The Property Ladder

A Room with a view. There is little doubt that the fiscal stimulus helped to avert an economic catastrophe. While monetary stimulus played a supporting role, it gave a memorable appearance that will echo for years. Interest rates dropped to levels not seen in generations, while mortgage interest rates fell to the lowest in memory. This economic euphoria is a one-time event. While some will enjoy a lower mortgage payment for decades, others levered their new borrowing capacity to climb the property ladder for a better view. This latter action brought forward future demand and is why the housing boom is tenuous.

The U.S. is fully recovered and filled the Pandemic gap (exhibit 1). The composition, though, is where trouble arises. Consumption’s return to trend hides that goods are the driving factor as mortgage refinancing drove spending while services lag materially. Further, the investment boom was a housing phenomenon with equipment and structures also tardy. Net exports are moving further negative as imports grow and exports remain stalled well below their prior peak. With Government expenditures adding little to the pie, it leaves the economy wanting. As consumption and housing investment recede, employment gains are required, or sluggish growth will endure.

Exhibit 1. GDP Contribution by Component

Source: Federal Reserve Economic Database, CRM Calculations.

Free Money. Monetary stimulus sprang into action as the Pandemic surged in 2020 with a two-pronged approach. Policymakers reduced interest rates and restarted the quantitative easing program introduced during the Great Recession. The latter program purchased Treasuries, corporate bonds, and mortgage-back securities seeking to lower interest rates on mortgages to support the housing market. This support resulted in an outcome materially different than the last crisis: higher housing prices (exhibit 2). The difference this time was that there was not a supply and demand imbalance: financing costs merely fell.

Exhibit 2. Purchase-Only House Price Index (Annual Change, %)

Source: U.S. Federal Housing Finance Agency, retrieved from FRED, Federal Reserve Bank of St. Louis

This distinction is critical to understanding the current housing market conditions and their implications for inflation and growth. Indiscriminate credit in the early 2000s brought increased demand for housing and a subsequent surge in new housing to balance supply with demand. The current situation brought no real change of demand. Yet a lower cost of financing (e.g., cost to carry a house) enabled a move up the property ladder or free cash to spend (e.g., new cars). The challenge is that this outcome is not enduring because it can only happen once.

Low, lower, lowest. Interest rates were low in the periods before the 1970s inflation. Yet, people old enough to remember those interest rates are now in their seventies. For most current homeowners experienced interest rates continually moving lower to their current levels (exhibit 3). Even people who refinanced over the last decade could enjoy interest rates nearly one percent lower on a thirty-year mortgage. This fortuitous outcome enabled those who hadn’t lost their job during the Pandemic to purchase a higher larger home or refinance with lower payments for their current house and enjoy more disposable income.

Exhibit 3. U.S. Mortgage Rate, 30-Year Conforming (%)

Source: U.S. Federal Housing Finance Agency, retrieved from FRED, Federal Reserve Bank of St. Louis

These lower interest rates enabled about 13 percent more purchasing power for those wanting to climb the property ladder.[1] This number is parallel to the average housing price increase over the last year. With incomes (for those employed) and demand unchanged (i.e., new buyers did not emerge during the Pandemic), financing is the most credible driver of current housing prices.

Spending Spree. Not everyone climbed the property ladder. Most were happy to refinance into lower rates and reduce their mortgage debt service (exhibit 4). More than nine million people took advantage of the lower rates to refinance.[2] The result is more than $300 per month for the average household.[3] The consumer responded with durable goods orders and new vehicles sales reaching a new high despite a global Pandemic. Indeed, the consumption rebound is unprecedented, particularly when employment remains 6.7 million people below the prior peak.

Exhibit 4. U.S. Mortgage Debt Service as a Percent of Disposable Income

Source: U.S. Federal Housing Finance Agency, retrieved from FRED, Federal Reserve Bank of St. Louis

The availability of lower-cost financing certainly contributed to the higher housing prices and increased consumer spending. This one-off phenomenon is not likely to reoccur. Thus, the strength of future housing prices will moderate as the financing boom wanes. This outcome does not mean that other contributing factors will weaken. As in all markets, it is demand and supply that determine prices.

Limiting Supply. The availability of more purchasing power alone is not sufficient to drive prices higher because not all people will leverage their newfound ability. The interaction of supply is also critical to the outcome. Since the onset of the Pandemic, the count of active hosing listing for sale dropped by more than one-half (exhibit 5). This outcome is unprecedented outside of times of war. During a housing crisis, supply usually increases as foreclosures flood the market. That supply dropped in a unique function of the Pandemic that is not repeatable.

Exhibit 5. U.S. Housing Inventory: Active Listing Count

Source: Realtor.com, retrieved from FRED, Federal Reserve Bank of St. Louis

This artifact of the Pandemic on housing supply is material. Over the last six quarters, the usual housing listings should’ve totaled two million. Listings during the period only totaled 760,000 houses, which resulted in a deficit of over 1.3 million homes.[4] This 60% gap between supply and demand is an extraordinary event contributing to higher housing prices. Of course, the natural response to a supply deficiency is to increase it.

Building Supply. Homebuilders responded by building houses at a rate not seen since the mid-2000s. Critically, it was the speed of the jump that was unique to this generation of owners. Supply has not jumped so much since the 1970s and the heyday of significant interest rate movements (exhibit 6). This action helped fill the deficiency of supply for active listing. Yet, the 200,000 annual rate of additional units above the prior trend did not fill the gap. The more troublesome outcome is that this supply is now reverting to trend.

Exhibit 6. U.S. New Housing Starts, Single Family Homes (Thousands of Units)

Source: U.S. Census Bureau, retrieved from FRED, Federal Reserve Bank of St. Louis

Home building takes time to bring their product to market. These long lead times suggest that homebuilders do not respond abruptly to the marketplace and must see through the data. This insight is why the reversion to the trend is worrisome for the future. High prices would suggest that homebuilders should bring supply to the market. Yet, they are pulling back supply at this critical moment. Indeed, there is some degree of constraints of material supply constraining that is impeding development. Yet, if the expectation is for further demand increases, then development would continue apace because of the long lead times. Thus, builders must not see supply as a future problem.

Calm before the Storm. A crucial policy enacted during the Pandemic was mortgage and rental forbearance, where landlords could not evict renters, nor could banks foreclose on delinquent mortgage borrowers. The result is 20-year lows in rental vacancies and benign yet increasing mortgage delinquencies (exhibit 7). With continuing unemployment claims still two million higher than before the Pandemic, the probability that of the policy masking a housing catastrophe is likely.

Exhibit 7. U.S. Rental Vacancy & Mortgage Delinquency Rates

Source: U.S. Census Bureau & Board of Governors of the Federal Reserve System, retrieved from FRED, Federal Reserve Bank of St. Louis

The reality is that over thirteen million households are behind on their payments. At the same time, around one in three expect eviction within the next two months.[5] This reality is why homebuilders are not building more houses in the face of high prices. Absent a policy change, the renters will face eviction at the end of July and mortgage foreclosures could follow by the fall. Adding supply when a wave of houses may enter the market is not a prudent path for most professional homebuilders. Lower demand meets a higher supply.

The excerpt is the Macro View section of Capital Risk's US Economic Outlook for the second quarter of 2021.

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[1] This number derives from a 3.75 interest rate mortgage changing to a 2.75 percent with a 30-year amortization period.

[2] See the Mortgage Bankers Association for data on refinancing activities. www.mba.org [3] Refinancing a $600,000 home from a 3.75% interest rate to 2.75% with a 30-year amortization period.

[4] Active listings average about 1.3 million units a year from 2016-2019. Thus, a six-quarter total is roughly two million units. www.realtor.com [5] U.S Census Bureau, Household Pulse Survey, July 2021. https://www.census.gov/programs-surveys/household-pulse-survey.html