A Real Estate Growth Market or a Bubble? How to Tell the Difference

Home prices took a nosedive during the Great Recession that started in 2008. Prices fell in all local markets, but much more in some than others. And afterwards some had a better recovery than others. Why? And, more important, could we have predicted that?

Job growth is part of the story, but not a very useful one because nobody can predict which markets will have more jobs in the future. Furthermore, how come San Francisco and Denver had the same job loss in the recession, but home prices fell 20 percent in the former and only 5 percent in the latter?

Something else is at work here and we can capture it by comparing real home prices with the "income" price -- the price that balances with local income. It is what we at Local Market Monitor call the Equilibrium Home Price.

Then we see that San Francisco was overpriced 50 percent right before the recession, Denver only 20 percent. Markets that were the most overpriced before the recession -- many in Arizona, Florida and California -- also had the largest drop in home prices.

The income price has been a very successful forecasting tool for decades -- not just in this recession. When markets are overpriced or underpriced, home prices always return to the income price.

We can use this to our advantage in 2017 because some investment strategies have a better chance for success in markets that are overpriced and underpriced.

Overpriced Markets

You might think an overpriced market -- or one that soon will be overpriced because of big price increases -- is one to stay away from. But, as long as you avoid buying at the peak, these markets can have the strongest price gains. And overpriced markets don't necessarily crash afterwards -- most of the time they just level off. In these markets you're speculating, no question about it, but you can minimize your risk by paying close attention to the dynamics of the price changes and the state of the local economy.

First, the price dynamics. An overpriced market got that way because home prices accelerated, and the peak of the boom is reached after they decelerate -- they still increase but at a slower and slower rate.

Next, the local economy. Once prices do peak, a crash is only likely if the local economy is poor. If job growth remains reasonable, prices are most likely to just level off.

Underpriced Markets

Unless the market is dying -- a small market that has lost its only large employer -- home prices will eventually recover. But is it worth your while to wait? This, again, is a speculative proposition. But the payoff can be good because recovering prices will not just return to the income price, they'll probably shoot well above it because of shortage of housing.

In short, look for underpriced markets where prices are in fact rising again, and make sure the rise in prices is linked to better job growth.