How will a Recession Affect California Home Prices

The biggest question on every California home buyer's mind right now is how will the impending recession affect home prices. Before we really get into it, let's first look at the definition of a Recession.

re·ces·sion/rəˈseSH(ə)n

A few more important questions are will there even be a recession, and if yes, when will it happen. A popular answer to that question among economists is 2020, although if it doesn't happen in 2020 then there is still a good chance of a recession in 2021 and 2022 according to the chart below.

Everyone remembers what happened in 2008 when property values dropped during the recession. But what was the cause of that recession? And do property values always drop during a recession? Let's look at a chart of the 6 most recent recessions dating back to 1980.

The year that stands out of course is 2008. Property values dropped 19.7% on a national level and even more in many areas of California. But look at the recessions in 1980, 1981, 1991, and 2001. Property values actually went up in 1980, 1981, and 2001. In 1991 properties values only went down 1.9%, which can hardly be called a bubble. So what is the explanation for why values dropped so much in 2008? Well in 2008 it was real estate that led the US economy into the recession. In 2008 you pretty much just needed a pulse to get a mortgage. There were stated income programs for people with low FICO scores and no down payment. People were buying homes with mortgage payments they couldn't afford on adjustable rate mortgages. The thinking at the time was property values would continue to go up forever. 

In 2019, it is far more difficult to get a mortgage. You need to have verifiable income, good credit, and except for the case of a Veteran using the VA loan program, a down payment. And while we're on the subject of the Zero Down VA loan program, it is important to note that even in 2008 VA did not loosen their underwriting standards. Even though VA has always allowed for 100% financing, VA had the lowest default rate of any loan program after 2008. A big reason for that is because VA makes sure the Veteran can afford the payment before closing the loan.

The chart below shows the Mortgage Credit Availability Index going back to 2004. Notice that in 2006 and 2007 the index reached a very high peak before crashing down in 2008. That is when underwriting guidelines tightened. And over the last 10 years underwriting standards have remained tight. 

Interest Rates During a Recession

During a recession mortgage rates will typically drop. We are in an interesting situation right now because interest rates are already very low. The Federal Reserves is not expected to lower rates further, UNLESS there is a recession. For now, interest rates are expected to stay in the same current range of 3.7% to 3.8%. While home prices may be high in California, there are still plenty of renters who would like to buy a home and can afford it. Interest rates are doing their part to help with mortgage affordability. 

Property values are affected by several factors. But when you really get down to it, supply and demand is what real estate values are all about. Are there more willing and able buyers than sellers? If so, then property values will continue to rise. Low interest rates and rising rents  will also help to push values higher. Unemployment is at or near all time lows. So even though home values in California are unaffordable for many, there are still plenty of renters who can afford to buy and will be looking to dive into the real estate market in the next couple of years. 

An interesting analysis looks at birth rates going back to 1928. The median age of a first time buyer is 33. To see how many people will be turning 33 each year we have to go back 33 years and review birth rates. The chart below shows birth rates increased significantly from 1986 for the next several years. These millennial's are established in their jobs, getting married, and ready to buy their first home. There will be more buyers entering the market each year for the next several years. This will increase demand at a time when supply continues to be low. This will result in prices continuing to rise whether there is a recession or not.

Property values are expected to increase each year through 2022, ranging from 2.2% to 5.4% per year. Price appreciation between 2% and 3% per year is a nice steady range. For a home buyer, there is not a better return on investment than buying a home. If we assume a home buyer purchases a $500,000 home with 20% down ($100,000) and values increase 2.5% to $512,500, the home buyer has realized a 12.5% return on his $100,000 down payment. If the buyer only put 10% down ($50,000), then the return is 25%. ($12,500 return on $50,000 down payment). If the down payment was only 5%, the return is 50%. And for a Veteran with $0 down payment, the return can't even be calculated since there was no initial investment. But let's assume the Veteran did have $10,000 in closing costs. The return is 125% in the first year. And don't forget, part of your monthly payment is Principal, which is not an expense. It is the actual paying down of the loan. A home owners future net worth will be far higher with these types of returns versus a renter who is helping their landlord payoff the mortgage.

As we head into 2020, all signs point to a continued strong real estate market, whether we have a recession or not. Interest rates are expected to stay low. Demand for homes from new buyers will continue to be strong as Millennial's reach prime home buying age. Supply will continue to be tight in most markets. And based on all these factors, including supply and demand, property values are expected in appreciate. This is a great time to buy a home in California.