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The US housing market’s recovery since the global financial crisis is finally showing signs of deceleration. House price appreciation, which has outpaced income growth for several years, has slowed over the last several months and the recent pace of sales in the new and existing markets has failed to keep up with 2017 levels. We believe housing market conditions have downshifted, and factors related to affordability, supply, and the economy may steer housing fundamentals this year. While we see challenges to any reacceleration in housing market activity, we nevertheless believe we are entering a period of housing market moderation that is unlikely to drag significantly on the broader economy.
US economic conditions appear supportive of housing
The economic environment remains generally supportive of housing. Low unemployment, accelerating wage growth, and strong household balance sheets are contributing to demand for shelter. These factors also reinforce our view that gains in household formation and the transition from renting to home ownership are likely to continue. We also recognize that economic fundamentals may be reaching an inflection point and could become less supportive of housing going forward.
However, the financial health of mortgage borrowers, measured by household leverage and the dramatic improvement in credit scores suggest that today’s borrower base has much greater financial capacity and creditworthiness to withstand normal economic fluctuations. This improved resiliency reinforces our view that deterioration in borrower credit performance is unlikely to pose a material risk to the general economy if we enter a recessionary period.
Affordability concerns on the rise
Affordability, as measured by payment-to-income ratios, has shifted from a positive driver of housing to a headwind as strong price gains and increases in mortgage rates have pushed payments higher. Despite sustained price appreciation since 2012, housing has been historically affordable, helped until recently by income gains and low mortgage rates. However, the increase in mortgage rates of over 75 basis points since the summer of 2017 has pushed affordability on a national basis back to long-term averages (Figure 1). Cities that have realized above-average house price appreciation, including Seattle, San Jose, Denver and Nashville, now have payment-to-income ratios well above their long-term averages.
Figure 1: Payment-to-income ratio versus mortgage rates
Past levers used to maintain borrower affordability have been greatly curtailed during this housing market cycle. For example, lending products designed to lower a borrower’s monthly payment, prevalent during the mid-2000s, now represent only a small fraction of the current origination mix due to post-crisis legislation. As a result, we think price appreciation will continue to slow as income growth becomes a stronger influence on the prices that buyers are willing or able to pay. Cities where house prices have risen more than incomes are likely to experience more dramatic deceleration in price appreciation.
Housing supply likely contained
The risk of faster-than-expected price deceleration due to increased supply seems contained, in our view. We believe the two primary drivers of existing home inventory – owner sales and foreclosures – likely have limited room to expand. While the supply of existing homes has increased, inventories remain well below historical levels (Figures 2 and 3). Sales of existing homes will likely remain depressed as owners with historically low mortgage rates are disincentivized to forego their attractive mortgage rate through a voluntary move. While this should depress turnover, one beneficiary may be the home improvement industry, as the incremental cost of a move becomes less attractive versus renovation. Supply due to foreclosures, even in a macroeconomic downturn, is not a material concern, in our view, as conservative lending standards implemented post-crisis have resulted in a strong mortgage borrower base that will likely outperform past periods of housing market stress.
Figure 2: Months supply of existing homes has picked up
Figure 3: But inventories remain low
New construction may face challenges
Increased supply of new homes has been more dramatic compared to the existing home market, but we think this represents factors unique to new construction. Affordability in new construction is comparatively worse, with historically wide price premiums over existing homes. High input cost inflation related to land, labor, and materials has fed into new home pricing and incentivized builders to concentrate on high-end homes. This has resulted in a mismatch between higher-end supply and strong entry-level demand. While builders have recognized this dynamic, the supply shift toward entry-level homes will likely be slow as costs and inventories are addressed. Despite our positive long-term housing demand outlook, fueled by the continued entry of millennials to the market, we believe near-term challenges in new construction could lead to increased volatility in this area of the market.
Risks to our view of housing are centered around the evolution of interest rates, the economy, and housing supply. Rising interest rates have eroded affordability over the past 12 months, but have recently taken a pause, which could potentially motivate buyers in the short-term. However, a dramatic move higher in rates would likely further erode affordability and pressure prices and sales. If the recent interest rate reversal is a sign of a deteriorating economy, a negative shift in employment could also become a headwind.
We believe the factors discussed above – declining affordability, higher mortgage rates and moderating economic growth impulses – suggest that the housing market is unlikely to continue posting above-trend price increases going forward. However, we also believe that several indicators suggest we are on a path to an orderly normalization and not a damaging unwind. We remain focused on the evolution of housing during this shift and continue to integrate information on the factors highlighted above as we adjust our outlook in the months ahead.
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Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate.
Aaron Kemp, CFA®
Aaron Kemp is a Senior Analyst on the Residential Mortgage-Backed Securities team. He is
responsible for evaluating and managing investments in a range of assets related to residential
real estate, including non-agency mortgage-backed securities, agency risk-sharing securities
and residential whole loans.
Prior to joining Invesco in 2009, Mr. Kemp spent three years at American Capital, Ltd., where
he was a manager in the debt capital markets group. In this role, he was responsible for
executing secured debt financings and leveraged loan securitizations. He also spent two years
at Friedman Billings Ramsey, where he was an analyst in the investment banking asset-backed
Mr. Kemp earned a BS degree in finance from Virginia Polytechnic Institute’s Pamplin College
of Business in 2003. He also earned an MBA from the University of Maryland’s Robert H.
Smith School of Business in 2009. He holds the Chartered Financial Analyst® (CFA)
Ray Janssen is a Senior Analyst, covering investment grade companies and crossovers within
the consumer cyclical sector, including retailers, homebuilders, autos, leisure and real estate
investment trusts. He joined Invesco Fixed Income in 2002 as an associate portfolio manager,
responsible for portfolio construction of the core limited accounts. In 2005, Mr. Janssen joined
the Credit Research team.
Mr. Janssen began his investment career in 2001 in Invesco’s Corporate Development
Program. Prior to joining Invesco, he was a product engineer for DaimlerChrysler in Michigan,
where he contributed to the design and development of the suspension for the Dodge Caravan.
During his four-year tenure, he obtained a US patent for one of his engineering solutions.
Mr. Janssen earned a BS degree in mechanical engineering from the University of Kansas in
1995 and an MS degree in mechanical engineering from Oakland University in 1997. He also
earned an MBA from the Kellogg School of Management at Northwestern University and a
master’s degree in engineering management from the McCormick School of Engineering at
Northwestern University, graduating with both in 2001.