Following our post last week about the commercial real estate market, we now turn to the residential housing market. In this market, as with the commercial one, there has been talk about the possibility of a crisis. Some markets are experiencing low inventory and, thus, higher prices, while other markets face weak demand and high inventory. With the Fed’s most recent interest rate hike, there is also increased uncertainty regarding the future of the housing market—buyers may be waiting for rates to drop, while sellers may be unable to sell.
Some key trends discussed in this post are: increased borrowing costs, housing market gridlock, zombie loans, and an HELOC boom. Regardless of whether your clients are directly affected by any of these, they are all indirectly affected by the news and bigger implications of these trends. As a Financial Professional it is important to know the ramifications of different market trends and how they may affect clients—both individually and at a higher level.
In the context of the residential housing market the most important downstream consequences from the pandemic are: (1) financial hardship assistance; and (2) inflation. During the pandemic, many borrowers benefitted from expanded forbearance and financial assistance options. As those programs end, defaults and foreclosures that would have happened years ago are now happening in larger numbers. Regarding (2), supply chain disruptions caused by lockdowns led to reduced product supply, which, in turn, increased prices, and sustained inflation. To combat inflation, the Federal Reserve Board has raised interest rates eleven times since March 20221.
In the residential real estate market, home foreclosure rates are steadily increasing. In fact, foreclosure filings (defaults, scheduled auctions, and repossessions) in May 2023 were 14% higher than in May20222.This is largely due to the increased cost of living (inflation) and the end of COVID-19-related debt relief programs (i.e., student loan debt, forbearance programs). This means that some, if not most, of this increase in foreclosure starts was anticipated—relief programs seemingly delayed the inevitable for many households, as current foreclosure rates are on-par with those witnessed pre-pandemic. However, the rising cost of living is resulting in foreclosures as well. While inflation has started to decrease it is still almost twice what it was pre-pandemic—leading the Fed to state it will likely keep interest rates high until inflation is closer to 2%. This means that as debts come due after years of forbearance and the costs of living outpace any increases in income, foreclosure filings will likely continue to rise. This is not an ominous sign of a reemerging housing crisis as there is one very important factor that sets now apart from the situation in 2007-2008: low unemployment. This will buoy many homeowners’ financial health, keeping the housing situation far from crisis level.
For the single-family housing market, one of the greatest issues is gridlock. The problem is best represented by this statistic: only 9%of all mortgages currently in existence have an interest rate above 6%, despite interest rates having been above 6% since August 20223. This suggests a relatively small number of mortgages have been initiated in the last year. This is because millions of current and potential homeowners took advantage of the extremely low rates available during the COVID-19 pandemic. Borrowers with these exceptionally good rates are waiting for rates to go back down before selling—if they were to sell or refinance now, the cost of homeownership would increase exponentially. Thus, they have no incentive to sell their house. This has led to a large drop in supply—new listings are currently 27% lower than they were just a year ago4. This reduced supply has led to a further increase in the cost of buying a new home—not only are borrowing costs higher, but purchase prices have also become inflated. While the rate can eventually be renegotiated (via refinance), the purchase price cannot be refunded when supply returns to more normal levels. For this reason, purchase price attractiveness is more important than interest rates (assuming rates will normalize at some point in the near future). There are now two good reasons not to buy or sell (increased borrowing costs and increased list prices), which only perpetuate the gridlock.
Another interesting trend in the residential mortgage-backed securities market is the reemergence of some Non-Performing Loans or NPLs. NPLs are loans in delinquency of at least 30 days and still accruing interest or delinquent loans in non-accrual status. These loans are often off-loaded by banks to investors—both individuals and Wall Street firms like Goldman-Sachs. This means the banks have written off the loans, but borrowers technically still owe on them. Investors can buy these NPLs for significantly less than their face value—hoping to make a profit by turning the loans into reperforming loans. Many of these NPLs date back to the aftermath of the housing crisis and have been non-performing for many years—so long, in fact, that most borrowers forgot they existed or assumed they had been closed. This is when NPLs take on “zombie” status—borrowers believe the debt has been cleared, but then the loan returns several years later5.
Even though the current ratio of NPLs to non-delinquent loans is very low, this ratio was over five times higher in 2009 following the housing crisis and remained above 3% until 20136. It is from this large pool of NPLs that zombie loans are currently emerging. Zombie loans have reappeared because they have become more attractive to investors in the face of dramatically increased home prices (higher home prices result in greater home equity). Since second mortgages are only paid off if equity remains in the home after the first mortgage lender is paid, higher home values make NPLs more lucrative because as home equity increases the chances of collecting any money at all are much higher. Even individual investors are holding hundreds to thousands of NPLs in the hopes of generating passive income (via reperformance), receiving a lump sum payout in the face of settlement or foreclosure, or reselling the loan to another investor once it has become reperforming.
An increasing number of homeowners are tapping into their accumulated home equity via Home Equity Lines of Credit (HELOCs)—new HELOC originations increased by 34% from 2021 to 20227. Higher interest rates have made refinancing less attractive, leading many to turn to HELOCs. And lenders have encouraged this by making such funds more easily available to combat the dearth of refis (many banks had made HELOCs harder to get because they are considered second mortgages and, as such, represent increased risk for banks as they are only paid off after primary mortgage obligations are met).
Source:Federal Reserve Bank of St. Louis (FRED)
Notes: (1) This is the first time we've seen an uptick in HELOCs since the housing crisis. (2) The gray box indicates the Great Recession (December 2007 – May 2009).
However, the increased interest rates also make HELOCs more costly—most are set up with variable interest terms so that, as the Fed increases rates, the associated borrowing costs also increase. This adds up quickly for homeowners with sizeable equity. Homeowners are generally using this liquidity to make investments—in property or otherwise. However, the high interest rates make the potential investment opportunities less attractive, meaning some HELOC holders have interest payments that aren’t being covered by increased income. At least anecdotally, it appears homeowners taking out HELOCs are more focused on the access to liquidity than the borrowing costs that may make that access prohibitively expensive.
Financial Professionals may see clients facing several issues in the residential housing market—some clients may be vested in properties that are no longer worth more than the loans on them, they may be stuck in a real estate situation that they cannot get out of because of market gridlock, or they may be considering alternative access to liquidity via their home equity. While clients should be making financial decisions aligned with their overall plan and time horizon, many may deviate because of behavioral blind spots. Some particularly relevant ones are mental accounting and positive illusions.
As discussed on this blog before, mental accounting is how individuals track their money. It includes things such as categorizing money (setting up accounts by fund type, such as savings), budgeting, and how individuals evaluate prices. The latter—evaluation of prices—is, at its most basic level, whether individuals feel good, neutral, or bad about a certain price level. Price levels can include stock prices, home prices, and grocery prices.
The feelings an individual has about a price are driven by something called a reference price. This is the price an individual expects to pay or a price they deem as fair. This price is often determined via “normal” prices or the price the individual paid in the past. For example, if you buy eggs weekly, you may have a strong reference price for a carton of eggs—this would be the price you normally pay for eggs. When the actual price goes above your reference price, you feel that price is “bad” or unfair8; when the actual price remains about the same, you feel neutral; and when the actual price is below the reference price, you feel good. So, when the price of eggs increased 35% on average in one month (December 2022 – January 2023)9, anyone with even a semi-accurate reference price for eggs felt the pain of that price increase more acutely.
The other data used to create a reference price is the price paid for something previously. While this is, in essence, what is described above, the difference is the context—this is relevant when an individual is considering selling the thing they own. This means the feelings about the price are the opposite of what is described above—we feel bad when the sale price is below the reference price; neutral when it is equal to the reference price; and good when it is above the reference price. Sometimes the reference point in this context is also the most memorable past price (i.e., the highest price the item sold for before).
Consider this in the context of selling a house, if the price offered on the home (or the price the real estate agent recommends listing for) is less than what the individual paid for it or is less than an especially memorable high price, they will be less likely to sell. This is because the seller is evaluating the price based on a memorable past price, which has become their reference price. Any sale below that reference price will be coded as a loss by that individual. This also means they are more likely to wait for the potential sale price of the house to increase to the reference price (or higher) before selling. To many people, this sounds intuitive and sensical. In reality, it is too simplistic of a decision calculus—it ignores holding costs, transaction costs, and the potential impact on overall wealth.
For clients invested in residential real estate that is declining in value10, they may be hesitant to sell at a price below their reference price. However, this may not be the best decision for them overall. Specifically, if they continue to hold, they are spending money (assuming there’s a mortgage) every month just to avoid the loss of selling below the reference price. They could use this money on other investment opportunities (or just invest it in the money market and earn interest).
To guide clients who use mental accounting to make financial decisions, focus them on the bigger picture. One of the main problems is these clients are focused too narrowly and are assessing the decision based primarily on a single component of their overall wealth; so they need help contextualizing the impact of such a decision across their holdings and with respect to their overall goals. FPs can facilitate this by showing a client the opportunity costs from holding the property and how the loss from the sale could be compensated for by gains in other areas. For example, if a client is paying $2,000 per month on a mortgage and they hold that property for another year, that’s $24,000 that could be used elsewhere (including earning approximately $1,000 in interest in those 12 months).
Many people display positive illusions. There are three main manifestations of positive illusions: (1) an inflated sense of oneself, (2) unrealistic optimism, and (3) illusions of control11. The second is also called an optimism bias and is the tendency for someone to overestimate the probability of good events happening to them and underestimate the probability of bad events happening to them. While positive illusions serve an adaptive purpose—they make us more persistent in the face of adversity, they increase feelings of contentment, and they protect our self-esteem—there is no research that has demonstrated they increase the quality of financial decision-making.
If a client holding property instead of selling cites an expectation that interest rates could drop, thereby increasing the demand for properties, they are likely falling victim to an optimism bias. To counteract this, use a pre-mortem or help them take an outside view. For the former, ask them to imagine it’s a year from now and interest rates have held where they currently are, what would they tell themselves to do if they could go back in time? To provide an outside view, remind the client that interest rates dropping may not happen any time soon (the effects of interest rate changes can take a year or more to manifest in the larger economy—see chart below); and declining interest rates will also increase housing supply, which will put downward pressure on home prices (in other words, the list price could be even lower than what it is currently).
Source: St. Louis Federal Reserve Board (FRED) FederalFunds Effective Rate Data
Note: (1) This demonstrates that, over the past 30 years, periods of increasing rates didn’t see decreasing trends again for at least a year. (2) Gray shaded areas represent periods where rates started increasing and remained increasing or steady—the shaded areas end when rates started to decline again.
Several key trends in the residential housing market have emerged since the end of the COVID-19 pandemic: increased borrowing costs (due to increased interest rates), market gridlock, and a relative HELOC boom. During this time of uncertainty, individuals may make financial decisions based on cognitive biases and illusions—such as mental accounting or unrealistic optimism. As an FP, it is important to understand how these blind spots can prevent your clients from making optimal decisions. Being aware of and knowledgeable about these tendencies can help FPs keep their clients’ behavior aligned with their goals and support those clients in the best way possible as they navigate economic uncertainty.
 Nowacki, Lauren. “2023 Fed Rate Hike Impact on Mortgages, Home Buying and More.” Rocket Mortgage, Jul 04 2023, https://www.rocketmortgage.com/learn/fed-rate-hike.
 Wile, Rob. “Home Foreclosures Are Rising Nationwide, with Florida, California and Texas in the Lead.” NBC News, 9 Jun 2023, https://www.nbcnews.com/business/economy/home-foreclosures-rising-in-us-where-which-states-rcna88394.
 Swaminathan, Aarthi. “Only a Tenth of Mortgages Have an Interest Rate above 6% — That’s a Big Problem for the U.S. Housing Market.” MarketWatch, 14 Jul 2023, https://www.marketwatch.com/story/only-a-tenth-of-mortgages-have-an-interest-rate-above-6-thats-a-big-problem-for-the-u-s-housing-market-36d1029e.
 Marx, Sarah. “Share of Mortgages in Forbearance Drops in June.” HousingWire, 17 Jul 2023, https://www.housingwire.com/articles/the-share-of-mortgage-loans-in-forbearance-decreased-by-5-basis-points-in-june-2023-relative-to-may-2023-to-0-44-from-0-49.
There is reason to think supply may go up—at least in certain areas—relatively soon. Data on Airbnb bookings has shown some movement away from non-urban locations that became quite popular during COVID-19 back to cities. This reduced demand lowers the prices hosts can charge in less popular areas. This is most problematic for individuals or companies who bought larger numbers of properties in a concentrated area to capitalize on low borrowing costs and changing travel trends. Owning a swath of less popular properties may no longer be profitable—leading holders to off-load some of their properties. This increases supply in the housing market, which has no effect on the cost of borrowing, but does put downward pressure on purchase prices. See: Morris, Chris. “Is Airbnb Crashing or Not? It Depends on What Data You Look At.” Fast Company, 13 Jul 2023, https://www.fastcompany.com/90922430/is-airbnb-crashing-or-not-it-depends-on-what-data-you-look-at.
 It is important to note that not all NPLs are zombie loans—some NPLs are written off and further collection is never attempted. Even more importantly, there are statutes of limitations that prevent collection after a certain amount of time (usually less than 10 years, but it varies by state). This means that many zombie loan holders are pursuing borrowers unlawfully (and the Consumer Financial Protection Bureau, or CFPB, has taken notice: https://www.consumerfinance.gov/about-us/blog/zombie-second-mortgages-when-collectors-come-for-long-forgotten-home-loans/).
 “Non-Performing Loans as a Share of Total Gross Loans in the United States from 2009 to 2022.” Statista, https://www.statista.com/statistics/211047/percentage-of-non-performing-loans-held-by-us-banks/.
 Ballentine, Claire, and Paulina Cachero. “US Homeowners Are Tapping $9 Trillion in Real Estate Wealth.” Bloomberg, 15Jul 2023, https://www.bloomberg.com/news/articles/2023-07-15/rising-real-estate-prices-make-helocs-popular-for-owners-tapping-equity.
 How “bad” do consumers tend to feel? Twice as bad as if it were an equivalent gain. So, if the price of eggs increases by $2, that feels like a loss of $4. This comes from loss aversion and explains why increasing prices has to be done thoughtfully since consumers will respond much more negatively to price increases than they will respond positively to price decreases. In the context of mental accounting and pricing, the reference price is the reference point that determines whether something is a loss or a gain. In other words, the reference price is how we know whether someone will feel loss aversion or not.
 U.S. Bureau of Labor Statistics, Average Price: Eggs, Grade A, Large (Cost per Dozen) in U.S. City Average [APU0000708111], retrieved from FRED, Federal Reserve Bank ofSt. Louis, https://fred.stlouisfed.org/series/APU0000708111.
 While home prices are relatively strong (especially compared to when the pandemic lockdowns first started lifting), there are major metropolitan areas that have seen significant decreases in average prices over the past year. These include (1) San Jose/Sunnyvale/Santa Clara, CA (-13.7%); (2) Anaheim/Santa Ana/Irvine, CA (-5.1%); (3) San Francisco/Oakland/Hayward, CA (-14.5%); (4) San Diego/Carlsbad, CA (-2.8%); (5) Boulder, CO (-2.6%); (6) Seattle/Tacoma/Bellevue, WA (-6.3%); (7)Portland/Vancouver/Hillsboro, OR (-2.4%); (8) Reno, NV (-10%); (9) Salt Lake City, UT (-6.1%); and (10) Austin/Round Rock, TX (-13.5%). See: “Median Sales Price of Existing Single-Family Homes for Metropolitan Areas.” The National Association of Realtors (NAR). https://www.nar.realtor/research-and-statistics/housing-statistics/metropolitan-median-area-prices-and-affordability.
 The finding of positive illusions originally came from this paper: Taylor, S.E.; Brown, J. (1988). "Illusion and well-being: A social psychological perspective on mental health". Psychological Bulletin, 103 (2): pp. 193–210. Additional components and consequences are discussed here: Kruger, Justin; Chan, Steven; Roese, Neal (2009). "(Not so) positive illusions". Behavioral and Brain Sciences. 32 (6): pp.526–527.