The Great Recession — and the housing boom and bust that set the stage for it — are fading into distant memory. But a decade into the recovery, the U.S. housing market continues its frustratingly slow return to normalcy.
Underlying Economy is Strong
Traditionally, the economy drives the housing market, and this should be good news for anyone in the real estate or mortgage industries today. Virtually every measure of economic performance is pointing toward driving demand for new and existing home sales.
Gross Domestic Product is fairly strong. Inflation, which has begun to climb as the economy has heated up, still remains under control. Unemployment rates are near historic lows, even as labor force participation rates have begun to creep back up. The country is creating about 200,000 new jobs a month, and unlike the temporary, contract and government jobs that were so typical during the early years of the recovery, these jobs are delivering sustained wage growth.
So the economy is strong, jobs are being created, unemployment isn’t an issue, and wages are improving. All of this leads to the formation of new households, and should translate into more home sales. At least that’s what usually happens.
Given all of the good economic news, home sales so far in 2018 can best be described as unexciting. Or disappointing. But under the circumstances, probably not surprising.
The Biggest Problem: No Inventory
It turns out that the housing market is not immune to one of the most basic of economic concepts: supply and demand. And the lack of available homes for sale is making a full recovery virtually impossible.
The inventory of homes for sale in a healthy, balanced market is about a six months supply; in today’s market, that number has dipped below four months, and in many of the higher demand markets supply has in some cases dropped as low as one month. This lack of inventory has an obvious impact — it limits the number of homes that can be purchased — and some less obvious impacts, such as creating bidding wars, which drive home prices up to a point where affordability can be an issue.
Much of this problem can be attributed to lackluster new home construction. New home starts are showing some signs of life, but will continue at lower-than-needed levels of single family home construction in 2018 and 2019, with about 850,000 starts this year, and 925,000 next year. Builders face a difficult environment today: land in most high demand markets is scarce and increasingly expensive; regulatory burdens extend the time needed to build a home and layer in pre-construction costs ranging between $80.00 and $100,000; tariffs on Canadian lumber have increased materials costs; and skilled labor is in short supply.
While all of these issues dampen homebuilding activity, they have a profound effect on the entry-level market, since it’s difficult for builders to turn a profit at the low end of the price spectrum.
Existing home inventory is also affected by borrowers who are in negative or near-negative equity positions. While the number of underwater borrowers continues to shrink as home prices rise, there are still about 2.5 million households underwater, with several times that number with less equity than they need to sell their home and be able to afford a new one. And research is beginning to indicate that a certain percentage of homeowners are reluctant to list their homes for sale, fearing there may not be anything for them to buy.
These headwinds for inventory are coming at a bad time, since demand is likely to continue to grow as Millennials are finally entering the market. As the number of young adults living with their parents slowly decreases, this age group is now the largest cohort in terms of home purchases, and makes up about two-thirds of first time homebuyers.
Affordability a Concern
Stronger demand and weak supply typically drives up prices. This has certainly been the case in the housing market, where prices rose by about six percent in 2017, and have been trending at close to a seven percent year-over-year increase to date in 2018. Affordability is already a concern in many of the markets that experienced rapid home price appreciation over the past few years — Coastal California, Seattle, Austin and Dallas/Fort Worth to name a few. National median home prices have surpassed the prior peak established in 2006, although adjusted for inflation, wage growth and lower interest rates, affordability levels are better than they appear at first glance. However, if home price appreciation continues to rise at twice the rate of wage growth, it won’t be too long before the math simply doesn’t work for a large number of potential borrowers.
Adding to this concern, of course, are rising interest rates. It’s undeniably true that rates of 4.5 percent or 5.0 percent on a 30-year fixed rate mortgage are well below the 25-year average of 8.25 percent, and even well below the 6 percent to 7 percent rates that were typical during the housing boom of the early 2000s. It’s also true that the current generation of first time buyers has come of age during a sustained period of historically low interest rates, and, coupled with historically high home prices, is probably experiencing some degree of sticker shock.
What to Expect for the Rest of 2018
So will strong demand push the market ahead, or will limited supply, rising prices and higher mortgage rates slow things down?
The most likely scenario is that 2018 will look very much like 2017 did, with a slight improvement in overall sales. Existing home sales will probably stay in the 5.5 million to 5.6 million range; new home sales will probably end the year between 625,000 and 650,000 units. Prices are likely to rise between 5 percent to 6 percent on a year-over-year basis, with affordability becoming an issue in some of the more expensive markets as higher interest rates add to the cost.
Buffeted by multiple headwinds, but buoyed by economic growth, the housing market will continue its decade-long struggle for a full recovery.