight Intel fabs costing $100 billion. My advice is buy in areas that will rent to Intel employees, northwest of Columbus.
Ah, yes, forecasting demand and supply is paramount when it comes to housing…
Hopefully Zillow learned that with their new home buying business not doing so well. It makes me question their Zestimate accuracy a bit.
Glad to see a deep dive into the residential real estate market Sam! Are you aware that Zillow is laying off 25% of their staff and has paused their homebuying program for 2021?
Vancouver city council is voting this week on approving a fast-track program where applicants can pay $218 per hour to submit “requests in writing that their request for a property research letter or document request be expedited and carried out outside of regular operating hours.”
“Thus, this new fee will provide customers an avenue to expedite time sensitive requests without unfairly delaying other requests in our queue. Further, as this fee will enable staff to complete some requests outside of our regular queue, we anticipate an overall improvement to our processing service level agreement.”
Looks like permitting will become more expensive one way or another.
Sounds like a trap with no guarantee the permitting process will ever get faster. $218/hour is a lot!
The harder it is to get a permit and the more expensive it is to remodel, the more expensive homes will become. Go government bureaucracy!
I know. It’s crazy, but this is how they propose to deal with their backlog. Maybe the other market signal being sent is for small time operators to hire contractors for cash and not bother the city with renovation requests? There is so much development going on, perhaps it’s not possible for the city to police every new basement bathroom. Definitely a riskier proposition for individual homeowners.
Charlotte shows up twice on the Burns chart.
I absolutely agree that you have to look at permits and increases in supply. Not enough investors look at permit activity. Of course demand also matters, and I have and will continue investing where jobs are going.
I’d worry about buying in Charlotte at this point. NODA prices way up and even S. Charlotte prices are becoming really stupid high. There are many homes, albeit limited supply, selling for close to 1.75-2x what they were selling for in 2018-19. Not turn key homes either, these things are 70’s/80’s not updated that are being bid up past asking (typically and additional 5-10% over Ask). Homes that would require another 100k-200k worth of work at the prices contractors are charging now in the area. That roughly works out to the typically 5-600k home costing 7-800k. The same homes that were selling between 250-300k 1.5 years ago…
Some of the bigger employers in the metro are going to be reducing head counts over the next 12 months, WFC being a major one. It is an easy 30k+ displaced alone from WFC given the 100k reduction target in major cities they operate in.
To give a comparison:
Immediate family member bought (2013) and sold (2017) in basically the 2nd most coveted Asheville neighborhood for ~450k and ~600k, respectively. The home is roughly worth 700-750k in todays valuations.
Same person, turned around and bought a 400k home in 2017 for 400k in Ballentine/Piper Glen area of Charlotte. That home values at around ~700-750k now. This is a large desirable neighborhood, zero current stock and when they due sell, they are not always listed. The value barely budged until COVID times.
STARTER HOMES. This is where we are going to see the largest gains next 5 years. Especially in areas where you can still buy below replacement costs. Builders simply can not build 1200 sqft 3 bed homes and be profitable in 95% of the US.
The midwest has tons of these homes in the 100-200k range. I could see these homes doubling in nominal terms within next 5 years.
Hi Sam,
This is a really interesting analysis. Skimming the John Burns R.E. Consulting site, it looks like they track the 65 largest MSAs in the county. Would they be willing to provide all 65 to you for your readers, or is that asking too much :-)
Thanks!
Maybe! Shoot them an email and ask. You never know until you try.
When I am thinking about housing, I consider the existing benefit of Texas to be a combination of existing high-earning tech hubs, copious natural resource mining for a trade war, thinking that Work From Home is short/medium term, and thinking that inflation is more permanent. A more sticky inflation like the 1970s to pay off the national debt seems more likely than international cooperation right now. Do you have thoughts about a more dour scenario?
It’s going to be interesting to see how things play out with some of the recent institutional entrants into real estate looking for yield from flipping / renting. For example, Zillow appears to be dumping a part of their Phoenix portfolio at a loss – https://www.12news.com/article/news/local/valley/after-buying-hundreds-of-homes-zillow-taking-losses-in-the-phoenix-area/75-61c393ba-5d00-4bac-931c-ba3e73c3cc80
Being from South Florida, I am not surprised by the lack of permits. There just isn’t much land left. They have built West to the Everglades and now they are converting old golf courses to single family home sites and buying out the poorer areas and bulldozing them and building multi-family housing.
Love your analysis. I believe you wrote an article on the number of companies moving out of California (or I could have read it somewhere else) and into other states which happen to be all those in the red quadrant. Correlation? Price increases will begin to slow, eventually, but will there be a reset or will prices stabilize? Could it be the cities in the red quadrant reflect actual demand from people/jobs moving to the cities or is it artificial? All interesting questions.
Tesla and Apple have set up shop in Austin. They have surely driven housing price growth. The key is for the demand for housing thanks to demographics and job growth continuing to outstrip supply growth. It very well could, as it has done in the SF Bay Area for decades.
It’s just hard for me to chase prices up so much so quickly. I’m always trying to look for value.
Austin only has 0.5 to 1 month inventory of home supply . You need a 6 month inventory to have a good balance so it’s going to be a sellers market for a while …
We’re trying to be forward-looking though. We have to assume supply will increase with permits way up.
I think we all learned from 2020 to expect the unexpected at anytime. Although I would like to see the housing market continue to rise as a homeowner, I know that things don’t go up forever and corrections are inevitable.
Fascinating feedback on your permit experience. What a hassle! Permits can be such a huge drag but the inspections are worth it for the most part. Better to fix things when the walls are still open then deal with surprise headaches down the road. But it can be a crap shoot as well with some inspectors contradicting each other or asking to fix things that really don’t need fixing just to be a pita.
Anyway thanks for the helpful market insights!