The Frozen US Real Estate Market.

Higher mortgage rates should be expected to depress the housing market, and the US has just seen one of the steepest rate increases in history.

Would-be homebuyers are facing massive sticker shock, with measures of affordability worsening at the fastest pace on record.  The US real estate market has frozen up with the volume of new sales slowing at a faster pace than even during the aftermath of the global financial crisis.

Does this mean that home prices are about to collapse?  Will we see a repeat of the Global Financial Crisis of 2007-2008?

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Transcript

The US real estate market has frozen up.  We are seeing the lowest number of homes listed for sale in 40 years (controlling for the time of year) and a collapse in housing affordability - driven by the recent increase in interest rates.

In 2021 a homebuyer with a 20% downpayment and $2,500 dollars a month to spend on their mortgage payment would have been able to buy a $758 thousand dollar home.  That same mortgage payment today would only buy a $424 thousand dollar home. You would expect a decrease in affordability like this to hit house prices, but US house prices are instead hovering near their all-time high.

According to Redfin – a real estate firm - In 2012 – in order to be able to afford to buy a median priced home in the United States homebuyers needed to earn 45 thousand dollars per year.  Today they need to earn 115 thousand dollars per year to afford the median priced home.  That calculation is based on the idea that affordability means spending no more than 30% of your income on your monthly mortgage payment.

So, how can house prices be sitting near record highs with borrowing costs also near 20-year highs?  If a $2,500 monthly payment used to buy you a $758 thousand dollar home just two years ago and it now only buys you a $424 thousand dollar home, has the average homebuyer seen a huge increase in income such that they can afford a much higher mortgage payment today than two years ago, or are they just willing to spend a much higher percentage of their income on housing than they were in the past?

Sam Khater, Freddie Mac’s chief economist, argues in a recent press release that. “House prices today are rising alongside mortgage rates, primarily due to low inventory. The headwinds, instead of affecting pricing are causing both buyers and sellers to hold out for better circumstances.”

When we look at the data, we can see that homes in the United States aren’t really transacting very much at all right now. Sales of existing homes have fallen more than 15 percent in the last year, to their lowest level in over a decade.

Economists at Wells Fargo are warning of a 1980’s style housing recession in the United States, while Morgan Stanley are saying that sustained high interest rates will just mean that very few transactions occur as the drop in demand at these high prices is being offset by a collapse in supply.

Now, while home prices do appear to have been resilient in the face of higher interest rates, that doesn’t mean that the higher interest rates have had no economic impact.  The frozen real estate market has hit homebuilders’ confidence, meaning that they are building fewer homes and hiring fewer tradespeople due to the difficult business environment.  Real estate agents will also be experiencing a hit to their earnings.

When people move home, they often buy new furniture, and the furniture retailer Restoration Hardware recently blamed the frozen housing market for a decline in sales which led to losses in their most recent quarter. They told analysts that times are getting tougher and that they will have to resort to more discounting amid a “frozen” housing market. 

Other spending that typically occurs when people spruce up a house before selling it will have collapsed too. So, while house prices appear strong, the broader real estate industry is suffering right now.

Let’s look at why house prices haven’t fallen, how demographic trends are affecting affordability, how the US real estate market is different to the rest of the world, and compare the current market to the real estate market in the lead up to the Global Financial Crisis in 2007-2008.

The thing that is both sustaining house prices in the United States and causing the housing market to freeze up is the 30-year fixed rate mortgage.  90% of American homebuyers finance their home purchase with a thirty-year fixed rate mortgage, and when I made a video earlier this year on Britain’s Mortgage Crisis, the comments filled up with Americans who were horrified that anyone would borrow any other way, but thirty-year fixed rate mortgages are not really available outside of the United States.

In Britain and Canada, and a lot of the rest of the world, mortgage interest rates are generally fixed for only a few years. That means that when rates go up, the pain of higher rates is shared more evenly between new home buyers and existing homeowners.

In countries like Germany, fixed-rate mortgages are common, but borrowers can’t easily refinance the way Americans can. That means new buyers are dealing with higher borrowing costs, but so are longtime owners who bought back when rates were higher than they are today.  

In the US, because the interest rate is fixed, homeowners get to lock in their monthly loan payments for thirty years, even if inflation or interest rates rise. On top of that, because most U.S. mortgages can be paid off early with no penalty, homeowners can refinance at a lower interest rate if rates decline.

What has happened in the US real estate market, is that homeowners with an outstanding mortgage are disincentivized from moving house, as selling their house would mean giving up their low interest rate loan and then taking a new loan at a much higher interest rate to buy a new home.  Unless your financial situation has significantly improved since your last home purpose this is a bit of a non-starter.

During the pandemic, interest rates hit historic lows, and Americans who were working from home at the time had plenty of time to refinance their mortgage.  While US mortgage rates are at 7.1% based on Bank of Americas website this morning, the average American homeowner is only paying 3.6% on their mortgage as most borrowers refinanced near the pandemic lows.

According to Morgan Stanley, only 2-3% of outstanding mortgages have interest rates in the 7-8% range, so most American homeowners are doing just fine. 

The thirty-year fixed rate mortgage in the United States came about because of government interference in markets during the Great Depression when nearly 10% of US homes were in foreclosure.  The government created the Homeowners’ Loan Corporation, which issued government guaranteed bonds to buy up defaulted mortgages and then reissued them as fixed-rate, long-term loans. 

The HOLC gave way to Fannie Mae and Freddie Mac — private companies whose implicit backing by the government became explicit after they were taken into federal conservatorship when the housing bubble burst in 2007. Banks would likely be unwilling to lend the average American a large sum of money at a fixed rate over thirty years without some form of government guarantee.

What all of this means is that existing homeowners in the United States don’t feel the pain when mortgage rates go up, while new home buyers and construction firms do.  The biggest problem for existing homeowners is that there is a strong disincentive in place to moving house when interest rates rise.

In the US, annual 30-year mortgage costs for new homes doubled to 50% of household median income when rates went up. A recent report from Goldman Sachs says that home buyers who have bought in this new interest rate environment are stretching themselves on mortgage payments relative to their income.  I spoke with a US real estate agent a few weeks ago who told me that borrowers are taking on bigger payments than they are comfortable with, in the hope that interest rates fall in the coming years so that they can refinance at a better interest rate when that hopefully happens. That strikes me as a risky bet.

Now, obviously if you want to sell your house and it is entirely unaffordable to most buyers – you will need to reduce the price until someone can afford it. So, what are the supply constraints that are keeping home prices so high?  

Well, the first supply constraint is that many homeowners who might want to move house have locked in a good rate on their existing home and are reluctant to sell it and then take on a higher mortgage rate on the new home.  This is providing a floor on prices.  There are of course some home sales happening, but these might be people who have inherited a home and want the cash, people who just have to move for work reasons, or people who own their homes outright with no mortgage and bought them many years ago at a much lower price.  Almost 40% of US homeowners own their homes outright, many of whom are baby boomers who bought in the 1980’s and 90’s at much lower prices and are quite happy with the prices they are getting when they sell today.

The second supply constraint is demographics.  According to Jim Egan at Morgan Stanley, between 1980 and 2012, the percentage of homes owned by those over the age of 65 held steadily at around 25%.  Since 2012, the percentage of homes owned by this age cohort began rising and has rocketed to 33%.  This is partially explained by the size of the Baby Boomer demographic, but there is much more of a trend of Ageing in Place amongst this group which has meant that there are fewer homes coming on the market from people who retire. 

Another big supply constraint can be seen in this chart of housing starts from 1960-present.  There was a big drop in the number of houses being built in the wake of the Global Financial Crisis. Building had only reached its old level when the pandemic struck.  During the pandemic, fewer homes were built, and we saw lumber prices rocket due to supply chain disruptions which restrained the construction of new homes too.  

This chart of homebuilder confidence shows a decline in confidence occurring as the fed started raising rates last year. Builders became cautious of being stuck with inventory when affordability was declining. Homebuilder confidence will need to grow before housing starts increase.

Household formation is a statistic which refers to the change in the number of households (or people living under one roof) from one year to the next. Young people moving out of their parents’ homes, people getting married or divorced all affect this number. It is the means by which population growth is transformed into demand for new housing.

When we compare these lulls in home construction to household formation statistics in the United States, you can really see the scale of the problem.  The number of households has been steadily growing, while the number of homes being built has failed to keep up.  We can see that supply of housing is tightening by looking at rental and homeowner vacancy rates and how they have declined since the global financial crisis.

When we look at any rent vs buy calculations right now, it is considerably cheaper to rent in the United States than it is to buy, and it is difficult to imagine house prices rising significantly from their current levels when affordability is sitting at a historic low. 

James Mackintosh wrote an excellent piece in the Wall Street Journal a few months ago about the fact that a lot of US homeowners with 30-year fixed rate mortgages are sitting on big mark-to-market gains on their mortgages. If you borrowed $500,000 to buy a house at 3% interest for 30 years, and then mortgage rates went up to 8%, that mortgage is now arguably worth just $287,000, meaning that your net worth increased by $223,000. Mackintosh argues that using this logic, well over $1 trillion in wealth has been transferred from banks and bondholders to borrowers as rates have soared—a gain in wealth that Mackintosh points out has been widely ignored by the beneficiaries.

There are ways that homeowners can make the most of the situation they have found themselves in, without being stuck in a home when they want to move.  Porting a mortgage – which involves transferring an existing loan to a different property – is somewhat common in Canada and the UK but quite rare in the United States.  Nonetheless some US homeowners will have this feature in their loan and can take advantage of it if they want to move.

An assumable mortgage is a type of home loan that allows homebuyers to take over the existing mortgage terms from the seller. Around 20% of active mortgages in the United States are part of government programs that make the loans assumable. Many mortgages that were extended through Department of Veterans Affairs and Federal Housing Administration programs are assumable.  If you have a mortgage like this on your home, it should make your home considerably more valuable as the buyer can take over your 3% mortgage rather than borrowing money at 7% to buy a similar home to the one you are selling.  Not many homeowners are even aware that their mortgages contain this feature, so it might be worthwhile reading the document.

Mortgage rates generally track the rate on 10-year Treasury bonds. To compensate investors for the higher risk of mortgages, rates for fixed mortgages have historically been, on average, one to two percentage points higher than Treasury yields. As rates on 10-year Treasury bonds have risen since mid-2020, mortgage rates have risen as well. But, since early last year, mortgage rates have risen much more than the 10-year Treasury rates, putting additional restraint on the housing market.

Quantitative Tightening - The Fed’s process of reducing their balance sheet by, in part, allowing a run-off of its holdings of mortgage-backed securities, might be partially to blame for this widening spread. Since early last year, the spread between the average 30-year mortgage rate and the 10-year Treasury yield has doubled from the 150-basis point spread averaged historically to around 300 basis points today. This spread can widen and narrow for a variety of reasons, but it is unusual for the spread to be this wide for this long. If the spread between 10-year yields and 30-year mortgage rates followed historical averages, mortgage rates would be approximately 5.5% right now, based on the current 3.97% 10-year treasury yield.

So, is the situation today similar to the situation in the lead up to the Global Financial Crisis which struck in 2007?  Not really. While some borrowers are stretching on mortgage payments relative to their income, lending standards are much higher today than they were in the early 2000’s.  Today the majority of Americans borrow 30-year fixed rate mortgages unlike the more exotic products which had become common in the lead up to the financial crisis.  Looking at borrower credit scores, loan to value ratios and debt to income ratios, borrower risk is much lower than it was in the 2000’s too.

In the wake of the global financial crisis the Making Home Affordable program was rolled out in 2009 to help financially struggling homeowners avoid foreclosure by modifying loans to a level that was affordable for borrowers and sustainable over the long term.  Banks today are better at dealing with distressed borrowers than they were in 2008 and are quicker to modify loans for borrowers who are struggling rather than foreclosing on their homes.  Thus, we are less likely to see the high foreclosure rates we saw in the global financial crisis even if borrowers start to find themselves in distress.

The housing sector is currently quite vulnerable to a downturn due to high valuations and low affordability.  For housing markets to find their balance and for the current frozen market to thaw, affordability needs to normalize. There are a few ways that this could happen.  One is that house prices could fall to levels where buyers can - once again - afford them.  This could happen if homebuilders increase supply or if sellers who bought their homes many years ago come to the market, as these people are less tied to recent market pricing.

Another way affordability could normalize is if interest rates decline.  The fed has already hinted that rate cuts are in the pipeline for next year.  The third way the situation could improve is if disposable income were to rise to keep up with the cost of housing.

There is a chance that all three variables will contribute to improving affordability in the coming years. Historically house price corrections in the United States take between two and a half to five and a half years to bottom based on the last three corrections. 

Thanks for tuning in to this week’s podcast, if you have a friend – or even someone you hate - who might find it interesting send them a link to this episode or to my YouTube channel where this is posted in video format.  Have a great week and talk to you again soon, bye.