Recent housing market dynamics

Earlier this week I gave a presentation on housing market dynamics. Below I provide an overview, the full slides either as html or pdf can be found here: https://lenkiefer.com/2021/10/06/presentation-on-recent-housing-market-dynamics/

Some observations and some pressing questions

U.S. house prices are increasing at about a 20 percentage point annual rate in recent months, the highest rate of growth ever recorded.

The level of real (inflation-adjusted) house prices is the highest in 131 years of house price data stretching back to 1890.

What does this mean for the housing market?

• Is the growth rate of house prices sustainable?
• Is the level of house prices sustainable?
• Will there be a house price correction?
• If there is a correction, what would be the trigger?

Real house prices in the U.S. are the highest in 131 years of house price data compiled by Robert Shiller.

What's more the rate of growth in house prices is also at a record high, with prices increasing 20% year-over-year nationally, and double that in some markets.

(house price map was made by my Freddie Mac colleague Genaro Villa: https://www.dhirubhai.net/posts/genarovilla_housing-activity-6844346907297378304-jI6d )

Long-run Determinants of House Prices

To help make sense of these trends, its useful to have a framework for thinking about the long-run determinants of house prices.

Over the long run, house prices should reflect

• rents,
• the user cost of housing and
• any credit constraints that drive a wedge between rents and user cost adjusted prices.

Price of Housing =βRent+ψUser Cost+λCredit

If?β = 1?and??and the User Cost and Credit variables are stationary this equation implies a stable long-run house price-to-rent ratio.

Terms on the right hand side of the above equation (or their proxies) are often referred to as?fundamentals.

Due to restricted data on rents, economists often approximate rents with supply and demand factors. We might think of demand as proportional to income and supply related to the housing stock.

Price of Housing = γyIncome +γkHousing Stock+ψUser Cost+λCredit

If?γy=1?and the Housing Stock, User Cost and Credit variables are stationary this equation implies a stable long-run house price-to-income ratio.

User Cost

The user cost can be written as the sum of three terms:

User Cost = (1?τy)(i+τp)?π+δ?E(dPH)

• The first is the sum of the nominal interest rate, i, and the property tax,?τp, less tax deductions at a rate?τy, and corrected for an increase in the overall price level,?π.
• The second component is the housing depreciation rate,?δ.
• The final component is the expected real housing price inflation,?E(dPH)

Short-run House Price Dynamics

While many economists might agree something like the above model would hold over the long run, in the short run there can be signficant deviations from the long-run trend/fundamentals. Indeed, if you look at current levels of rents, income and other factors, many models would say that today house prices are far above fundamentals.

How do markets move in the short run?

• In the short run, housing supply is inelastic
• Thus, housing demand largely determines price
• The restoration of equilibrium (return to long-run trend) depends on the speed with which the housing market adjusts
• The housing market does not adjust quickly
• the half-life of a shock is often measured in decades

Sustained deviations from fundamentals can drive the fundamentals themselves.

Rapid house price growth can lead to a loosening of credit, expanding demand to segments of the population that might not have been active in the housing market before.

Rapid house price growth can feed expected future house price growth, lowering the user cost of housing.

Return to fundamentals?

The recent rapid rate of house price growth is not sustainable over the long run.

However, the literature is divided on whether or not the?level?of house prices will revert to fundamentals

• Even in models where the level does revert it takes a long time
• the half-life of a shock is often measured in decades

Many house price models have an acceleration feature, where rapid growth in the fundamentals can boost current growth temporarily driving prices away from fundamentals.

Given the boom-bust cycles in historical real estate it is important to think about what could drive prices down.

Mortgage Rates

Recall the User Cost equation

User Cost = (1?τy)(i+τp)?π+δ?E(dPH)

If user cost affects house prices 1-1 in the long run (ψ=1 above), then a 1 percentage point increase in mortgage rates would lead to a?(1?τy)percentage point decrease in the?level?of house prices over the long run.

That's not very significant considering annualized growth is currently about?20 percent.

However, higher mortgage rates could cause credit to become more binding and potentially reduce expected house price growth.

Thus the?indirect effects?of higher mortgage rates, and the signal that could send to housing market participants are likely much more significant than the direct effects.

Over decades we have become accustomed not just to low mortgage interest rates, but falling mortgage interest rates. Rates have gotten lower each decade recently.

Mortgage rates have a powerful impact on mortgage payments. Despite the fact that the average UPB on a conventional purchase mortgage has increased almost $100,000 since 2018, the average monthly principal and interest payments (depicted by the blue dotted lines in the chart below) are only up a small amount due to lower mortgage rates.

Mortgage Credit

Unlike the previous boom, mortgage credit has not expanded rapidly.

Research has shown that the growth in mortgage debt in the last boom was primarily driven by investors and others who increased debt on existing properties rather than new entrants/first-time homebuyers. (See for example Neil Bhutta from the Fed's work on this topic https://www.federalreserve.gov/econresdata/notes/feds-notes/2015/the-ins-and-outs-of-mortgage-debt-an-update-20151207.html )

In the current environment the expansion of credit has been measured, especially relative to equity.

While borrowers do not appear overextended at the present time, a contraction in credit still could have a substantial impact on housing markets.

Housing Supply

In the short term, housing supply is very sticky or nearly perfectly inelastic.

But over time, the increase in housing supply could provide some relief to the pressure on markets.

Much like with mortgage rates the direct effects of increased supply are likely to be limited and unlike potential rate increases, very gradual.

Currently we are dramatically undersupplied.

Exhibit 1 from Freddie Mac Research Note: "Housing Supply: A Growing Deficit"?https://www.freddiemac.com/research/insight/20210507_housing_supply.page

Summary

• Real house prices in the U.S. are the highest ever recorded.
• The current?growth rate?of house prices is not sustainable indefinitely, but it could persist for a long time.
• Whether or not the current?level?of house prices is sustainable remains to be seen.
• Increases in mortgage rates, an expansion in housing supply or a contraction in creidt could be the triggers that result in a house price correction.
• However, history has shown that deviations from fundamentals can persist for a very long time (decades) and during that time risks tend to build.

Find the full slides (either html or pdf) here:

https://lenkiefer.com/2021/10/06/presentation-on-recent-housing-market-dynamics/