Juiced by low, low interest rates, the U.S. housing market thrived in the pandemic. But with prices rising at a record rate, an overheated market will be tested by surging mortgage rates. Is it headed for a 2008-style bust?
After moderating last summer, house prices re[1]accelerated at the turn of the year. Two popular measures rose sharply, lifting their annual rates back to the high teens—which is even faster than in the 2006 bubble. Fear of missing out on future price gains had investors trying to make a fast buck and first[1]time buyers simply trying to get a foot on a fast-moving escalator. Some buyers likely jumped into the market ahead of expected Fed tightening. However, timelier data on median prices suggest the rate of increase may be plateauing.
Fiery prices are a direct result of ultra-cheap credit. As with overall inflation, the heat in home prices stems from excess demand driven by too-low interest rates. A rapidly recovering economy and job market, as well as relocating remote workers, also pumped demand. Existing home sales reached 6.1 million in 2021, the highest since 2006 and above the solid 5.5 million annual rate before the pandemic. However, after spiking to one-year highs in January, sales pulled back to 5.8 million in March due to higher mortgage rates. Still, demand is strong enough to vacuum up listings, resulting in a lean two-month supply at the current sales rate, well below the normal six months. Sales of new homes, though easing, are also holding above pre-virus levels.
For builders, starting new units is easy; it’s completing them that is hard amid a lack of skilled workers and materials and soaring costs. Unit completions have moved sideways for more than a year and are below normal in relation to the number of households. Fortunately, builders recently started the largest number of units since 2006. In addition, the number of units under construction is at all-time highs and above long-run norms in relation to household units. More supply is coming; but it will take time. The migration of teleworkers to lower-density regions with more ample land supply will help.
The market’s other big challenge is that soaring prices and borrowing costs have hammered affordability. The Atlanta Fed’s Home Ownership Affordability Monitor reached its worst level since 2008 in January—even before yields really began to run. Since then, 30-year mortgage rates have spiked more than 1½ ppts to 12-year highs above 5.2%. This will add more than $3,000 to annual mortgage payments on a median priced house, pushing total payments (including property taxes and insurance) to an estimated 39% of median household income—above the long-run norm of 30%. We expect 30-year mortgage rates to rise only moderately further, but without a slowdown in prices, housing costs could soon top those of 2006 (42%).
Due to fading affordability, price increases are expected to largely flatten out later this year and in 2023, giving family incomes time to catch up. Prices tend to respond to rate hikes with a lag of several months. While continued job growth should provide support, existing home sales will likely return to pre-virus levels by year-end, restoring market balance. In fact, the market is already starting to simmer down. New mortgage applications fell 15% in mid-April from January, while a gauge of builders’ activity (though elevated) has fallen each month this year. Housing starts are also expected to drift back to pre-pandemic norms, before tracking population growth. However, a lengthy pipeline of homes under construction will support builders for some time.
Assuming that home prices moderate, fixed mortgage rates don’t rise much further, and the economy doesn’t contract, the housing market should sidestep a deep correction. One positive difference compared with 2008 is that household debt (relative to income) and debt payments are much lower. In addition, mortgage lending standards are stricter and credit scores are much higher. Last year, new loans to subprime borrowers (credit score below 620) were only a fifth of the peak in 2006. Household savings and homeowners’ equity are also substantially higher today, while the unemployment rate is lower and wages are rising briskly, supporting family income. The lack of oversupply in the resale market and overbuilding in the new market should temper any price pullback.
Slower home prices will come too late to prevent rents from rising further. Since more people can’t afford to own, they are forced to lease. Rent in the CPI is already rising the most in 15 years at over 4% y/y, and other measures show even larger moves (Zillow’s observed rent index is up 17% y/y to March). Home prices tend to lead rents with a lag of up to 1½ years, and the recent trend flags a possible 2-ppts pickup in CPI rent growth. The rent measures in the CPI (actual plus closely-correlated owners’ equivalent) account for nearly one-third of the index and might add more than half a percentage point to headline inflation in 2023, slowing its decline.
Bottom Line: The housing market will likely cool rather than collapse. Assuming the economy lands softly, so too should real estate, supported by healthy household balance sheets and limited supply. Unlike in 2008, it’s the economy that will wag the housing market’s tail. Still, with affordability under stress, let’s hope the Fed’s bark proves worse than its bite.