How Will Higher Rates Affect the Housing Market?

In 2021, inflation-adjusted home prices eclipsed levels of the mid-2000s as housing demand surged amid a tight supply of homes for sale. Still, homeownership affordability (measured by the median mortgage/income ratio) remained favorable, in our view, thanks to record-low mortgage rates; the 30-year fixed-rate mortgage averaged about 3% in 2021. However, affordability has since eroded as a result of the 30-year rate increasing 200 basis points since the end of 2021—to over 5% in late April—and a continued uptick in home prices. We had been expecting a more gradual increase in mortgage rates.

There’s a recent precedent of slowing housing demand amid sharply increasing mortgage rates. In late 2018, home sales slowed considerably as the average 30-year fixed rate rose about 100 basis points to 5% in less than a year. However, the slowdown was short-lived as mortgage rates quickly moderated. We don’t expect mortgage rates to quickly reverse course this time, though.

We believe a higher mortgage rate environment will cause housing demand to ease as more prospective buyers move to the sidelines and some are priced out. According to an analysis from the National Association of Home Builders, the recent rise in mortgage rates has priced out over 11 million households. Our 2022 housing starts forecast for about 1.6 million units is unchanged because homebuilders have a considerable backlog to work through. However, we expect new-home sales to slow as 2022 progresses. We now forecast housing starts to decline about 10% to 1.45 million units in 2023. Still, we think there’s plenty of pent-up demand for new homes, and less buyer competition and more entry-level construction should usher in price relief. We forecast starts to rebound 4% to 1.5 million in 2024 and return to 1.6 million by 2027, moderating to 1.45 million-1.5 million by 2031. Between 2022 and 2031, we model 15.4 million cumulative starts, about 2% lower than our previous forecast.

Considering the modest change to our 10-year housing starts forecast, all else equal, we expect to lower our fair value estimates for the homebuilders we cover—D.R. Horton, Lennar, and Toll Brothers—by a low-single-digit percentage.

While some observers may fear an imminent housing market crash, we don’t see a likely scenario where supply overwhelms demand. Based on our analysis, since the global financial crisis, residential construction has not kept pace with household formations; we estimate U.S. housing stock is undersupplied by approximately 3.5 million units. Furthermore, lending standards have been far more restrictive since the crisis, and we believe mortgage borrowers have been well qualified. Indeed, over the past couple of years, borrowers with a credit score of 760 or better accounted for about 70% of mortgage originations compared with about 25% during the mid-2000s. As such, even if the U.S. economy were to enter a recession, we wouldn’t expect to see a wave of foreclosures like the late 2000s.