Some have called this the weirdest housing market in recent history due to the unusual mix of high interest rates and declining affordability. And yet, we still have record high home prices across the 20 largest housing markets in the country. This month, we're diving into the U.S. housing market, a topic very relevant to many investors given a house is often the largest single asset one owns. In this episode, we're excited to shed light on the US housing market, what makes it challenging, what makes it unusual, and what needs to change for it to improve. We're joined by Preston Caldwell, Morningstar's Chief US Economist and Brian Bernard, Director of Equity Research specializing in the industrial sector, which includes homebuilders.
Nicholas VanDerSchie: Some have called this the weirdest housing market in recent history due to the unusual mix of high interest rates and declining affordability. And yet, we still have record high home prices across the 20 largest housing markets in the country. This month, we're diving into the U.S. housing market, a topic very relevant to many investors given United States home ownership rate of 65.6%. And for many, the house is often the largest single asset in one's portfolio.
In this episode of Simple But Not Easy, we're excited to shed light on the U.S. housing market, what makes it challenging, what makes it unusual, and what needs to change for it to improve. I'll be joined by Preston Caldwell, Morningstar's Chief U.S. Economist and Brian Bernard, Director of Equity Research specializing in the industrial sector. Before we get into the conversation, if you'd like to know more about how we support advisors, we welcome you to email us at simple@morningstar.com or me directly at Nicholas.VanDerSchie@morningstar.com.
Now, let's get started. Preston, Brian, welcome to Simple But Not Easy.
Brian Bernard: Thanks for having me.
Preston Caldwell: Good to be here.
VanDerSchie: Great. Preston, starting with you, I want to welcome you back to Simple But Not Easy. You joined us almost a year ago now to discuss the 2024 market outlook. We're really glad to have you back. What have you been up to?
Caldwell: Well, in my job as chief U.S. economist, the fun never ends. At least right now, I'm glad the job is continuing to be interesting. The U.S. economy is still in a uncertain state. Inflation has normalized to a great degree as we had expected, but we're not quite ready to declare mission accomplished yet. But, I think the big puzzle here is, how strong is the U.S. economy and therefore how much will the Federal Reserve need to cut interest rates ultimately? Because it's been really quite a puzzle how strong the economy has been over the past year or so in spite of restrictively high monetary policy. So anyway, yeah, there's been a lot on my plate, definitely.
VanDerSchie: And Brian, you're Director of Equity Research with a focus on industrials. We're glad to have you on the podcast. Can you tell us about your role and tenure at Morningstar?
Bernard: Sure, yes. I've been at Morningstar for going on nine years, five years in that Director role. So I lead a team of industrials analysts. We have nine on the team. Now, I still do stock research as well. I cover home builders, building products, and waste management. And I also lead our housing research efforts and work closely with Preston.
VanDerSchie: Great. Let's get into the conversation. And I want to begin by focusing on themes existing homeowners are thinking about. And a great place to start would be to frame the conversation of today's housing market by first reviewing changes since the pandemic. And I know a lot has happened over the past few years and understanding that context is really key to making sense of it all. Preston, there seems to be a widespread belief that housing affordability has been accelerating at a faster rate than any time in the past few decades. And while sentiment can sometimes just be noise, other times it is a true signal. So let's start with a big question. What's happened?
Caldwell: Yeah, so the way to really gauge housing affordability is to look at the median mortgage payment as a share of household income. And that ratio was fairly stable in the decade before the pandemic. But from 2019 to 2023 on average, we went from a 19% median mortgage payment as a share of income to 28% by 2023. So that was a huge increase. It took us to levels of housing affordability that haven't been as bad since the peak of the housing boom in 2007. Much higher than the historical average of the last several decades. The biggest driver of that deterioration and affordability was higher mortgage rates, which increased by around 300 basis points, comparing the 2019 to the 2023 annual averages going from around 4% to 7%. Increasing home prices also played a role. So from 2019 to 2023 median household income grew by about 26% while home prices using the Case Schiller index increased by 46%. Now, and we can talk more about this. It's very surprising for home prices to perform so strongly in spite of higher interest rates. In any case, we are forecasting that affordability does improve considerably in coming years as interest rates fall further. And also home price growth is more tepid compared to how it's been recently. So we're ultimately expecting that median mortgage payment as a share of income ratio to go back to 20% by 2028, almost the 19% that it was in 2019, largely as a result of falling mortgage rates.
VanDerSchie: And, Preston, you mentioned some of the drivers. Brian, I want to turn to you. What are some of the other significant factors driving this?
Bernard: Well, yes, with home prices, as Preston said, that just was really strong over the last couple of years. And really, during those pandemic years, we had a perfect storm of demand. If you look back, the years leading up to the pandemic, on average, you'd have about 1.1 million annual household formations. We had 4 million households form in that 2020 to 2021 period. There's just a lot more households looking for new and existing homes. Some of the factors there is we had the millennials reaching that prime home buying age. I mean, that was a thesis that we had years ago, and that generation was slower than we'd expected to really gain to buying homes, but that really accelerated during the pandemic. You had a period there where we had record low mortgage rates at 30, or average fixed rate fell to a record low of 2.65% in early 2021. You had surging savings during the pandemic. You had some households getting checks from the government not being able to go out to dinner, less discretionary spending. You saw that average savings rate went up to 15% versus an 8% historical average. On top of that, you had work from home that allowed more flexibility, allowed households to perhaps look outside of where they would normally want to live. And you had changing household preferences too. People were stuck in their homes longer. They realized, hey, I want a larger home. I want a larger yard. All those things really worked together and resulted in that unprecedented level of demand that we saw over those couple years.
VanDerSchie: Thanks, Brian. So let's dive into the supply side now. And from the opinions that I've seen, the U.S. has an under supply of homes, but at the same time, we have an oversupply of apartments. And so, Brian, I guess, do you agree with these opinions and what are you seeing?
Bernard: Yeah, well, it's interesting. I see a lot of calculations for under supply. Most people will agree that we are under supply, because I've seen the estimate as low as 1.5 million to over 7 million units that we need. It all kind of depends how you calculate it. The way that we've looked at it kind of pegs it at 2.5 million homes needed. That's both single family and multifamily. So I agree that there's a shortfall of supply there. In terms of the multifamily, so what's going on now is that we have a record backlog of multifamily construction right now. There's about 850,000 units under construction. So, that's going to take a while to be absorbed by the market. You see developers are kind of pulling back over the short term here to allow that to happen. But when those things deliver, those units deliver, I don't think we're going to be in an oversupply position. We're still going to be under supply, but it's just going to take a period of time that needs to be absorbed by the market. So, yeah, I mean, the reason that we are in this position is that, during the great financial crisis, we just had a decade of underbuilding. And then, obviously when we had, as I mentioned, we had that big pickup in demand during the pandemic while there was all these supply constraints, right? The supply chains of these builders were disrupted. You couldn't get garage doors. You couldn't get windows. That slowed things down as well.
VanDerSchie: So, makes sense. Preston, anything to add on this?
Caldwell: Yeah, and I mean, of course, there's also a structural element to insufficient housing supply, mainly in our largest and most prosperous cities has been underperforming for some decades, largely as a result of regulatory restrictions, mainly at the state and local government level in terms of zoning and other obstacles. You know, there were two economists just several years ago who estimated that if you had an unrestricted amount of housing supply, then as a result of being able to draw more workers to these high productivity cities, U.S. GDP could be increased by 36%. So, this is a huge issue and it's interesting to start to see politicians too at the national level even kind of wake up to the importance of this issue. We've heard it talked about a lot more on the campaign trail this year.
VanDerSchie: I've heard someone say inventory is the most important data point to understand when it comes to housing. Brian, can you share some of the inventory trends you're seeing when it comes to new houses being built?
Bernard: Yeah, so one data point that we track closely is month supply of homes for sale. So, that's calculated as the number of homes for sale divided by the sales pace. Put another way, just tells you how long it would take to sell all available homes given the current sales pace. Inventory on its own is less of a useful indicator, but for both new and existing homes, a healthy range is four to six months, and the historical average is closer to the high end of that range. But the month supply of existing homes fell to a record low of 1.6 in early 2022. Now, by that time, construction supply chains have begun to heal. Homebuilders saw the opportunity to capitalize on less competition from that resale market, and they began building more speculative homes. What that means is, a lot of homebuilders won't start building a home until they have a sales contract deposit in hand. But, when you're building under a spec strategy, you're building without that sales contract. You're really, you're just hoping to put something out there and compete with the resale market. It's riskier, but obviously in the environment, it can make a lot of sense. And a lot more homebuilders were starting to do that. And, we had a period here where supply of new homes actually, for a month, it peaked to 10. And again, that should be kind of for a healthier average, should be more around four to six.
It's come down a bit. We're around eight months supply right now of new homes. But suffice to say is that we're, you know, we do have a plenty of supply of new homes for sale here. In terms of the type of home is being built now, you're seeing homebuilders to address affordability. They are shifting towards building smaller homes on smaller lots with less amenities. We're really trying to, again, address that affordability issue. You know, like an extreme example, if you're interested is Lennar, look at their Elm Trails community in San Antonio. That is where they're building one bed, two bath homes that are like 600 square feet, $155,000. I mean, it's kind of crazy that these builders are building such small homes, but you're seeing more of that and it's working. So, yeah, I mean, overall the homebuilders are doing well because they've been able to increase supply there.
VanDerSchie: 661 square feet. It was like my first studio apartment when I moved to Chicago. So, we talked about new homes, but what about existing homes or resales? And, you know, if we had to separate the existing home issue into two parts, number one, being homeowners refusing to sell because they've locked in cheap mortgage rates versus number two, the pool of available buyers that can actually afford a new home. Preston, which direction does the scale tip or better said, which factor is playing a bigger role in the slowdown of existing home sales?
Caldwell: Yeah, well, I mean, in terms of the slowdown in home sales, obviously with many mortgage rate borrowers being locked into low rates, that lowers the amount of transaction volume. You have fewer people seeking to move because they have a much better interest rate than they can get on the market right now. Now, I think that, the underlying issue here is what is the impact on housing prices here? Because a lot of people have cited this as the main factor propping up housing prices. I'm a little more skeptical of this because, I mean, the mortgage lock-in effect is nothing new. I mean, fixed rate mortgages have been the norm in America for some time. We used to have a few more variable rate mortgages than we do now, but still it's always been the norm to have a long-term fixed rate mortgage. And so even still, in historical business cycles, when we've seen interest rates rise, we typically see not a decline, but at least a fairly weak rate of growth in housing prices. So, citing that as an explanation makes me a little skeptical. And just from our first principles basis, it's true that mortgage lock-in reduces the number of people seeking to sell their homes. But keep in mind, every person that's going to sell their home is also someone who's ultimately going to be a buyer if they're motivated by that reason.
So the net effect in terms of total housing supply and demand is near zero. Again, I really don't think that the lock-in effect is probably the main factor at play. I think it's kind of an ad hoc explanation that people have come up with to explain what's happened. And maybe it's more so just, the strong financial conditions that we see across the board. We see high asset prices in equities and in other markets. And so it's not surprising that housing prices have also performed strongly. And then also just kind of the, the geographic dislocations from the pandemic, with all these people, moving into new states, new areas, that kind of dislocation can at least temporarily prop up housing prices. So, yeah, those are my thoughts on that front.
VanDerSchie: That makes sense, Preston. Brian, what's your take on this?
Bernard: No, I mean, I think that's a fair assessment. Much like I said with the calculation for the shortage of homes, everyone's got a different opinion on here. I just, you know, kind of some interesting data points. I saw what that rate lock in effect is, a recent report from the Federal Housing Finance Agency studied that and, they concluded that the rate lock in effect prevented about 1.7 million home sales over 2022 or 2024. And they found that they thought that that was at least responsible for a 7% increase in homes. So, but again, it's what Preston said is, I mean, I think that that's a fair assessment. But yeah, I mean, as rates go down, we are going to have a bigger pool of buyers. Again, that's another data point that from the National Association of Homebuilders found that if mortgage rates fall to, kind of our long term run rate of 4.75, that's going to unlock about 7 million more households that can afford homes.
VanDerSchie: Okay, great. So let's pivot the conversation now to focus on households looking to buy and become first time homeowners. We've talked about how a decade of low interest rates has created this lock in effect, along with a decade of under building that's created some supply constraints. So with that as the backdrop Preston, what does the future look like for this cohort of people trying to become homeowners?
Caldwell: Well, I talked about affordability improving over the next few years. So my expectation, based off of monetary policy, continuing to ease is that this financial burden of home owning becomes easier over the next several years. And again, part of that, the main driver is interest rates, but there is also a contributor in so far as we expect home price growth to be fairly tepid in the very low single digits over the next five years. So that's one thing to keep in mind that, that it will become more affordable to own a home. But, don't expect as much price appreciation as we've seen in the past. Don't let that be, a cornerstone of your financial planning, seeing your home price go up like it has in the recent past. So, overall, I do think, the long run issue is really. Especially for those of us who live in the most expensive metro areas is how the supply side restrictions are dealt with because if those are dealt with, though, even if home prices, even if home and affordability is fairly reasonable nationwide, we will see home affordability continue to get worse, most likely in our most productive, expensive metro areas. But a potential, it was thought a couple years ago that a potential solution for that was remote work, but now increasingly we're seeing renewed calls back into the office with Amazon and otherwise. So maybe remote work won't be the panacea that we thought it would be, or it's too soon to tell. So, but again, on the whole, we do expect affordability to trend in a better direction.
VanDerSchie: And there's often this narrative that institutions and private equity firms are buying up all the houses and we hear about them buying up large neighborhoods in high population areas that have benefited from migration trends, think maybe the Sunbelt or the western part of the U.S. Brian, is the Wall Street landlord a major factor hurting first time home buyers?
Bernard: No, I don't think so. I think that that narrative is really overstated. If you look at the data, there's these large institutions own maybe 500,000 single family rentals. That's about 3% of the housing stock. Now, that being said, there are certain metros, like you said, in the southeast Atlanta, Jacksonville, where they do own a greater percentage of single family rentals. But again, I don't think that it's this narrative where you're looking for one house in a neighborhood and BlackRock comes and buys that from you. And just to put this in perspective, too, we're talking about single family rentals. There's only about 14 million of those in the U.S. as well. And I think they play an important role because that's good for households that want to get into that single family home, but maybe can't afford a down payment. And that's a good stepping stone there. So I just, I don't think that that's a big issue. And if you look at even like home builders, they're starting to build more single family rentals for these institutions, but it's still relatively small. If you look at D.R. Horton the largest builder in the U.S. in 2023, they built just over 6,000 of these units again, for these large institutions, but that's like 7% of their delivery. So it's not as if that they're shifting all their production to serve these guys. So quite simply, I think it's not an issue. If anything, I see these things, these single family rentals as a stepping stone for getting into an ownership position.
VanDerSchie: That's a good perspective for our listeners, Brian, thanks. Preston, from your point of view, are there other factors that could be impacting demand for first time buyers, the affordability issue aside, what else might be at play here?
Caldwell: Well, I mean, despite the surveys showing fairly poor household and consumer sentiment, you know, household finances in aggregate are not in bad shape. So, at the end of 2023, we were at a total household debt at 72% of GDP, which is actually a bit below the pre-pandemic level at 75%. It's not anything like where we were in the mid-2000s. 2007, we were at a household debt to GDP of at 99%. There's a huge run up during that decade with households getting into more and more debt to finance unsustainable consumption and purchasing of homes. We do see some signs of stress. Yes, credit card debt or credit card delinquencies have ticked a bit above pre-pandemic levels. But in the aggregate, yeah, I don't think that financial stress among households is playing a particularly negative impact in terms of demand, at least, compared to the pre-pandemic baseline.
The job market is very strong, obviously, and wage growth has essentially caught up to inflation and then some, it's exceeded it at this stage. So, I do think, one positive driver for just overall housing supply and demand has been immigration. And one thing I would say is that, at the economy-wide level, I think immigration, it shifts supply and demand in those two, probably largely offset. But for housing markets in particular, the increase in demand is probably more than the increase in supply, just because so many factors on the supply side, namely land, are restricted, especially in the short run. Therefore, this boost in immigration we've seen in the last few years probably has had a net upward impact on housing prices, even as it hasn't had much of an impact on the overall inflation index. Yeah, so, yeah, I think that's really a key driver for housing prices right now. But, for the overall consumer, I don't think much really has changed in the past several years compared to how it's been, over the last decade or so.
VanDerSchie: Fair enough. And, location trends are something that we all read about, and fair enough. And location trends are something that we all read about a few years ago, the migration from San Francisco to Austin, for example. There was also, Northeast migration to Florida. Obviously, I'm overgeneralizing here, but there is a geographic story. Brian, where are the good places to be a first time home buyer? I assume it's not Austin or Fort Lauderdale?
Bernard: Yeah, Austin is still a very expensive market. Look, I mean, there's still pockets of affordability. When I say affordability, we're going back to what Preston said earlier, looking at that median mortgage to income payment. But there's other factors that we look at. But you look at some of the more affordable markets right now, it's in the Midwest, right? Places like Scranton, Pennsylvania, Akron, Ohio, Chicago actually is still relatively affordable, Cleveland, Detroit. Now, I mean, some of these places maybe are far less glamorous than San Francisco and Austin, right? But that's still places where you can, there's, there's still good affordability. You know, some of those cities that you mentioned, when we saw that migration, we got a really had a run up in prices. Another interesting one was Boise, Idaho, that attracted a lot from California. And that was a really hot market during the pandemic. You're seeing that unwind a bit. In fact, if you look at kind of home prices are modestly down in Austin, you're seeing the same in parts of Florida. Yeah, I've read that that could be, the migration story unwinding people going back to where they came from. I think I don't, it's probably more that, that just attracted supply. I know, for example, like Boise, there's a lot of public builders that were not there that are there now. So, but I think, long story short, affordability is challenged throughout the U.S. But again, the Midwest looks to be probably the best in that.
VanDerSchie: All right. So Scranton, Pennsylvania and Akron, Ohio got it. For all the potential home buyers out there. Okay. So the last item on my agenda for today was to really look toward the future. And we've already done that to some extent, but it might be good to resurface as we conclude. And I'll start with the Federal Reserve because, the Fed is a major swing factor in what the housing market looks like 18 months from now. They made their intentions clear last month that they're undertaking a rate cutting cycle. I guess, Preston given your role as an economist, what does that mean for housing and specifically, how do short-term interest rates influence the 30-year mortgage?
Caldwell: Yeah. So, yeah, just, I mean, in terms of monetary policy and interest rates, we have the federal funds rate, that's, an overnight interest rate. Then we have, various treasury yields that we look at from the very short run all the way up to a 30-year treasury yield. Now, at first glance, one might expect the 30-year mortgage rate to be most influenced by a 30-year treasury yield. But as it happens, the duration of a mortgage is much lower than a 30-year treasury for various reasons. You have a higher interest rate, but which naturally automatically translates into a lower duration. But the biggest factor is prepayments. So, lots of people prepay their mortgage, whether because they can refinance or, you know, they just simply have to move. Therefore, the 30-year mortgage is actually probably most correlated to the 10-year treasury yield if you had to pick out a single benchmark interest rate. But it also is influenced by the shorter end of the curve running all the way up to the Fed funds rate. So, in short, as the federal funds rate continues to fall, as virtually everyone is expecting, the 30-year mortgage rate should fall further. And, the market right now is expecting, ultimately, the federal funds rate to fall by almost another 200 basis points. We're actually expecting it to fall by almost 300 basis points compared to current levels of near 5%.
But in any case, that is a substantial reduction. Now, we are also expecting a further fall in the 10-year treasury yield. So, we expect the 10-year treasury yield to drop from current levels around 4.1% to ultimately 3% by 2027. So, with both the long and the short end of the curve drifting down, both will weigh on the 30-year mortgage rate. And that's why we're expecting it to fall from a current rate of about 6.4% to 4.75% by 2027, which is our long-term expectation. And just in terms of, sorry, just in terms of, you know, the key drivers of that, our expectation is that inflation dips below the Fed's 2% target in 2025 and in 2026. And also, economic growth starts to weaken a bit over the next year, and unemployment ticks up a bit, getting up to 4.5%, 4.6%, which is not, it's not super high, but we expect it to remain at that elevated state until well into 2026. And that should call for continued monetary easing from the Fed well into 2026 in order to stabilize economic growth. And yet, we don't think that inflation will, high inflation will pop back up again. And so, that's why we expect interest rates to continue to fall quite substantially.
VanDerSchie: So, Brian, with everything Preston said there, it does seem that the 30-year mortgage rate is headed lower. If that does ultimately play out, a side effect will be increased demand. So, I guess the question for you is, are home builders ready for this?
Bernard: I'd say yes and no. You know, I think a lot of the management teams, at least for the public builders, certainly agree with our view that mortgage rates are coming down. And, but in terms of their ability to really boost supply, there's constraints that we talked about, Preston mentioned land, right? Labor, the issue with labor for construction went way before the pandemic. I mean, we just have a lot of these trades are of retirement age and just having less, of the younger generation going into it. So, I mean, that's been a constraint for home building, municipal regulations, it still takes long time to get your land entitled and such. And so, I mean, these things are just kind of a, have been a barrier to really boosting production. And I mean, in my mind, I don't know that we have the capacity to get much above 2 million starts. At one point we had, I think our peak was at 2.6 million during the housing boom, but right now with all these issues. I mean, I think that that's kind of, we'll keep a lid on it. But, I mean, the home builders are prepared to really kind of produce at that level, I think.
VanDerSchie: And then Brian, given how closely you follow the homebuilders every 90 days, they provide an update on their businesses and kind of what the future may look like. Based on what you're seeing, what type of mood are they in?
Bernard: It depends on the home builder. The big ones like the D.R. Hortons are very optimistic. But it's interesting because, you see this optimism and then you look at the housing market index, that's, you might see as a home builder confidence that's from the National Association of Home Builders measures that. And that's been below the 50 neutral level now for much of the year. It's been trending higher recently, but still below neutral there. And I think that just shows the differences between the big and the small builders. The big builders have had success, despite these affordability concerns, because they've been able to offer incentives, they've been able to offer these mortgage rate buy downs that I mean, they eat the cost of that, but they've been very profitable and they're still very profitable even with that. But that's harder for a smaller builder to do, right? Smaller builders have been, it's more trouble with construction and land financing. So I think that's where you kind of see the difference there. But you look at that going back to the housing market index. Again, it's been up the last couple months. And I think all home builders are feeling a bit more confident about next year, you know, believing that rates will come down and that buyer will come back.
VanDerSchie: Great. Thanks, Brian. So before we wrap as we do here on Simple But Not Easy, I want to give you guys each an opportunity to just provide a 10 second takeaway of today's episode with our listeners. Brian, I'll start with you.
Bernard: Yeah. I mean, I think affordability has been an ongoing challenge, but I think with mortgage rates coming down, that should be better in the future. And, I guess I cover home builders and I think that you look for the next 10 years, it's going to be a very constructive environment for them.
VanDerSchie: And Preston, what about you?
Caldwell: Yeah, I think Brian covered the key points there. I would just reiterate we are expecting affordability to improve, but you never know when a speculative bubble can rise. And, I have been surprised by strong home prices over the last several years. So if that continues and if it accelerates, then that's an entirely different situation. And at the same time, I wouldn't bet on home prices, continuing to rise at a fast rate, that's certainly not something you should factor in your financial planning. And so on average home prices, looking over a century or more, they tend to show pretty mediocre returns. So definitely keep that in mind.
VanDerSchie: And there you have it, another episode of Simple But Not Easy. As always, we're grateful to our guests for spending time with us today. And once again, if you'd like to know more about how Morningstar can support you, please drop us a note at simple@morningstar.com or me directly at Nicholas.VanDerSchie@Morningstar.com. That wraps up this week's episode. Before we depart, if you enjoy hearing the insights on our podcast, please consider leaving us a five star review on Apple or Spotify. Until next time, thanks for listening.
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