Existing home sales are down, but new homes not so much

Falling home sales tend to foreshadow price declines, and existing home sales have plummeted since early last year—when the Fed was preparing for its first interest rate hike—to the lowest level since the GFC. New home sales, in sharp contrast, have climbed over much of this year and are currently above their pre-pandemic levels. Why the difference?

There are many nuances, but the primary factor is that many existing homeowners were able to lock in record low mortgage rates when Treasury yields were a mere 0.5%. To sell their home now, and buy another, would mean a substantial jump in their financing costs—a strong incentive to shelve their plans.

Another factor is the ability of new home builders to support potential buyers by offering free home customizations or upgrades and—more frequently—direct support for financing the home. This could be an offer to cover closing costs or even contributing capital to “buy down” the interest rate, creating a lower monthly payment for the buyer for the life of the loan.
 

Home affordability has plummeted

Today’s housing market is less affordable than at any time since 1984. Monthly principal and interest payments are up 94% in just the last two years, according to Intercontinental Exchange, and a typical household would have to spend 41% of their income to make their monthly mortgages payments, up from an average of 25% over the last 35 years.

Higher mortgage rates, while clearly a problem, are not the only problem. In the 1980s, when affordability last reached similar lows, the average home price was around 3.5 times the median household income. Today that figure is closer to six times the median household income. Simply put, incomes have not kept pace with the steady rise in home prices since the GFC and certainly not since the surge in prices after COVID-19.

However, it is perfectly reasonable for home prices to have outpaced income when financing costs were falling. Surging prices simply brought the market back to an equilibrium—with mortgage costs low, families could afford to pay higher prices. But when those higher prices meet a nearly 40-year high in mortgage rates, affordability collapses and something has to give.

There are not enough homes in America

Part of the problem has been just a matter of space: Whether a simple shortage of available land and/or increased restrictions on using that land for environmental preservation, finding places to profitably build new homes has become more difficult in recent decades.

But the larger problem has been a dramatic reduction in the number of new homes built after the GFC. While it is understandable that both builders and consumers would want to take a step back from investing in housing, for almost a decade the completion of single-family homes was almost half its long-term average. And while new construction has steadily risen from the lows in 2011, it has only recently risen above its long-term averages. It will take time for the country to generate enough supply to make up for the lost decade in home construction.

Meanwhile, the U.S. has been relatively unique in the developed world in seeing steady population growth, both from domestic births and immigration. Furthermore, demand for housing is growing more acute as the millennial generation enters home-buying age. And, Americans have been migrating, from the rust belt to the sun belt, from the cold of New England to the warmth of Florida. While migration itself does not mathematically cause a net shortage of homes, in practice it does. Migration can result in large swaths of existing homes being abandoned or nearly worthless as communities are drained (remember those stories about homes for $1 in Detroit?) and an acute shortage in the warmer/sunnier areas where people want to live. For cities in these areas growing rapidly, new construction is required, returning us to the problem of available space.

More recently, COVID-19 changed the demand side of the equation for many families. Working from home meant less burdensome commutes, making suburban or even rural living more palpable. And, working from home, together with (for a while at least) educating your kids at home, fueled a demand for more living space. The result was a rise in the perceived value of owning a home, at a time when the availability of single-family homes was in short supply.

Finally, an increasing percentage of America’s homes have been bought for use as second homes or for investment purposes. A recent study by the National Association of Realtors estimated that 13% of the entire stock of American homes are owned by institutions or investment vehicles looking for rental income. According to nonprofit news outlet Stateline, nearly 25% of all single-family homes sold in 2021 were bought by investors, up from 15-16% annually since 2012.

Bottom line, America has a housing shortage, with the absolute number of homes available to purchase at a nearly 25-year low, as shown in the Figure below. The U.S. housing agency Freddie Mac estimated back in 2020 that the country was short about 3.8 million housing units, or a little more than 1% of the entire U.S. population. While that number has stabilized since then, a substantial shortage is likely to remain for some time.
 

Are falling prices the answer?

In a word, no. Not only will lower prices not address the shortage of homes, but the shortage itself is likely to put something of a pricing floor (pun intended) on the housing market. Put differently, rising prices over the last decade can be seen as a perfectly rational response to a shortage of supply and an increase in the quantity of homes demanded.

As we look into 2024, a modest correction in home prices wouldn’t surprise us, but stable or even rising prices wouldn’t surprise us either as long as the economy doesn’t slow into a recession. We believe the economic outlook is key as weak economies can often force homeowners’ hands, as a loss of income or rising borrowing costs prove too great a burden.

But the economy has proven resilient through the current interest rate cycle, has yet to see an actual recession, and—most importantly—the aggregate consumer has been buoyed by low unemployment, more affordable mortgage rates locked in when rates were low, and modest overall debt levels. Debt service costs, as shown in the figure below, have risen with higher rates in the past few years, but remains at the low end of the historical range.
 

To be sure, mortgage delinquencies have risen, but they remain well below the recent highs and are unlikely to rise significantly without a commensurate rise in unemployment.
 

2023 is not 2007

The underlying problem in the GFC was excess leverage. People, companies, and banks had borrowed so much that a small change in the value of their assets or the cost of borrowing had systemic effects.

But the aggregate consumer, as we have discussed, is nowhere near as leveraged today as they were in 2007, and neither is the financial system. Bank balance sheets are generally much stronger than they were in 2007, in part due to lessons learned in the GFC, and have improved as banks took steps to prepare for higher interest rates and a potential recession. While some could say it took the collapse of Silicon Valley Bank and Credit Suisse to focus global banks on the risks, we believe the problems with these banks were more internal than systemic, and there is ample evidence the banking system as a whole is much better capitalized than it was in 2006.

Finally, the stock of mortgages today is different than it was in 2007. In the years leading up to the GFC, sub-prime mortgages (loans made to borrowers with low credit ratings) were around a quarter of all mortgages. Today, it is in the high single digits.

While it is difficult to find evidence of the frailty that was present in either the consumer or the financial system in 2007, we are mindful that few saw the evidence in 2007 either. And on the face of it, the funds required to afford a mortgage today, with rates and prices where they are, seems unsustainable.

However, in the broadest terms, we believe current home prices are largely a function of low supply, coupled with high demand, and it will take a significant change in either one of those variables to cause the market to reset at significantly lower prices. More likely, in our view, home prices cool, maybe correct modestly, and the housing market muddles through until falling interest rates lower borrowing costs, improving affordability. And while turning points in any market are always fraught with uncertainty, we just don’t see high enough levels of leverage anywhere in the corporate, consumer, or financial sectors to suggest a small decline in home prices could trigger the kind of viscous spiral that happened in the GFC.

Finding investment opportunities in mortgages

The residential mortgage-backed securities (MBS) that are part of so many benchmark bond indices are guaranteed by the issuing Federal agencies, such as Fannie Mae or Freddie Mac, so they carry the same credit rating as the U.S. Government. As such, we are not worried about credit (default) risk in traditional bond benchmarks whatever the outcome of the current housing affordability problem the country faces.

However, many of these same securities have seen a drop in prices as banks have sold them in an attempt to improve the quality of their balance sheets. (Mortgages are long-maturity assets while banks fund themselves with short-maturity cash deposits). In our view, these securities may have upside relative to other benchmark bond asset classes as supply and demand for them normalizes.

Similarly, mortgages which do not conform to the agencies’ standards for guarantees (so called “non-conforming” mortgages) may also offer attractive valuations. In part due to lingering effects from (largely warranted) criticism of the agencies’ ability to assess risk after the GFC, they let the pendulum swing. Today, the due diligence, credit enhancement, loss protection, and third-party oversight provided by many of these securities may provide compelling valuations, especially considering yields offered are often well in excess of that provided by similarly rated corporate bonds.

Finally, the prevailing mortgage rate is currently unusually high relative to government bond yields, suggesting it may have been driven higher by uncertainty about how high Treasuries could go, not how high they are. The figure below shows the prevailing 30-year mortgage rate (the orange line), the benchmark 10-year U.S. Treasury rate (the blue line) and the difference between the two (the white line). At near 3%, the excess yield over Treasuries that consumers must pay to get a mortgage is near the 25-year high. 

The chart also shows that the only times this excess yield reached these extreme levels it didn’t stay there for long, returning to the long-term average within a year or so. It seems likely to us that today’s mortgage rates are pricing in a great deal of uncertainty, and rates could come down as much as a full 1% without Treasury yields falling or the Fed cutting rates.

While falling mortgage rates would be good news for consumers and likely provide a boost to the housing market, active bond investors can take advantage of the potential for such a move. For example, some mortgage-based securities separate the interest paid into one security and the principal repaid into another. If mortgage rates do fall, recent borrowers are likely to refinance quickly, potentially creating an outsized return in principle-only securities.

There are many eyes on the housing market

When the Fed began its rate-tightening cycle, it intended to affect the housing market. Because of its necessity, liquidity, and a well-developed capital market for its financing, the housing sector is one of the most directly and immediately impacted sectors when interest rates rise.

And, for the Fed, it is not just the price of a home that is important, but the large part of the economy dedicated to building homes and the large multiplier effect that buying and selling homes has. Lower affordability can put the country’s builders on pause, and—as we have seen—turn a highly liquid market to molasses. This means less workers are hired to prep a house for sale, fewer movers are employed, less realtor fees are paid out, and a drop in consumer spending insofar as buying a new home typically results in some new furniture, refreshing the landscaping, or the perfect excuse to upgrade the TV. That is, making homes more expensive is a quick and often effective way to combat inflation.

Likewise, should inflation look likely to reach the Fed’s long-term target (and the most recent figures are encouraging), or the economy falters faster than the Fed would like, lowering interest rates can quickly renew the housing market, injecting confidence and consumption back into the wider economy.

Or the market can do it on its own. We mentioned above that mortgage rates were unusually high relative to Treasury yields, likely due to fear about how high rates could go. But in the last month benchmark 10-year Treasuries have fallen about 0.5%, which should pull mortgage rates lower and could encourage lenders to be more optimistic that long-maturity rates have peaked, narrowing the premium required for the uncertainty.

It looks to us—despite the fears of a “terrible” and “impossible mess”—that the best course of action for the Fed, existing homeowners, and want-to-be homeowners, is to wait. If inflation continues to fall at its current pace, lower rates could come as early as next year, boosting affordability and injecting some life back into the housing market.

While we wait, we encourage investors to take a closer look at the mortgage-related bond markets for opportunities to benefit from unusually high mortgage rates and the potential gains realizable as yields fall.