The housing sector surged during COVID for a few reasons. The Federal Reserve kept short-term rates low and the money supply soared. Now, with rising short-term rates and mortgage rates creeping higher, the housing sector is beginning to normalize. Sales are down, construction is down, and the most recent reports on home prices show a sudden and sharp deceleration. Sales soared in 2021 but have since plateaued, as growth in consumer spending has come from services, not goods. Expect something similar in the next few years with housing, with national average home prices roughly unchanged while rents continue to catch up.
Recent problems in the housing sector are widespread. Existing home sales have dropped for six straight months and, with the exception of the first few months of COVID, are the slowest since 2015. New home sales are the slowest since early 2016. Private residential construction rose for twenty-four straight months through May and has now declined for two straight months. But perhaps the most dramatic change is in prices. The national Case-Shiller index rose more than 1.0% every month from August 2020 through May 2022. Home prices rose 8.9% in the first five months of 2022. As a result, some are thinking we are in for a massive housing bust the kind which hit the US after the last boom in the 2000s. The housing market will feel some pain, but we are facing nothing like what happened in the last housing bust. Last time, national average home prices bottomed in 2012 about 25% below where they peaked in 2007. From peak to bottom, housing starts plummeted 79.0% and new home sales fell 80.6%. Existing home sales dropped 52.3%.
So why do we think we are not in for a huge housing disaster like 2007/2008? First, the last housing bust was preceded by several years of massive overbuilding. We had too many homes available for sale, as well as too many homes available to rent. By contrast, the most recent turbulence in the housing market has not been preceded by overbuilding. If anything, we’ve built too few homes in the past decade, not too many.
Second, although home prices have risen substantially since 2020, relative to replacement costs, they are only up about 2% and only about 4% higher than the median in the past forty years. Why does replacement cost matter? Because the more it costs to replace your home, the more your current home is worth. So, yes, home prices are up substantially, but if the costs of copper pipe, drywall, lumber, and labor are up, too, then it makes sense for home prices to rise.
Third, rents should continue to rise at a rapid pace, putting a sturdier floor under home values. In the last housing crisis, home prices fell and housing rents decelerated sharply. Many people were leaving homeownership and landlords couldn’t squeeze them for more rent because there were simply too many homes available.
In the current environment, where higher mortgage rates are persuading some potential home buyers to remain renters, landlords are in a much stronger position. They can keep raising rents because the market isn’t oversupplied with homes. In turn, higher rents should keep home prices from falling like in the prior housing bust. The more a home can generate in rent, the more valuable the home becomes. The bottom line is that what we are seeing right now in the housing market is a bad case of indigestion from higher interest rates. Due to overly loose monetary policy and other COVID-related policies, home prices got too high versus rents in the past couple of years, and both prices and rents need to correct. We project continued gains in rents in the next few years as home prices stabilize.