Has Denver real estate lost its mojo?

And are we sitting on a bubble about to burst?

Anyone living along the Front Range has certainly noticed a large uptick in house prices from 2007, almost doubling in many areas.  This begs the question: Is Denver approaching a bubble? Are we going to see a correction like 2007 or the 80’s?  According to a recent article in the Denver Post, Denver’s housing market has entered a danger zone and is one of three metro areas at risk for “a severe price decline”.  Furthermore, a recent Wall Street Journal analysis highlighted Denver as one of three problem spots for overvaluation and at a high risk for a bubble.

First, what typically causes real estate appreciation?  Basic economics show that an imbalance of supply and demand is the primary culprit of any price increase (or decrease).  In the case of real estate, supply (or lack thereof) consists of existing homes, newly constructed homes and buildable lots.  Demand can come from existing residents (moving within the area), new households (first time homebuyers), relocation (net migration in/out), or dissolution of a household (divorce, death).

In Denver’s case, both supply and demand issues have converged to create the perfect storm.  Supply in Denver has been limited for several reasons, including natural boundaries (many areas to the west of metro are protected areas  such as public lands); limited water resources (to build a new subdivision requires considerable water resources that are both expensive and difficult to acquire); zoning (only limited areas are developable); lack of buildable land (as the metro has grown, the number of large tracts left has diminished); and building costs (as a result of water, zoning, building requirements, etc… costs have risen considerably for builders). 

Along with supply issues, demand has also increased considerably.  According to the most recent census estimates, Colorado gained 101,000 people last year through net migration, making Colorado the second fastest state on a percentage basis, and 7th across the nation for population gains.  The vast majority of net migration occurred in the Front Range.  Along with net migration, Denver is considered a relatively young city, so births are still outpacing deaths, furthering the increase in population.

As a result of the large strains on the available supply of houses in the metro area and the insatiable demand caused by increases in the population, Denver’s housing market has propelled to one of the fastest-appreciating in the country.  Many areas in Denver have seen double digit increases in prices the last 10 years, pushing prices well beyond the peak prices experienced before the real estate crisis in 2006. Before discussing whether Denver’s bubble will burst, it is important to understand what caused the last bubble.

What caused the last bubble in 2006 that resulted in a pronounced correction in real estate prices both in Denver and throughout the country?  The primary culprit behind the last bubble was lax lending standards.  For example, a borrower could “state” their income and still qualify for a loan.  Many of these same borrowers opted for adjustable rate mortgages (ARM’s) that adjusted based on the prime rate (or libor) and when rates increased their payments also increased substantially.  This increase in payment was unsustainable on their current income and therefore many borrowers were unable to make their payments.  A series of cascading events occurred which led to a number of defaults.  These defaults increased the supply while at the same time lending requirements tightened which led to a decrease in demand.

Fortunately, in the current real estate cycle, lax lending should not be the primary culprit for a large correction.  After the 2006 crisis a number of new laws were enacted (think Dodd Frank) to “tighten” underwriting requirements which basically eliminated the “stated” product and also ensured a borrower’s ability to repay based on their income (even for adjustable rate mortgages, the highest payment must be factored in to ensure the loan can be repaid).

So what could cause the recent run up in prices to “deflate or pop” in Denver?  A large change in supply or demand would need to occur for a sudden price correction.  On the supply side, there are gradual shifts to increase supply (new houses) but nothing large enough to drastically alter the equation.  I also don’t see a large wave of defaults with the new tighter underwriting standards.  Next, on the demand side, net in migration due to job growth, quality of life, etc. is predicted to continue, which should continue the elevated demand.

Although many mainstream media outlets continue to highlight the looming bubble in Denver, long and short, I don’t see anything drastic either on the supply or demand side that will alter the current situation overnight (i.e. pop the bubble) leading to a large correction.  I do, however, see warning signs that will lead to a tapering of prices or possibly small declines in certain areas in 2016 and beyond.  What will cause the deflation in real estate prices in Denver?  Stay tuned for details.

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