Issue 13: Year-End Thoughts on the US Housing Market

Special Edition: Year-End Thoughts on the US Housing Market

A supply shortage is still the main driver
Although some experts are fretting over a potential housing market crash as mortgage rates breached 7%, the fact remains that inventory still hasn’t been enough to meet demand and homebuilders have been reluctant to ramp up construction and add to supply given high rates and a daunting outlook. According to the National Association of Realtors (NAR), US home sales declined -7.7% in November, roughly 37% from their recent peak in January 2022. Even with fewer sellers bringing new listings, that slowdown in sales means houses are spending much longer on the market, leading to an increase in supply, which is now expected to rise by nearly 23% in 2023. While that will help normalize property market action to a degree—in other words, don’t expect massive pandemic-era real estate returns in 2023—supply will remain at pre-COVID levels, with tight inventory through the year.

Property prices better supported this time around
As we have pointed out in prior Perspectives, a mortgage rate “lock-in effect” and shortage of supply both serve to support home prices, preventing year-over-year declines expected in 2023-2024 from becoming too painful. Some investors, increasingly pessimistic about the economy in general, and housing in particular, are now anticipating property prices to decline more and faster, based on the anchoring effect of the traumatic ’08 crisis in their minds. Recall that it took over five years for the housing market to go from peak to trough in the last cycle. Even then, the steepest housing price decline over a 12-month period during the Global Financial Crisis (GFC) was -12.7%. In the current cycle, home prices peaked in June 2022 amidst foreclosure and default rates at their lowest level in decades. Without extreme distress like that witnessed during the GFC, we simply don’t see a crash. Possible exceptions include San Francisco and other pandemic “Zoom Towns”, where wretched affordability and a downturn in tech could push most buyers out of the market.

Mortgage rates continue to fall
A high mortgage rate coupled with high home prices have crushed affordability this year, as monthly payments of the typical borrower have risen by more than 50%. In early November, the US mortgage rate shot to a 20-year high of 7.08%, but has been declining in recent weeks heading into the holidays, offering some relief to potential homebuyers. Underpinning the mortgage rate are actually two moving parts: the government borrowing rate and the mortgage spread. That spread, which one can measure as the gap between the 30-year fixed mortgage rate and the government borrowing rate, is much higher today than it has been in the past. Why?

Because mortgages in the US are securitized in agency mortgage-backed securities (MBS)—which are effectively free of credit risk—it can’t be that spreads are high due to higher perceived default risk. Instead, the driving factor is market uncertainty about the effects of Fed policy, which has resulted in outsized fluctuation in interest rates. Indeed, if we visualize the relationship between the MOVE index—a volatility index, like the VIX for bonds—and the observed mortgage spread, we note that MBS spreads tend to widen when the MOVE index spikes (see below). Looking ahead, the mortgage market is already pricing in another two (or so) rounds of rate hikes as inflation moderates. As uncertainty declines from current highs, the corresponding risk in mortgage spreads should dissipate, bringing mortgage rates down and marginally improving affordability.

Expect higher variability across regions in 2023
Over the next twelve months, relative affordability will likely drive the housing market in different parts of the country, particularly in the South and Midwest, where housing demand remains strong and could actually see home prices increasing throughout the year. Compared with conditions in places like California and New York, these markets are relatively affordable, and job creation is relatively robust. A combination of affordability and labor market strength could lead to significant regional outperformance in properties. Meanwhile, real estate investors are moving away from multi-million-dollar homes, instead favoring starter homes, which are more easily converted to rentals. If mortgage rates decline as local job creation booms, buyers will flock to these markets.

Rents continue to soften, good news for CPI
Demand for multi-family housing was steady in 2022 amid tight single-family home supply and affordability challenges, pushing multi-family housing starts, which remain close to cycle highs. The latest November data show that single-family housing starts dropped -4.1% MoM, while the rate for units in buildings with five units or more jumped +4.8% to its highest since April. As economic uncertainty prompts households to reconsider moving and become more frugal in their rental decisions, softening demand and expanding supply are leading rents to decline across the US. Of course, rent is the largest component within core CPI, so a decline in rents can’t come too soon for the Fed. Due to lags in data collection, the CPI will register this slowdown a bit later, but real-time data are already showing rental demand declining. Property platform RealPage reported YoY growth in national effective rents at 6.5% in November, down from its March 2022 peak of 15.7%, marking a third straight MoM decline.