The U.S. housing market had been rising steadily after bottoming in 2010; however, recent data suggest that it has hit a soft patch. This weakness has us wondering whether this is just a temporary pause or whether the economic backdrop is still supportive of continued growth in U.S. housing.
As the next chart shows, both existing and new home sales retrenched in 2018. This trend continued into 2019, with the number of existing home sales falling below five million for the first time since 2015. The Pending Home Sales Index, a leading indicator for the industry, also pointed to further softness, falling for a third month in a row in December of last year.
Despite recent increases in the unsold inventory of homes, the market still looks tight. Unsold inventory in January would provide 3.9 month of supply at the current pace of sales. Although this is higher than the 3.7 months’ supply in December and 3.4 months’ seen one year ago, it is still well below the six to seven months’ that is considered to be indicative of a balanced market.
In December, housing starts fell 11.2% to a seasonally-adjusted annual rate of 1.1 million, the lowest level since September of 2016. However, as the following chart shows, housing starts are still relatively low when viewed on a long-term basis. Builders indicate that land and labour shortages, combined with lumber tariffs, are impediments to more construction activity.
Home prices have grown steadily since bottoming after the recession: the Case-Schiller Home Price Index is up over 40% from 2012’s levels (chart below), which is outpacing the 28% increase in family income. More recently, however, annualized price growth has stabilized at 3%, which is roughly in-line with income growth.
Notwithstanding the strong price appreciation and tight supply, U.S. housing is still affordable: the median mortgage payment remains below 2006 levels while family income is about 30% higher. As a result, a mortgage payment on a median-priced home is equal to 16.2% of gross income, which is below the two-decade average of 17.5% (shown in the next chart).
Ownership rates are rising after falling for a decade, as demographics remain supportive of home purchases. The single-largest age cohort, 27 years old, is getting closer to what is considered the prime buying age of 31 years old.
One of the reasons homeownership rates have been so low since the recession is that young people have not embraced it like previous generations – at least not yet. While some may be put off by how poorly housing prices performed during the recession, we believe that many simply don’t have the capacity to add mortgages to their already-elevated indebtedness. The following chart shows how significantly student loan debt has grown as a percentage of total household debt since the recession. It seems that many young people are having a hard time paying off their academic bills, which means they aren’t even considering transitioning into home ownership bills.
Even though housing remains affordable now, the U.S. housing sector could be in the late innings of the current cycle. At roughly 4.3%, 30-year mortgage rates are near historically-low levels, but rates have been on the rise, increasing more than 1% from the lows reached in 2013. Federal Reserve rate tightening is expected to lift long-term interest rates by 0.7% in the next two years, which would bring the mortgage service ratio to 17.2%.
Combined with higher rates, continued home price appreciation would cause mortgage payments to approach 18% of income by the year 2020. Further price appreciation would be expected if the supply of new housing stock remained constrained, as builders would struggle with labour shortages and rising material costs.
In sum, there are many structural challenges facing the U.S. housing market: rates are likely to continue going up, young people are already carrying high debt levels, and construction cost inflation will probably continue. Despite these challenges, we remain optimistic about the long-term prospects for U.S. housing: mortgage payments are still below their two-decade average, demographics are supportive, and ownership remains a life goal within American society.
Even if we’re right, we don’t believe we’ll see a return of the pre-recession housing market euphoria. But more importantly, if we’re wrong, we don’t believe we’ll witness a return of the housing market crash. If housing affordability wanes in the next few years, it could start to weigh on the economy, but not significantly. Since the end of 2012, construction as a percentage of GDP has grown from 3.4% to 4.1%. BMO Economics estimates that the wealth effect from rising real estate prices likely tacked on another 0.25% to GDP in 2017. Historically, a slowing housing market tends to precede a slowdown in the economy, but given housing’s current share of GDP, a cooling housing market would mean that the economy would only lose a moderate source of support.