Is the US housing market headed for a price correction?
U.S. home prices rose 18.8 percent in 2021, according to the S&P CoreLogic Case-Shiller U.S. National Home Price Index. During the first three months of 2022, home prices continued their upward trajectory. According to the National Association of Realtors (NAR), the “median existing-home price for all housing types in March was $375,300, up 15.0% from March 2021 ($326,300), as prices rose in each region. This marks 121 consecutive months of year-over-year increases, the longest-running streak on record.”
Despite surging home prices, there are growing concerns regarding the overall health of the U.S. real estate market as the pace of sales cooled in recent months amid fast-rising mortgage rates and continuing supply shortfalls. Recent analysis by Redfin suggests that at least some homebuyers have moved to the sidelines. But the same analysis suggested that around 54 percent of homes still sold above their list price.
Given the outsized role that the housing sector plays in the U.S. economy, it is worth considering whether we are approaching an inflection point in the real estate market. Indications that the Federal Reserve has finally realized that it needs to front-load rate hikes to curtail surging inflationary pressures have caused the bond market to reset interest rate expectations. Consequently, the 30-year mortgage rate recently surged past the 5 percent level (average mortgage rates are up 2 percent since December 2021).
While rising mortgage rates weigh on buyers’ ability to bid up home prices going forward, it is still not clear that an actual correction or sustained reduction in median sale price is likely this year. On the demand front, several favorable structural drivers are still in play. First, millennials are reaching the sweet spot for becoming first-time homebuyers. According to a recent NAR report, “the combined share of younger millennial (23 to 31 years old) and older millennial buyers (32 to 41 years old) rose to 43% in 2021, up from 37% the year prior.”
Second, the shift of some white-collar workers from top-tier to second-tier cities has generated substantial fresh and ongoing demand for housing in urban and suburban regions experiencing rapid population growth. Fortune magazine’s Shawn Tully notes: “The home-office economy has unshackled families to leave high-cost metros on the coasts and flock to super-affordable Sunbelt cities, greatly boosting their markets.”
A third factor has to do with price-to-rent ratios. While sharply surging price-to-rent ratios in fast growing metros (Boise, Phoenix, Austin, etc.) might be a cause for concern, the stunning increase in rents across the nation in recent months may act as a push factor for potential homebuyers.
Essentially, expectations of continuing rapid increases in rents may force some to consider becoming homeowners with a fixed and predictable monthly mortgage payment. The fact that real estate may act as an inflation hedge is an additional bonus.
Finally, the emergence of deep-pocketed corporate buyers and investors has been a factor sustaining demand, especially in Sunbelt cities. Private investors are competing with and frequently outbidding first-time home buyers.
On the supply front, housing inventories continue to remain low. The fact that new housing construction (especially of single-family homes) was muted for a decade after the 2007-08 crash has left the U.S. with a substantial supply shortfall. High cost for materials and supply bottlenecks have further hampered home builders from ratcheting up new construction and delayed the arrival of new units onto the market.
Furthermore, many existing homeowners are unwilling or unable to put their homes on the market. Many who have locked in historically low mortgage rates in recent years are unwilling to take the risk of entering a red-hot housing market where they may not only have to pay a high price to find a new home but also risk a potentially much higher mortgage rate. Insufficient new and existing home inventory will likely keep prices elevated in the near term.
While a housing market correction in 2022 is unlikely, there are several serious headwinds facing the real estate sector. Increasing problems associated with housing affordability poses a growing threat. In many parts of the country, especially in metro regions that have experienced a substantial rise in both rent and home prices, the portion of monthly budgets that households devote to shelter-related expenses has surged well past ideal or sustainable levels. (Typically, spending around 30 percent of monthly income on rent or mortgage [and HOA] payments is considered ideal.)
At present, the very tight labor markets and strong household balance sheets offer sufficient ballast to sustain real estate demand despite elevated home prices. As the Federal Reserve belatedly turns hawkish and implements aggressive rate hikes to fight inflation, there is a definite risk of an economic hard landing in 2023. Once higher interest rates cool the economy sufficiently enough to cause unemployment rates to rise, many more households will encounter difficulties meeting their housing-related expenses.
A recent study by the Dallas Fed offered the following stark warning: “Our evidence points to abnormal U.S. housing market behavior for the first time since the boom of the early 2000s. Reasons for concern are clear in certain economic indicators—the price-to-rent ratio, in particular, and the price-to-income ratio—which show signs that 2021 house prices appear increasingly out of step with fundamentals.”
The one mitigating factor is that the financial sector has not lowered borrowing standards this time around, and that potentially reduces the risk of broader shock to the real economy when the housing market eventually cools.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.