With U.S. inflation surging to a four decade high, investors are seeking assets that will protect them against it. Traditionally, real assets such as gold, commodities, and real estate have played that role, while financial assets—both stocks and bonds—have not held up as well.
This rendering dates back to the 1970s, when inflation and interest rates soared to double digits and real assets outperformed financial assets handily. As housing prices rose by 2 ½ times during the decade, investors began to view homes as speculative investment vehicles.
The underlying conditions for the housing market today, however, are different from the 1970s. While mortgage rates were much higher then, so were inflation rates. Tax breaks from owning homes were also greater than today, and homes were viewed as a tax shelter as marginal tax rates for households were 73% for the highest bracket.
Therefore, investors need to weigh whether housing will be as good an investment vehicle going forward.
The principal reason for believing it will be is that demand-supply conditions in housing have been very tight. Following the 2007-2009 bust, new starts plummeted to nearly 400 thousand units from more than 2 million units during the peak of the boom (see chart).
The dearth of supply has been the key factor buoying prices, and recent data have been mixed: New starts climbed to nearly 1.8 million units in February, but inventories of existing houses for sale are still well below pre-pandemic levels and could take until 2024 to normalize according to a Zillow survey.
The main concern today is that housing is becoming increasingly unaffordable for many Americans. This is a result of record home price appreciation of 27% in the past two years coupled with surging mortgage rates this year.
U.S. home prices currently are at all-time highs in absolute terms, and they are approaching eight times median family income, which was the high during the housing boom in the mid-2000s. Yet, until recently home prices were still affordable for many Americans because mortgage rates were at record lows.
At the start of this year, for example, the ratio of monthly mortgage payments to median family income (based on the cost to finance the average home price at the prevailing 30-year fixed rate mortgage) was under 40%, near the middle of the range for the past two decades and well below the peak level of 60% in the mid-2000s.
My assessment in a prior commentary was that affordability would likely become an issue if this ratio were to approach or exceed 50% of income, as housing would become a disproportionate share of peoples’ incomes. There are a variety of combinations of home price increases and mortgage rates that could generate such an outcome: For example, if home prices were flat and the rate for 30-year mortgages approached 5%, or if home prices rose by 10% and mortgage rates reached 4.25%.
In the meantime, the 30-year conventional mortgage rate has increased from 3.1% at the start of this year to about 4.5% as the Federal Reserve has commenced tightening monetary policy. There are indications that rising mortgage rates may be impacting housing demand: The median monthly payment on a new mortgage jumped 8.3% in February from January, while pending home sales fell by 4.1% in the same period. This marked the fourth straight month of declines in pending sales, which suggests a soft tone for the usually busy spring season.
Moreover, mortgage rates could rise further if the Federal Reserve is compelled to raise interest rates by more than what is priced into the Treasury market. Bond investors currently anticipate that the Federal Reserve will raise the federal funds rate to about 2.0% by year’s end. However, this presumes that inflation will recede over the second half of this year. If not, interest rates will still be negative after inflation and necessitate further rate hikes into next year.
Further compounding the situation is the impact of Russia’s invasion on Ukraine on commodity prices and raw materials. It has resulted in a renewed surge in construction costs for new homes. Lumber prices, for example, spiked in January and February back to levels of last summer, and indications are they have continued to climb in March, as well. Overall, the 45% increase in costs for construction materials in the past two years is the highest on record.
The bottom line is the U.S. housing market is now exposed to two types of shocks—surging mortgage rates and construction costs—that will result in new home buyers being priced out of the market. This may not result in an overall decline in housing prices, because they tend to be sticky and supply is tight. Indeed, home prices may continue to rise for a while as buyers rush into the market ahead of further mortgage rate hikes and cost increases. Prospective home buyers may also view owning a home preferable to renting one, as the costs can be locked in.
Nonetheless, the likelihood is that housing demand will soften if mortgage rates rise further. First, house prices are very expensive in absolute terms and debt-servicing costs are increasing, as well. Second, tax breaks from owning homes are less favorable than in the past as a result of the $10,000 cap on SALT deductions and the $750,000 limit on mortgage interest deductions. They could impact sales of high-end homes and second homes.
Consequently, investors need to consider how the landscape for housing has changed that could make it a less effective inflation hedge than in the past. While homes may outperform financial assets, the days of double-digit price increases are numbered and prices could soften in some of the hottest markets.