Housing More Pain Ahead?
With the rising interest rates and the Fed saying they will "taper off" the buying of MBS, we have seen mortgage rates skyrocket. There have been rapid increases in mortgage rates as of late. We are seeing clear signs of demand destruction and cooling within the US. So what does this mean going forward? Many people are asking if housing is posed to cool further or if there is a possibility that it will bounce back. In this post, we will go through that data.
First, I'd like to discuss housing on aggregate. We will be looking at the US in its entirety (broadly speaking). When we think about housing in terms of price rises, we have to consider the elasticity of demand within different markets and how that can be affected. I will not do a deep dive on that in this post, as that is more of a policy discussion, but I will slightly touch on it. Policy plays a considerable part in the elasticity of demand in terms of housing; zoning laws and urban growth boundaries can make the housing market in terms of demand inelastic. When one thinks about housing markets, one must disaggregate from Houston (little regulation) to New York, San Francisco, Toronto, and the like (tons of regulation). As previously stated, this is about as deep on that as I will go in this post, but I thought it was necessary to understand housing elasticity of demand.
We all know that interest rates are increasing rapidly; while they have started to cool, this has significantly dampened housing demand, especially new sales. Mortgage rates have done a decent job cooling demand, and at the time I pulled this chart from Refinitiv New Home Sales had fallen 17% MoM. When I pulled the data, the estimate was 750k and it came in at 591k (well below the estimate). This can be seen below in Chart 1.
The next housing trend I'd like to call out is that starts and permits remain on an upward trend from a historical standpoint. Even as housing cools starts and permits are both extremely elevated. This could put further downward pressure on housing as supply keeps coming online even as the housing market starts to cool. This is also concerning because builders will have to sit on those inventories, the same thing that happened in 2008 when builders had overbuilt. Looking at this upward trend that we see in permits and starts, as stated, it seems like we could have oversupply, and this could put further downward pressure on pricing. Chart 2 shows this below.
The real question is how exuberant housing is within the US as seen in Chart 3. The real housing prices have risen rapidly and have overextended their 95% confidence upper bound, roughly around 1.25, and we are now seeing upwards of 3.25. The price-to-rent is also overextended and comes in at about 2.5, so it overextended over the 95% upper bound. Price-to-income, which measures house prices to disposable income, is not showing any exuberance. There has been an extremely hot housing market, and the housing market within the US is clearly exuberant.
As we are seeing signs that housing demand is slowing, homebuilder sentiment is also deteriorating, but there are further signs that prospective buyers are now in pessimistic territory. As interest rates stay elevated, that will continue to deter prospective buyers. This is because the present discount value is affected when rates are low. Obviously one can "afford" more house, but as rates rise PDV changes. So obviously, the amount of house prospective buyers can now "afford" has changed. In that, the payment (depending on the house's value) could have just gone up by 30%. To keep it simple, if you had a mortgage of 680k, a down payment of 6.4%, amortization of 25 years, and an interest rate of 130bps if rates just went up 400bps on a VRM your payment just went up by 40%. This is a tremendous way to see demand destruction because this completely changes one's ability to afford that home. This can be seen below in Chart 4.
Now, what is the good news? Well, the good news is that the US has been investing in machinery and equipment + intellectual property as a ratio to real estate investment. Canada, however, is suffering from the opposite issue. So even as housing slows, we have a solid base for economic build back after the recession and the ability to make sure that production is relatively strong. This will put further pressure on the Canadian economy as real estate assets deteriorate. This can be seen in Chart 5 below.
So looking at some of the data within the United States, we are seeing clear signs of demand destruction. I expect more deterioration within the housing market and prices to continue on a downward trend as supply starts to build even relative to demand falling. With all the negatives being said the positive thing is that as a ratio of residential investment again machinery equipment and intellectual property, we have done a decent job as that ratio shows of investing in things that will increase the productive capacity. Looking forward, this is probably a time to just see how things play out and wait for the moment to find the opportunity within the housing market.