After an intense two-year bull market, the real estate market is showing signs of impending collapse. Mortgage applications fell for the seventh straight week for the week ending April 22, and mortgage rates rose more than 200 basis points on the year.

What does this mean for prices in May and beyond? Let’s review the possibilities.

Image source: Getty Images.

A total collapse

The case for lower prices is clear: rising interest rates are reducing demand and, for the first time in years, demand is falling below supply. Pinball machines and other short-term real estate investors see the tide breaking and try to get out of the market as quickly as possible. As they sell for less than market value, this changes the comparable prices in the valuations of other sales, and the whole market begins to fall.

Finally, the increase in interest rates also means that investors and owners with adjustable rate mortgages can no longer make their payments. They either have to sell in a low demand market or face repossession. If banks start getting their hands on homes, they will try to sell as quickly as possible – and not necessarily at the best price.

This type of perfect storm worst-case scenario is certainly bleak. We’ve seen it before in housing in 2008, and it’s the same type of emotional selling we see when high-flying growth stocks crash. The market has been supported by easy money for a while, and the Federal Reserve has just thrown down the stool.

Of course, it’s likely that this type of collapse is more of an outlier black swan-type event. More likely, May will be a month of transition, either into a long-term downtrend or into a more constrained market.

A high-end market

While it seems certain that house prices are overvalued, that doesn’t mean they have to revert to the mean all of a sudden. The S&P CoreLogic Case-Shiller Index, which measures changes in the selling prices of single-family homes in the United States, rose 34% from February 2020 to February 2022.

The Case-Shiller index isn’t perfect, but this kind of house price growth is unprecedented over two years, especially when some of it happened during a recession.

What caused this level of growth? It started with the inflation of building materials. Wood prices went up 400% at one point. Steel prices rose 67%. Couple that with supply chain shortages and pandemic-related work stoppages, and you have a supply shortage. Even if demand remained constant, prices would probably have increased more than general inflation.

But demand has not remained constant. The increase in work-from-home opportunities has led many Americans to leave big cities for more rural areas. However, the exodus was probably not at the level one would expect. Cities like Los Angeles (176,000), San Francisco (116,000), and Chicago (91,000) all lost residents from 2020 to 2021, but none of them lost millions. Either way, any level of increase in demand coupled with the shortage of supply was sure to raise prices.

What does this mean for May? Builders have become accustomed to quick sales on specific homes. In Utah, where I live, it was not uncommon just a few months ago for new homes to have 15 or more offers on their first day of listing. Homes routinely cost tens of thousands of dollars more than their list price.

This type of demand is not diminishing in an instant because mortgage rates have increased by 2%. And manufacturers also have a budget constraint. They can stop pricing with as much margin as they were, but the prices will only go down until they lose money. In the meantime, don’t be surprised if some sellers have been waiting for the market to peak and start listing their homes now, before it’s too late.

My guess is that there will be a slower decline in demand than the doomsday scenario above would require, and that supply will remain constrained for the foreseeable future.

All of this would mean a range-bound market. In stocks, a range bound market is when prices remain within a specific range for an extended period of time. They may go up 10% for a few months and then go down 10% over the next few months, but they don’t turn into a new long-term uptrend or downtrend.

So where are we going?

Smart, long-term investors may be hoping the market will calm down a bit. It’s hard to build wealth when you’re in a bidding war for every new purchase. A good investment often comes with an advantage, and there’s no advantage if you and 17 other people bid on the price of the same duplex that was built in 1977 and needs a new roof.

If you don’t want to engage in these bidding wars, the best advice right now might be to just hold steady. Continue to collect passive income from your existing properties and accumulate capital so you can strike when demand drops.

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