The Affordability Quandry
Homes are officially expensive.
Demand: It’s just the comps.
Supply: Gone, again.
If the Fed is going to pause, why are long-term interest rates going up? Last month, Chairman Powell hinted that the Fed will be much more cautious as it evaluates future rate hikes, and one would have expected long-term interest rates to start going down after that news—but the opposite happened. Since the July announcement, 10-year interest rates are up by nearly 0.50%, and that doesn't help the average consumer much. Even more interesting is that home prices haven't moved lower yet, and that's creating a major housing affordability issue across the country. In this Market Insights article, we will dive deeper into the affordability quandary with a discussion of proprietary analysis on housing affordability. Here's a sneak peek: the only times in the last 40 years when homes have been this expensive were 1987-1990 and 2006-2007...
Homes are officially expensive.
"Well, duh, Jared. We already knew that."
Yeah, and they're really expensive right now. In fact, homes are so expensive that we need to highlight the phenomenon in the context of some other pivotal moments in US economic history. The graph below (two down, the line graph) is the result of our analysis, which shows the magnitude of the current affordability crisis. But first… why are rates going up?
Chairman Powell suggested at his last press conference that the Fed was going to be more cautious as it evaluated rate hikes in the future and also that a recession was no longer the base case for the Fed’s economic projections. While that all sounds great, the problem is that the bond market has been expecting a recession to relieve some of the pressure on inflation. If the economy is going to reaccelerate, then more upward pressure will exist on inflation, and rates will have to go higher, whether or not Powell wants them to.
We’re already seeing a bit of evidence in the reacceleration of prices through the Cleveland Fed’s Inflation Nowcasting data. Last month, Core PCE (the Fed’s preferred inflation metric) dipped down to 2.4%, which was extremely encouraging for Fed watchers. However, you can see in the table below that the number increased to an annual rate of 4.2%, which is back up to the danger zone (the chart is included below). Further upward pressure exists on prices due to wages reaccelerating since March; annual wage gains are back up to 6% from a 2023 low of 5.3% earlier this year. As people make more money, they spend more money, and that creates inflation.
A snapshot of the Cleveland Fed’s Inflation Nowcasting results from August 15, 2023.
The concern about a reacceleration in inflation is what's causing a selloff in 10-year bonds and, therefore, increasing interest rates. We've been maintaining that the Fed has to fight inflation above all other considerations, otherwise, implied inflation expectations in longer-dated bonds are too low. Perhaps the market is waking up to the fact that the Fed's inflation fight will take longer than expected, and this will keep pressure on longer-term rates to stay higher for longer.
The reliance of the American consumer on mortgage financing to purchase a home is what creates the direct link between longer-dated treasuries, income levels, and housing prices. Mortgage underwriters use income as the primary factor in determining whether or not you qualify for a mortgage and how much you can borrow. Since the price you can afford is directly dependent on the income you earn, there must be a direct link between the two. There might be other variations throughout history in the form of underwriting standards, leverage ratios, upfront funding requirements, etc., but the positive correlation between income and home prices is always there.
Across the country, homes are as unaffordable now as they’ve been only twice in that last 40 years… 1987-1990 and 2006-2007.
The chart displays four different lines:
Income Index — We used historical median incomes from St. Louis Fed dating back to January of 1987. For purposes of displaying it on the graph, all the data is normalized.
Housing Index — We used the Case-Schiller Home Price Index as a proxy for a home value index across the United States. The data was normalized on the chart for display purposes.
Un-Affordability Index — We overlaid prevailing mortgage rates at the time each Case-Schiller data point was published to estimate the monthly payments that would be generated by a home of that value at that time. We created a ratio of projected annual mortgage payments against the median income data to calculate, relatively, the share of one's income that would need to go toward the cost of a home. The higher the index goes, the higher the percentage of one's income that would need to go toward the purchase of a house.
Summer 2023 — This shows the current level of unaffordability against periods of history. The only times when homes have been this expensive in the last forty years are 1987-1990 and 2006-2007.
These lines tell us all sorts of interesting things.
The income index and housing index track each other pretty closely until the year 2000. When Fed Chair Greenspan lowered overnight funding rates in response to the Dot Com bust and the recession it caused, the fuel that powered the housing bubble was added to the fire of mortgage-backed securities. It's interesting how these lines continue to deviate until the Great Financial Crisis, come back together around 2010, and then take back off to the levels we see at present. Both of these deviations were preceded by elongated periods of low interest rates.
The only other times in the last 40 years when housing has been this expensive for the average American are 1987-1990 and 2006-2007. There was a relatively mild recession from the summer of 1990 until the spring of 1991, and one of the worst financial periods (ever) occurred from 2008-2011. No matter how you look at it, this seems to be a pretty good indicator of tougher times ahead.
The recession in the early 1990s was caused by the Fed increasing interest rates to combat higher inflation after a long expansion cycle. There were also themes of debt accumulation during the 1980s and an oil price shock that caused a relatively mild recession.
The recession from 2008-2011 was the result of a systemic failure. Holding interest rates low forced investors to seek investment returns in riskier asset classes. One of those asset classes, mortgages, was going through a mathematical renaissance that brought a lot of attention and capital into mispriced instruments (we just ignored the whole "fat tail" thing because the market hadn't seen it before). At the same time, less sophisticated investors put their trust in rating agencies that were tangled in a web of conflicts while they rubber-stamped approvals on those new instruments without doing the proper diligence. When the whole system fell, the American taxpayer was left funding the recovery.
The last two times homes have been this expensive were also times that (1) were preceded by periods of low-interest rates, (2) followed by the Fed raising rates to battle inflation, and (3) at a time when the American consumer had previously taken on a lot of debt. And what about 2023? Yes, we're coming out of a low-interest-rate environment. Yes, the Fed is raising rates to battle inflation. What about consumer debt? Consumer debt service as a percentage of a person's disposable income is around 5.7%; this number compares favorably to 6.0% in 2007 and 6.1% in 1987. The MAJOR difference is that our NATIONAL debt now stands at 121% of GDP vs. 67% in 2007 and 48% in 1987.
In addition to major differences in sovereign debt levels, there are also major differences in demographics and the housing supply now vs. history. The US was experiencing rapid population growth in the 1980s, and Baby Boomers were just beginning their careers; whereas now, those Boomers are much more reliant on a smaller, younger workforce. The US was able to grow its way out of recession via consumption in the 1990s, and that's unlikely to happen this time around. Additionally, the dependency on this smaller workforce is keeping wages (and inflation) higher, which will give the Fed less room to navigate when rates need to come down.
Interestingly, it will probably be residential real estate that creates the thorn on the Fed's side. This time around, there's a generation of homeowners who have a ton of equity in their homes and are financed at interest rates that will never be seen again for their lifetimes. These homeowners are more likely to be older or retired, and so even a major labor discontinuity probably won't force them to get housing supply on the market. If home prices don't come down, the Fed won't be able to lower rates as quickly, and that will make for a harder economic recovery.
Demand: It’s just the comps.
Supply: Gone, again.
Let’s check in on our trusty table summarizing the current conditions in Denver’s housing market within a 10-mile radius around downtown:
Residential market data for area within 10-miles of Union Station in Downtown Denver as of August 16, 2023
With volumes as light as they've been over the last six months, even the smallest reversal in trends feels like a tsunami of activity. New listings hit the market at rates even lower than last year while pending activity stayed close to flat, so the net effect on conditions was a drastic decrease in supply. The market had been experiencing excess supply against the previous year for quite some time, and last month flipped to a deficit.
The overall impact of constant demand with falling supply is an increase in prices. As supply flipped from excess to deficit, so did the price trend from down to up. This year confirms some very weird behavior: the buying season is happening in the 3rd quarter instead of the 2nd. What makes this especially "weird" is that rates are higher now than they were three months ago, and one would have instead expected a further decrease in activity in that environment.
It is not FOMO with our current portfolio of clients. Most of them are first-time home buyers or people who are in the process of forming households and raising families, so we expect this demand to continue. At the same time, it feels as if Boomers are entirely out of the market right now. With rates as high as they are, it's hard to qualify for a reverse mortgage unless you're free & clear, and it's extremely hard to move if you still have active financing. (The rates are such that even downsizing is leading to higher mortgage payments for a lot of folks who would otherwise be looking to move.)
Welcome to the High Plateau. Volumes are lower, prices are higher, and home affordability is just out of reach. The new normal. If you want to beat the competition and lower your mortgage payment at the same time, give our integrated broker a call. We can help you afford up to 8% higher purchase prices while lowering your monthly payments.
