What goes up must come down?
US house prices have so far defied many analysts’ expectations and barely budged in the face of the highest mortgage rates in two decades, with the average rate on a 30-year fixed mortgage soaring to nearly 8% in recent weeks. After a brief and shallow dip earlier this year, the S&P CoreLogic Case-Shiller US National Home Price Index has resumed its upwards path, even as yields on 10-year US Treasuries have soared to levels not seen since 2007.
And with benchmark bonds now marching to a “higher for longer” mantra, the key question is how long can the US housing market withstand the pressure of more expensive financing?
In an interview with the Odd Lots podcast, Morgan Stanley US Housing Strategist James Egan — who correctly predicted the resilience that we’ve experienced so far in US home prices — now sees a limit to how long this dynamic can continue.
If rates don’t fall soon, he says, it will be difficult for house prices to rise much more given the shock to affordability. That being said, there may be a floor on how far prices can fall, due to a combination of structural and cyclical factors keeping inventory extremely tight.
Per Egan, here are some of the dynamics we’re seeing play out right now.
1. The impact of higher rates has been slowThe average rate on a 30-year mortgage has surged to 7.89%, according to Bankrate.com, but that doesn’t mean that everyone is paying the same rate, of course. One reason why US house prices have so far resisted the gravitational pull of soaring interest rates is because many homeowners locked-in lower borrowing costs before the Federal Reserve started hiking in its attempt to tame inflation.
“The effective rate of mortgages in the United States, the outstanding balance, is somewhere between 3.6%, 3.7%,” says Egan. “The prevailing rate is approaching 8%. That is a gigantic gap that we haven't seen in decades, over 40 years at this point in time. And so even though it’s eroding … it’s eroding on the margins.”
2. Deteriorating affordability means lower demandWhile existing homeowners may not feel the impact of higher rates, rising borrowing costs still have a major impact on anyone buying today. And as borrowing to buy a home becomes more expensive, it’s inevitably going to cut into demand for housing.
“One of the things that characterized 2022 was just an historic, at least through the history of our data, decline or a deterioration in affordability,” Egan notes. “Year-over-year changes were three times worse than what we witnessed during the great financial crisis.”
“And if mortgage rates were to stay at 8% for a longer period of time, affordability deterioration would return back to a place that we haven't seen in decades, the 2022 period notwithstanding.”
Because prices have held steady even as the mortgage rate has surged, the actual payment that new buyers need to make has rocketed higher. According to Morgan Stanley’s calculations, the monthly payment on a median-priced home has jumped 27% over the past year alone to more than $2,000 a month.
“It’s going to mean that demand is weaker,” Egan says. “If rates are going to stay elevated, we think that demand will remain tepid.”
3. But higher rates could also mean tighter supply
Tepid demand means that you need low supply to help keep house prices afloat. And of course, this is where the much-discussed lock-in effect comes into play, with people who have cheap mortgages disincentivized to move and helping to keep a tight lid on the number of homes for sale.
“Existing home sales have fallen more than twice as quickly,” Egan says. “If we control for affordability deterioration, [they’ve fallen] more than twice as quickly as they did during the great financial crisis. Housing starts from their peak in this cycle — in kind of April/May of 2022 — single-unit housing starts are down over 20%.”
What’s key, however, is that much of the mortgage rate lock-in effect happened with the move from 3% to 7% mortgage rates. As such, the marginal impact of going from 7% to 8% is more modest.
The first move in rates, Egan notes, “took a lot of homeowners, a lot of mortgaged homeowners from sort of at-the-money around the prevailing mortgage rate to deeply out-of-the-money locked into their mortgage payment.”
But with the latest shift higher the impact will be more muted, Egan argues: “It’s not capturing the same quantum of marginal homeowner and so the impact on things like supply, the impact on demand, especially the rate of change is not going to be the same this time around than it was in 2022.”
In the aftermath of the 2007 housing bust, many homeowners simply walked away from their underwater mortgages when they couldn’t make their payments. However, in 2023, with house prices still close to their all-time highs and the cost of rents surging, there are signs that Americans are more dedicated to preserving the equity in their homes.
“One of the axioms that kind of came out of the last crisis was, well, you can sleep in your car but you can’t drive your house to work,” Egan says. “Flash forward to this year, prime delinquencies [in mortgages] start increasing a little bit, much more than than we certainly expected them to. And if you look at the way in which they’re increasing, it's not this straight current 30-, 60-, 90-day delinquency. It’s maybe inflation’s higher, miss one payment but stay at 30 days delinquency for a while, miss another payment, stay at 60 days delinquency for a while.”
“We think one thing that could be happening here is these borrowers are looking to protect the equity they have in their home,” he adds. “They're looking to protect the very low cost of shelter, the cost of financing of their home that they have. And those things might be leading to a payment priority shift back towards mortgages.”
5. So it all comes down to supplyWith affordability this stretched and rates this high, the big variable is on the supply side. But what causes supply to expand meaningfully from here is highly uncertain. Homebuilder sentiment is tumbling again and has fallen to its lowest level since January. Meanwhile, there’s a huge cohort of homeowners who are essentially inelastic holders and are unlikely to sell for any reason.
According to Egan, from 1980 to 2012, a steady 25% of all homes were owned by those 65 and older. Today that figure stands at 33%, and the team at Morgan Stanley only sees it going higher.
In theory a recession that comes with a substantial job losses could create more forced sellers.
But even there the effect is ambiguous, Egan notes. That’s because in the aftermath of the great financial crisis, as home prices plunged and defaults on home loans surged, a whole infrastructure for mortgage modifications was put in place in order to prevent foreclosures.
That previous experience with mortgage modifications and other forbearance measures could end up curbing the link between layoffs and liquidations. “Servicers are much more practiced at implementing these foreclosure mitigation options,” he says. “Borrowers, we believe, are much more likely to know they are available to them.”
So, Egan argues, while it’s unclear what will cause a meaningful pickup in supply, it is now the key variable for price.
“We have to become super-focused on this low inventory, this low supply environment because a growth in supply for any reason will lead to weakness in home prices,” he concludes.
Related links:
‘Blame the Boomers’ for Surging House Prices, Barclays Says
Here’s How Weird Things Are Getting in the Housing Market
The Fed Hiked Rates Rapidly But Housing Is as Broken as Ever