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Wharton: What’s Ahead for the U.S. Housing Market?

After a year of rising mortgage rates and shortages in both supply and demand, the best option for prospective homebuyers and homeowners is to bide their time.

Published by Shankar Parameshwaran with permission from Knowledge @ Wharton, Wharton's online business journal.

The U.S. housing market last year bore the brunt of higher mortgage rates that rode spiraling inflation in the broader economy, but that will change this year, according to Susan Wachter, Wharton professor of real estate and finance.

“The Fed is using the housing market as a fulcrum to slow overall activity and get the inflation rate down,” she said in a recent interview on the Wharton Business Daily radio show that airs on SiriusXM. “When they succeed in doing that, housing and rents are likely to come down most and fastest, and that may get us out of the inflation bubble sooner than we think in 2023.”

Until that happens, “the housing market for sure is doomed; it’s a sinking ship,” said Wachter, as she surveyed the landscape: Pending home sales are at historic lows and home prices are down, too, as mortgage rates reach record levels. Housing supply is also running low because new housing construction is declining in response to tepid demand, and existing homeowners are unwilling to sell their homes financed at attractive low mortgage rates of 3% to 4% and move into newer homes at double the mortgage rate.

Demand is running low not just because new financing is costlier or because people are wary of an imminent economic recession, Wachter noted. More and more younger Americans are staying put with their parents and new household formation is declining — both dampeners for housing demand. The gainer from those downers is the multifamily rental housing market, which has seen a construction boom and sharp rises in rental rates, although those rates are beginning to slow down, she added.

The outlook for 2023 and beyond, however, is not hopeless. “The housing market across the board is in a doom situation for a bit, but we are not about to see a recurrence of the systemic crisis that we had in 2012,” said Wachter. She also did not expect home prices to crash like in the 2012 recession, or banks to face financial disasters and the “doom loop” of foreclosures and prices declining.

For 2023, Wachter advised both homebuyers and homeowners to wait and watch. Prospective homebuyers could benefit from further price declines, and homeowners could continue enjoying the fruits of their relatively lower financing of earlier years for a while longer.

An edited transcript of the interview follows.

Wharton Business Daily: How has the real estate sector reacted to the impacts of rising interest rates and inflation over the past year?

Susan Wachter: The real estate sector, and specifically housing, has taken the brunt of the Federal Reserve’s aggressive stance on monetary policy. It is the housing sector that is in recession and is pulling down the rest of the economy.

Wharton Business Daily: Data on weekly mortgage applications shows a sharp pullback in the past two years from a surge in early 2020. What do you read in those trends?

Wachter: We are at historic lows in pending home sales. That’s not just a reaction to high sales, although sales were high for a bit. Housing prices are now coming down, [after] increasing in a historic range over the past preceding year. So, a decline was in the cards. But the [latest] decline is a pretty sharp — and historic — reversal of those price increases. We’ve never seen such a sharp reversal. But the rise in mortgage rates is also historic — they doubled from March to where they are now.

Wharton Business Daily: The Fed is expected to go slow on raising rates over the next couple of cycles. But interest rates are double what they were a year and a half ago. It almost feels like it’s like a new normal.

Wachter: I would certainly hope it’s not a new normal. The Fed has an aggressive stance to get the inflation rate back to its goal of 2%. Once the rate of inflation gets back to 2%, which I think will happen, but perhaps not in 2023, then mortgage rates will happily decline once again to affordable levels. But between now and then, there’s a big gulf and the housing market for sure is doomed. We see that right ahead of us. It’s a sinking ship.

Wharton Business Daily: The supply of housing is another issue that has persisted for a while. It does not seem easy to correct, in order to get us to where we need to be.

Wachter: Yes. That’s why pending home sales are down so much. It’s not just a demand factor, which is because of the affordability crisis that followed the aggressive interest rate stance and the mortgage rate increase. It’s also because of the lack of supply.

We see lack of supply on two fronts. One, single-family housing construction is down, but that’s short-term. Long-term, we have a structural deficit in the housing supply. When we hopefully recover from the possible coming recession, that [deficit will] still loom there. In the previous housing debacle — the 2007–2012 downturn — we saw housing prices fall 30%. I don’t think we’re going to get there, because at that time we had oversupply. This time we have supply shortages in new construction and in inventory.

Fed’s Inflation Policy the Main Trigger

Wharton Business Daily: Is the inventory to a degree exacerbated by the combination of the pandemic, supply chain issues, and labor availability?

Wachter: Ironically, none of the above. It’s actually [because of] the Fed’s inflation policy. As interest rates go up, and as mortgage rates go up, owners of homes with a 3% to 4% mortgage rate are not giving that up. They’re holding on to their homes and are not moving. So we see mobility at all-time lows. [Even] people who may want to sell their homes to move to a smaller house [aren’t doing so] because they face [new] mortgage rates in the high 6% levels. Even though mortgage rates have fallen since the 7% highs of a few weeks ago, 6.5% is still double the rate they may [already] have, so they’re not moving. They’re not selling despite the fact that they could still get good prices.

Prices, however, are down 2% over the last few months and they will probably continue to fall, because of [high] mortgage rates and [low] affordability, and because of the potential looming recession or at least a slowdown. What’s different this time is prices are falling even before the recession. That did happen in 2007–2012, but that was a housing-induced recession, and we had very risky mortgages.

That’s not the story [now]. In fact, the story here is the Fed is using the housing market as a fulcrum to slow overall activity and get the inflation rate down. When they succeed in doing that, and it looks like there is some success, housing and rents are likely to come down most and fastest, and that may get us out of the inflation bubble sooner than we think in 2023.

Multifamily Housing the Lone Shining Star

Wharton Business Daily: What is the status of the rental market?

Wachter: Well, people don’t want to be and can’t be a homeowner at these prices. Potential first-time home buyers looking at these prices who are not qualified or can’t buy are going into the rental market. Multifamily construction has been booming. We have an oversupply of multifamily housing. Multifamily housing construction starts have been very, very high. That’s good news because we do have a structural deficit of housing across the board.

Fears of a recession looming, and a lack of consumer confidence, are causing households to pull back on lots of different fronts, including the housing decision. People are not buying if it’s not affordable, but they’re not renting as much either. We see younger adults still staying home with their parents. They’re still in the basement, and in fact, we see more of that. You see household formation decreasing.

So, the rental market is seeing supply coming on and demand pulling back as people can’t afford the rents either. In 2021 and 2022, folks who were not able to buy were moving to the rental market and pushing up rents. But now that’s not affordable either. What’s the alternative? Roommates and parents are the alternatives. We see, however, that rent growth is slowing down.

Less Pain This Time Around

Wachter: The housing market across the board is in a doom situation for a bit, but we are not about to see a recurrence of the systemic crisis that we had in 2012. Home equity is sufficiently high so that even if prices fell even 20%, most people would be equity-positive and would not be faced with foreclosure. [Also], banks would not be faced with the kind of financial disasters they faced the last time, and the doom loop of foreclosures and prices declining.

That said, we have more to go in terms of house price decreases and rent decreases as well. It is already incorporated into the new rent contracts that are being taken on today.

We are likely to see six months from now a major decline in the housing rental equivalent component of CPI (Consumer Price Index), and that will pull down overall inflation, together with supply chains. Inflation of the rent and housing portions of the CPI may zero out a year from now, say by December 2023. Since that is one-third of the CPI, that could be very good news indeed for the overall CPI a year hence.

Wharton Business Daily: What should potential home buyers and homeowners be thinking about going in 2023?

Wachter: If I were in the shoes of potential home buyers, I would look to further price declines. On the homeowner side, you’ve got that historic low mortgage. You’re not going to see that again for at best a year or two. So hold on there, too.