What’s up with the real estate market? | Guest column

As we all know, the residential real estate market and prices have been on a tear for several years, and this was only accelerated by COVID.

The reason for the dramatic rise in prices is simple: supply and demand. Following the 2008 financial crisis, home builders have been much more cautious and deliberate in ramping new construction. This has caused a serious shortage in the supply of new housing across the country.

Based on historic data, the shortfall in supply is estimated to be running 40-50% below long-term sustainable demand.

We get a lot of questions from clients about whether the strong house price gains can last. Is the “bubble” ending? We believe, at least in the near term and barring a major economic setback, housing prices will continue to rise at a rate above that of overall inflation due to the continuing supply shortfall. So, no, the housing “bubble” will most likely not end soon in our estimation.

Real estate figures prominently as an important asset for many of our clients. For any asset class, so-called “bubbles,” or a rapid rise in the price of an asset, have both emotional and financial implications.

Rising or high asset levels, whether it be stocks or real estate, tend to increase one’s financial “confidence” resulting in a tendency to overspend. Bubbles can also lead to short-term myopia, known as recency bias, that can cause people to buy and sell assets at the wrong time. Emotions tend to be very heady or euphoric near the tops of markets, leading to the risk of buying at the top. Conversely, massive market declines create fear, which causes investors to shun the asset when the opportunity to buy is best.

Is the “emotional” phenomenon we see in stock bubbles now occurring in residential real estate? In some ways, yes, in the sense that a dramatic rise in price is probably driving emotion-based buying (i.e. fear of missing out). In other ways, it is not similar. Primary residences are generally considered a long-term asset and tend to have lower price volatility. Also, unlike stocks, homes have less chance for “sequence of returns” risk (a rapid decline in investment assets early into one’s retirement). But there can be instances in which an emotionally-driven or ill-timed home purchase can have a negative financial impact, particularly as it relates to constrained future cash flow or impairing other important savings goals.

From a financial planning perspective, the “emotional connection” to our major assets, whether securities investments or real estate, needs to be recognized and understood in order to optimize asset resources and better prepare for long-term success, particularly in retirement.

Diversification of investment holdings and a disciplined investment plan are ways we can reduce the risk of emotion-driven investing (particularly trying to time the market). While diversification within real estate may be impractical for most people, the goal of a balanced allocation between real estate and dividend stocks, for example, can help mitigate financial risk in retirement through diversification of income streams.

Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.