US home sales plunged more than 25% since the beginning of the year (see Chart 1). In our view, this was triggered by a sharp deterioration in housing affordability rather than as a sign of a collapsing housing bubble.
In particular, we see no lending and building excesses as in the housing bubble that preceded the 2008-09 financial crisis.
Source: US Census and NAR1
We anticipate some more downside in home sales in coming months and expect house prices to come under pressure with a lag. We also think housing activity will remain muted in 2023 until affordability conditions improve again.
The main risk to housing, in our judgment, would be a deep and protracted recession with large unemployment increases. This could turn the affordability problem into a solvency crisis. We estimate the probability of a recession in the coming 12 months at about 50% but do not expect a sharp rise in unemployment.
The sharp decline in home sales this year follows a boom in 2020-21 (see Chart 1 again). We attribute the housing boom in 2020-21 to a shift in housing preferences triggered by the Covid pandemic and much improved affordability conditions. While the shift in housing preferences is difficult to quantify,2 the improvement in affordability can be traced to the fall in mortgage rates and the rise in disposable income linked to the Covid-19 relief packages.3
Chart 2 shows housing affordability for a median homebuyer family in the US in terms of the expected debt-service payment and the equity down payment relative to income.
*Housing affordability measures the debt-service and equity down-payment of a median homebuyer family and is calculated based on median home prices, median family income and the 30-year mortgage rate. We assume a loan-to-value ratio of 80% and full amortization of the mortgage over the 30 year duration.
Source: US Census, Freddie Mac and own calculations.6
These favorable affordability conditions reversed sharply since the second half of last year (see Chart 2 again). Based on our calculations, the debt-service ratio nearly doubled to currently 27%, which is a 30-year high.7 Put into dollar terms, we estimate that a median family currently has to pay $2060 per month to service a new mortgage for a median-priced home versus just $1225 in 2019, which is an increase of more than 66%. Furthermore, the equity down payment ratio jumped to 99%, which is an increase of more than 20% points and also a 30-year high.8
The deterioration of affordability is due to the near doubling of mortgage rates, the phasing out of the Covid-relief packages – which implied a 2.5% decline in incomes in the first half of this year – and still strong home price increases through the first half of this year.9
The rise in inflation has further squeezed affordability. Real disposable incomes dropped 8.5% in the first half of the year, forcing households to cut their savings rate and leaving less income to invest in housing.10
In our view, housing preferences have not made a u-turn and we think that many people are still looking to change their housing situation. However, we believe that the deterioration in affordability conditions is so powerful that most people who are looking to change their housing situation can simply no longer afford it.
Another look at chart 2 shows that the speed and extent of the deterioration in housing affordability is even stronger than in the bubble period before the financial crisis. However, this is no déjà-vu, in our view. As we outlined in previous ZAIS Insights, we see no excesses in mortgage lending and housing construction (see Chart 3).11
Source: US Census and Board of Governors of the Federal Reserve System12
The low vacancy rates – the rental vacancy rate is also low by past standards15 highlight that housing supply remains tight despite the plunge in home sales. The inventory of all houses for sale increased since the start of the year due to the drop in sales but remains very low by past standards both in absolute terms as well as in terms of months of sale (see Chart 4).
Source: US Census and NAR16
The inventory of new houses for sale rose more strongly since the start of the year, but the share of completed new houses for sale remains extremely low (see Chart 5 on the next page). We believe that the backlog of unfinished new houses will gradually decline as supply chain disruptions caused by the Corona pandemic fade but we do not expect a strong increase in new housing supply.
Source: US Census17
In our view, labor shortages, limited land supply, increased material costs and tighter financing conditions will continue to limit the construction of new homes. Indeed, housing permits and housing starts have both dropped by around 25% since the start of the year.18
The current level of housing starts stands just a touch above the level of new household formation (see Chart 6). Subtracting an estimated quarter million of annual housing demolitions from housing starts, we estimate that net new housing supply runs about 150 thousand units below the demand from new household formation.
Source: US Census19
For the rest of the year, we anticipate some more downside in housing activity. We expect existing home sales to drop below 4.5 million but to stabilize above 4 million before the end of the year. We also think that new home sales are likely to drop below 500,000 but not much further. We expect housing activity to stabilize in 2023.
The main risk to our view would be a deep and protracted recession that results in a sharp rise in unemployment. A surge in unemployment would not only worsen the current affordability problem for new home buyers but could also create a solvency problem for existing home owners.
We estimate that the probability of recession over the next 12 months is about 50%. In our view, recession could be triggered by more Fed tightening or external shocks such as recessions in Europe or Asia. However, we also think household and business fundamentals are strong and any recession is unlikely to be deep and protracted.
Thus, while we think the labor market will cool down over the coming 12 months, a sharp rise in unemployment is unlikely in our view. In particular, we think employers will be more cautious to let staff go given the overall shortage of labor and firms’ frustrating experience to rehire workers when the Covid pandemic started to fade.
Overall, we view the current dynamics in the housing market as a cyclical adjustment that moves demand closer to supply. We believe this adjustment will also bring down house price appreciation, albeit with a lag.
National house prices continued to rise strongly for the first five months of the year while home sales were already falling (see Chart 7). In June, however, house prices suddenly stalled with prices actually falling in five of the nine Census Divisions (only the South-East Central and Middle Atlantic Divisions reported ongoing strong price increases in June).20 For July, CoreLogic reports that US house prices fell 0.3% from June.21
Source: FHFA, the last observation for July 2022 is based on the latest house price data from Corelogic22
Based on our analysis house, prices respond to changes in affordability, leverage and supply conditions with lags between two and six quarters. Chart 8 shows our estimate of the house price appreciation rate since 2000. Given our estimates of the adjustment lags, we forecast that the house price appreciation rate will ease to 10% by the end of this year. Looking into next year, we see three possible scenarios.
Source: S&P/Case Shiller and own estimates23
Assessing the likelihood of the scenarios is difficult given current uncertainties. We view the base scenario as the most likely and the bear scenario as the least likely. In any event, we think housing fundamentals remain robust given the health of household balance sheets and limited housing supply. Thus, we expect housing activity to recover faster than after the financial crisis.
One restraint that is likely to stay, however, is affordability for lower-income families. The strong increase in house prices since the middle of 2020 has not only contributed to the overall deterioration in housing affordability but has also significantly changed the distribution of house prices. In the three years prior to the Covid pandemic, new houses costing less than $300,000 accounted for more than 40% of all new houses sold. Now that share has dropped to below 10%, while the share of houses costing $500,000 and more has doubled (see Chart 9).
Source: US Census24
We believe that means that disproportionally fewer households in the lower-income range will be able to afford a house. The high rate of inflation compounds this crowding out effect, in our view, as lower-income households are less able to save income to purchase a home.
As a result, we expect that more households will be forced to rent rather than buy a home. We think this shift from buying to renting will also become visible in the inflation data, with primary rental inflation to stay stronger relative to owners’-equivalent rental inflation.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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