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The great moderation is upon us
Before the pandemic, the historical average of annualized house price growth was approximately 4%. Yet, pandemic-era dynamics exacerbated an already large housing demand and supply imbalance, fueling record-breaking annual house price growth, peaking at nearly 21%.
Today, as affordability wanes and housing supply ticks up, house price growth is decelerating and will likely continue to trend towards its historical average. Buyers and sellers alike have now anchored their expectations of “normal” to sub-3% mortgage rates, multiple-offer bidding wars, and double-digit annual price growth.
As a result, the “great deceleration” may feel more severe as the housing market comes off its two-year sugar high and shifts to a not-so-new normal. The normalization will look different depending on local market conditions, but a repeat of the housing market crash is unlikely. So, if this time it’s different, what are the forces that will drive the housing market forward or hold it back?
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There remains a deep-seated desire for homeownership, especially among younger millennials who continue to age into their prime home-buying years. This desire is buoyed by the increased ability to work-from-home and the need for more space.
Compared with the fourth quarter of 2021, the homeownership rate in the second quarter of 2022 for households under 35 years old increased by 0.8 percentage points, more than any other age group. The homeownership rate increase happened during a quarter when the 30-year, fixed mortgage rate increased at the fastest quarter-over-quarter pace since 1980.
That’s because buying a home is both a financial and lifestyle decision. While the more than 50% year-over-year decline in affordability will continue to temper millennial homeownership demand in 2022, lifestyle choices that highly correlate with homeownership will persist and keep millennials as the driving force in potential homeownership demand.
Millennial demand also makes this housing slowdown different from the previous boom and bust. Looking back at the housing bubble in the mid-2000s, house price appreciation was characterized by a surge in demand driven by wider access to mortgage financing and a rise in speculative and fix-and-flip buying. While speculative buying still persists, the primary driver of current housing demand is first-time homebuyers, armed with mortgages that have been underwritten with much stricter lending standards, further mitigating the risk of a housing bust.
Buying a home is the largest financial decision a person will likely make, predicated on one’s lifestyle choices, financial security and economic certainty. Affordability is a concern, especially among first-time homebuyers who do not have the benefit of equity from the sale of a home. Mortgage rates at or above 5% are likely the not-so-new normal and, if house prices don’t moderate sufficiently to offset the affordability loss from higher rates, then potential buyers will continue to lose purchasing power.
Additionally, inflation and the corresponding risk of a Federal Reserve-induced recession with potential labor market consequences remain concerning and are severely impacting consumer confidence. This could weigh on purchase demand, prompting an acceleration in house price moderation.
While increasing from historic lows, housing supply remains a challenge. The recent rise in inventory is more about homes sitting on the market longer than new inventory being added. The months’ supply of existing homes in July 2022 was approximately three months, still below the historical average of six months, but trending toward it.
While more new homes are expected to come to market, existing-home sales are likely to stall. The reason? The rate lock-in effect of higher rates, which incentivizes homeowners to keep their current mortgage and stay in their existing homes. Existing homes historically filter down to the first-time homebuyer, so the ongoing supply shortage will continue to weigh on the housing market, and particularly first-time homebuyers.
The likely outcome
The housing market has the demographic wind at its back, which will keep a floor on how low demand can go. The recent pullback in demand is a function of two factors — some buyers can no longer afford to buy given the higher mortgage rate environment and higher home prices, while others are choosing to wait until they feel the economy is on more solid footing. Yet, there remains a long-run shortage in supply relative to demand, which supports a natural moderation of house prices nationally, rather than a sharp decline.
Indeed, a sharp decline in prices would require a wave of distressed selling, which is unlikely. The housing crisis that triggered the Great Recession was fueled by job losses in combination with homeowners with little to no equity.
While some pockets of the country that became overvalued over the course of the pandemic will face a more severe slowdown, homeowners today have very high levels of tappable home equity, providing a cushion to withstand potential price declines.
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