Here are some strange things happening in the housing market
We are reaching milestone after milestone in the USA.
Higher mortgage rates usually do not bode well for the housing market, and the US has just seen one of the sharpest increases in history.
Prospective homebuyers are in for a huge shock now as affordability measures tighten at their fastest pace yet. In fact, we are seeing several milestones achieved in the market, with mortgage spreads and benchmark interest rates reaching levels not seen in decades, while the volume of new sales is slowing at a faster rate than even during the global financial crisis.
So does this mean that apartment prices are about to collapse? That's one possibility. But another possibility is that the housing market just got weird. So does this mean that apartment prices are going to crash? That's one possibility. But another possibility is that the housing market just got weird.
James Egan, Morgan Stanley's US housing strategist, recently cut his house price forecast to show a year-on-year decline in December 2023. But he expects a decline of just 3% – a long way from a total collapse.
The problem is that we are in uncharted territory. Yes, mortgage rates have skyrocketed, reducing affordability. But at the same time, unlike the era before 2008 and the bursting of the subprime mortgage bubble, there are very few forced sellers and therefore very little inventory.
"A lot of these statistics that we use to predict things like housing activity, by which we mean home sales or housing starts as well as home prices, are at levels that we either haven't seen before, or if we've seen them, we haven't seen them in decades," Egan says in a podcast interview. Odd Lots.
“The listings of existing homes available for sale — we have that data for single-family homes going back to the early 80s — it's never been lower than it was earlier this year. We only raised very little from the bottom in the last three months", he explains. "But we think they will continue to keep records tight, which will keep house prices more supported."
To understand where apartment prices are headed, the team looks at four key things: supply, demand, affordability and availability of credit. While the first two components do not tend to change quickly, affordability and availability of credit can move very quickly. And that is exactly what we are seeing now.
The result is that because the vast majority of homeowners are on fixed-rate mortgages, and because home equity is still high, most people are insulated from the coming shock. But this isolation has a cost, what Egan calls the "lock-in effect."
"Current homeowners, in order to sell their home in many cases will have to take out a mortgage that may be 200, 250, 300 basis points higher than their current mortgage," says Egan. "They just won't be willing to sell their home at the lower price point that might be cheaper for a first-time home buyer."
And so there is a chance that we are going into unknown territory, where housing activity indicators deteriorate rapidly, even when prices remain stable.
Here's a look at seven charts that show just how extraordinary the housing market picture looks right now.
Apartment prices went up after covid
The increase in apartment prices in the years since the outbreak of Covid-19 has been very dramatic, exceeding the records even from the early 2000s. As Egan points out, each of the past 16 months has represented stronger growth than the previous peak before the global financial crisis. Naturally, this raises the question of whether such rapid increases in apartment prices are sustainable.
"Each of the last 16 months was a year-over-year growth record if we were to compare it to 2004 and 2005," says Egan. "We increased it significantly when you add the mortgage rates over 300 basis points from the beginning of the year. These things will combine to lead to the monthly mortgage payment on the apartment at the median price of over 50% from year to year."
The interest rate on the mortgage was in the market
The average 30-year mortgage rate has increased from less than 3% in 2020 to nearly 7% now, according to the Mortgage Bankers Association. This is the highest since the early 2000s. But this considerable move was overtaken by another key index: the spread (or difference) between mortgage rates and index interest rates as measured by the 10-year US Treasury yield.
With the economic outlook so uncertain as the Fed raises interest rates and with volatility in the bond market significantly higher than it has been in the past, many large investors have been reluctant to buy mortgage-backed securities and this has helped contribute to the higher cost of borrowing to buy a home. At the same time, the Fed has also distanced itself from the market as it winds down its balance sheet.
"When you have so many of what have been your bigger buyers in the last couple of years for various reasons, they don't have as much desire and ability to enter the market now, combined with the rate volatility that we've seen or maybe even exaggerated by the rate volatility that we've seen, that can lead to this spread gap." , says Egan.
Housing affordability is rapidly deteriorating
The surge in housing prices combined with the increase in mortgage rates mean that housing availability is now deteriorating at an unprecedented rate, especially compared to the average income. The chart below shows the year-to-year change in the monthly mortgage payment on a median-priced apartment as part of the average household income (in blue), plus the year-to-year change in the monthly payment (in gold).
"We have deteriorated significantly," says Egan. "The GFC deterioration compared to a year never exceeded 30%, we reached the limit in the twenties. But why do we think apartment prices won't collapse here, why do we think it's different this time, is because the question we have to ask after the deterioration in affordability is whose is the deterioration in profits."
Refinancing activity has fallen off a cliff
As Hagan points out, it is worth considering only those whose cost level is deteriorating. Most homeowners have fixed-rate mortgages and most have refinanced in recent years to take advantage of ultra-low interest rates, meaning it's less likely for existing homeowners than for future homeowners. You can see the extent of refi activity in the chart below, which shows Morgan Stanley's Truly Refinanceable Index, which calculates what portion of the conforming mortgage position has an incentive of at least 25 basis points to refi. The index is lower than any point since at least 2005.
"When you think about the record amount of mortgage originations in 2020, the fact that we broke that in 2021 for a new record amount of mortgage originations, most of these homeowners were able to buy their home or refinance their mortgage at historically low rates," explains Egan. "Their probability is locked for 30 years. They don't see the deterioration of reasonableness. This deterioration comes to first-time home buyers. Potential home buyers. That's where it sits."
The locking effect
The fact that homeowners lucky enough to get lower rates have little reason to sell in an environment of higher mortgage rates and softening prices helps create a "lock-in" effect as existing homeowners are reluctant to put their homes on the market.
"They're pretty much locked into their current homes at these low rates," Egan says. "So what we think we're already seeing, what we expect to continue to see going forward, is that the inventory, the listings of existing homes that are available for sale, we have that data going back for single-family homes to the early 80s, it's never been lower than it was at the beginning of the year ".
Housing sales slowed sharply
So many homeowners staying put thanks to higher mortgage rates can help keep prices down. But it will almost certainly be bad news for realtors when new home sales fall off the cliff. Sales volume is already falling at a faster rate than during the global financial crisis thanks to a combination of deteriorating affordability and a low supply of new homes coming onto the market.
"When a deal is made on a house, he looks at the last time the house was sold," says Egan. "Therefore, if we do not sell these houses at lower prices than they were purchased, it will help support the activity of house prices. But on the other side of that, it means that the same existing home owner also doesn't buy another home after they sell their home, which we think is going to exacerbate the decline in sales volumes."
But credit standards have been tightened
Of course, when one sees a graph like home sales falling at the fastest rate since 2008, one is bound to wonder if we are headed for a replay of the subprime mortgage bubble that sparked the financial crisis. For Egan, there are several factors that make things different this time, including a structural housing shortage in the US. But perhaps the biggest consideration is credit availability.
Before 2008, it seemed that anyone could borrow a lot of money to take out mortgages on multiple properties. But lending standards tightened significantly after the financial crisis, and problematic mortgage products like Option ARMs all but disappeared from the market. This means that people who own homes now should in theory be able to hold on to them even as economic growth slows.
"You just don't have those resets. You don't have a homeowner relying on the credit availability environment for the future and the credit availability that has tightened," says Egan. "We gave up six years' worth of relief in the six months after the appearance of Covid in March 2020. We are at the tightest levels we've been at in 20 years, in fact. And if anything, due to the pressure on the weight of assets in large banks, we think that the path from here may even be towards stricter lending standards."
Of course, much of this statement depends on the extent to which higher interest rates hurt the economy. If things get bad enough and many people lose their jobs, we could see a wave of distressed sellers that could clear inventory and put downward pressure on the market.
"Because of homeowners' lack of reliance on the ability to refinance, we don't think it will force them into defaults and foreclosures," says Egan. "But this also means that we think that the risk of a dramatic increase in defaults and foreclosures that can, if we think about what could lower apartment prices, is those distressed transactions, those forced sellers."
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