The Housing Market Correction

The Fed Turns Up Rates and Housing Turns Down

At the press conference following September’s FOMC meeting, Fed Chair Jay Powell stated that the housing market would probably “have to go through a correction,” and that this “difficult correction should put the housing market back into better balance.” These comments follow Chair Powell’s earlier remarks at the June FOMC press conference in which he stated that homebuyers were in need of a “reset.”

Chair Powell’s remarks are not surprising. For much of the past two years, housing demand has greatly outstripped supply, leading to a rise in home prices far exceeding income growth. Chair Powell has often cited the large number of job openings relative to the count of unemployed as evidence that the labor market is unhealthily tight and a certain degree of loosening would be welcome. The housing market reached a similar state in 2021, with many markets seeing record numbers of offers per home for sale. The supply and demand imbalance drove home prices up substantially and pushed many marginal buyers to the sidelines. A historic plummet in the share of consumers rating that now is a good time to buy a home was perhaps the clearest indication that an unsustainable seller’s market was taking hold.

Of course, many factors played a role in creating the disparity. The pandemic produced an increased need for household space, a paradigm shift that ignited the surge in demand for single-family homes. The rise of remote work alone accounted for about 60% of the increase in home prices between November 2019 and November 2021, according to the San Francisco Fed.¹ COVID also set off a surge in migration which brought equity rich buyers from high-cost areas to low-cost locations, driving prices up even further. Inventories of homes for sale were trending down before the pandemic and went lower as the prospect of hosting in-person tours prevented many sellers from placing their homes on the market. The frenzied state of the market and unwillingness to enter into an unusually competitive bidding process further reduced supply. Low financing costs were also a driving factor. In January 2021, mortgage rates averaged 2.65%, a record low rate which allowed buyers to come up with larger bids.

Mortgage Rates in the Driver Seat

Chair Powell’s recent comments were in the future tense, but we note that a housing “correction” or “reset” is already well under way. Since the FOMC first indicated that tighter monetary policy would be forthcoming in late 2021, mortgage rates have risen sharply. Alongside the steep climb, existing home sales have declined 19.9% year-over-year as of August. New home sales have also declined, with sales down 14.1% year-to-date through August. The plunge in new home sales and drop-off in buyer traffic has soured builder sentiment. Consequently, single-family building permits have retreated for six straight months and are now down 15.3% over the year. Unfortunately, there are few signs that a bottom has been reached with mortgage applications for purchase index and the pending home sales index continuing to decline.

The primary driver behind the housing market correction thus far has been sharply higher mortgage rates. As of this writing, the average 30-year commitment rate is 6.70%, twice as high as the 2.96% averaged in 2021. The rapid increase in financing costs on top of rising home values has significantly decreased affordability. According to Black Knight’s Mortgage Monitor for August, the average monthly mortgage payment required to purchase the average-priced home with a 20% down payment is now up $840 over the past year. Tight labor markets have helped boost incomes and partially offset some of that increase. Still, the average mortgage payment as a percent of income was estimated by Black Knight to be almost 37% at the end of September, a point not seen since 1985.³

So, where do mortgage rates go from here? This year’s climb in rates is mostly attributable to the Fed tightening monetary policy in order to tamp down mounting price pressures. The Federal Reserve does not directly control mortgage rates. That noted, mortgage rates tend to closely follow 10-year Treasury yields, which are heavily influenced by expectations for monetary policy and inflation. The fiercely hawkish Fed is one reason why we expect mortgage rates to remain above 6% through Q4-2023. As mentioned previously, we expect unemployment to rise and inflation to abate over the course of next year, which should in all likelihood prompt the Fed to reverse course and ease monetary policy by cutting rates. Even then, mortgage rates are likely to remain above 5% throughout 2024.

Home Sales Likely to Fall Further

Financing costs are likely to weigh heavily on housing activity over the next several years. That noted, underlying demand remains strong, especially among the large cohort of younger buyers who are reaching the age when first-time home purchases tend to occur. This cohort, however, is also likely more sensitive to changes in mortgage rates and is at higher risk of job losses during a recession. The strength in household formation recently is, at least in part, due to tight labor markets and increased job opportunity. If unemployment rises as we expect, home buying activity is likely to pull back further. Across all ages, higher rates and the negative wealth effect from falling asset prices should further reduce purchases of second homes and vacation properties. With that in mind, we look for existing single-family sales to fall to a 4.7 million-unit pace in 2023, a 6.5% fall from the 5 million-unit pace we estimate for 2022. We anticipate a similar deceleration in new home sales.

The supply side looks just as daunting. The refinancing boom which occurred in 2021 resulted in over 85% of current mortgage holders with a rate that is below 5%, according to Redfin.² Mortgage rates remaining over that level for the foreseeable future takes away much of the incentive for sellers to put their homes on the market. Even with the slowdown in buyer demand, single-family inventories have risen only modestly. Many sellers are simply unwilling to trade into a higher cost mortgage unless forced to do so. We note that our current forecast is for a recession to occur in 2023, with the unemployment rate rising to a peak of 5.4% in Q1-2024. The increase in unemployment is likely to bring about an increase in selling activity, which should boost inventory levels. On the other hand, sellers that are forced into that position might instead choose to rent their homes. All told, existing single-family inventories are likely to increase over the next several years, but not substantially.

There is unlikely to be any material inventory build from new construction. The steep drop off in new home sales means builders are likely to put new single-family projects on hold. Mortgage rates moving lower further out in the forecast horizon should give builders confidence to begin boosting production. Furthermore, the recent downdraft in building material costs, notably lumber prices, indicate that building material shortages are improving, which should help builders maintain operating margins while offering price discounts on homes. Still, the recent trend decline in single-family building permits points to a sharp pullback in new construction in the near term.

Multifamily development also is likely to cool from its current lofty pace. Multifamily permits have averaged 707K over the past three months, the strongest pace since 1986. Increased homeownership costs do appear to be supporting rental demand, but broad inflation pressures and rising rents are leading renters to seek out smaller units and more roommates. Apartment vacancy rates are low compared to recent history but have risen for three straight quarters. The large number of new units currently under construction that are expected to deliver over the next few years suggests the elevated pace of apartment rent growth seen recently will moderate significantly. The broad slowdown in multifamily fundamentals should yield a slightly softer pace of multifamily construction, although the pace of activity is likely to remain fairly strong. All told, new residential construction is poised to retreat as higher interest rates weigh on demand. We look for total housing starts to end 2022 at a 1.57 million-unit pace and fall to a 1.43 million-unit pace in 2023. Single-family starts are likely to be the primary source of drag on overall starts, however, we expect multifamily construction to also cool somewhat.

Home Prices Are Likely to Decline in 2023

The housing correction is under way. But what does that mean for home values? As mentioned previously, underlying demand for single-family housing appears strong. The previous decade saw an influx of younger people moving into urban centers, and that trend appears to be reversing with more Millennials seeking suburban locations. Aside from this demographic tailwind, the rise of remote work represents a structural shift in demand which will bolster demand for single-family homes over the long term. The surprising surge in new homes sales and only modest decline in existing sales during August, which followed a brief move lower in mortgage rates, is a sign that prospective buyers are standing at the ready to jump back in the purchase market at first sign of lower financing costs. In terms of supply, higher mortgage rates may only serve to exacerbate low inventory levels, with potential sellers keeping their homes off the market or choosing to rent instead. Builders slamming the brakes means new construction is unlikely to materially add to supply.

That said, the transactions that do occur will likely be for lower prices. Fast-rising prices and higher borrowing costs are pushing buyers to smaller homes and lower cost areas, a trend that is likely to continue and weigh on home price averages. According to the S&P CoreLogic Case-Shiller 20-City Home Price Index, home prices dropped 0.8% in July, the sharpest monthly decline since 2012. The declines that have occurred in many markets reflect mortgage rates in the 5%-6% range, and mortgage rates are now well above 6%. The increased sensitivity to interest rates suggests home buying will pull back even further.

Keeping that in mind, we now look for home prices to register year-over-year declines in 2023, with the national median existing single-family home price expected to fall 5.5% during the year. We note there is likely to be significant regional variation. Markets where home prices shot the highest are now vulnerable to a disproportionate swing to the downside, notably in previously white-hot markets in the Mountain West which saw an influx of remote workers at the onset of the pandemic. Home prices in desirable locations with comparatively tighter supply are likely to hold up much better. Reduced investor activity in many markets should also weigh on prices. That said, the long-standing shortfall in supply and strong underlying demand will ultimately limit the extent home prices depreciate. Even with a modest correction, prices are likely to remain above the average levels seen in 2021. If our forecast for Fed rate cuts is realized, mortgage rates are likely to fall slightly just as cooling inflation pressures boost real income growth. A modest improvement in sales activity should then follow, which will reignite home price appreciation heading into 2024.

Endnotes

1 Kmetz, Augustus; Mondragon, John; Wieland Johannes. (2022) “Remote Work and Housing Demand.” FRBSF Economic Letter. Federal Reserve Bank of San Francisco. (Return)

2 “85% of Mortgage Holders Have a Rate Far Below Today’s Level“. Redfin. Sept. 20 2022. (Return)

3 “Black Knight Mortgage Monitor“. Black Knight, Inc. Aug. 2022. (Return)