US house prices remain too high

May 23, 2023 10:40
Photo: Reuters

The importance of the housing market cannot be overstated: we all need a place to live, and our personal wealth is often closely tied to property. For economists, the market is of particular interest because residential fixed investment directly accounts for about 5% of US GDP. However, the significance of the housing market extends beyond that, as it is highly cyclical and tends to provide clues as to where other areas of the economy are headed. Over the past year, house sales, building starts and residential fixed investment have all fallen sharply, a reflection of the rapid increase in mortgage rates. This decline is largely in line with the adjustment seen around previous recessions. In recent months, however, new house sales, starts as well as housebuilder confidence have picked up, suggesting that the bulk of the adjustment may be behind us. Still, there will probably need to be a more significant drop in prices before a sustained recovery can occur.

The recent improvement in housing activity can be attributed to two primary factors. First, mortgage rates have stabilised, albeit at elevated levels. As a result, financing costs and housing affordability are at least no longer deteriorating. Second, the supply of housing remains tight. The number of existing homes on the market is still close to its historical low, largely because the end of the exceptionally low interest rate period has discouraged homeowners from selling or changing their properties. In fact, approximately half of outstanding mortgage balances were refinanced or refreshed at historically low rates during the pandemic. Homeowners looking to move now will face higher borrowing costs and higher prices, as current home prices are about 35% higher than they were pre-pandemic. Additionally, the stock of completed new houses available for sale is also very low and will change hands quickly once they are put on the market (although no longer as quickly as in the second half of last year). Finally, both rental and homeowner vacancy rates are either at or near their all-time lows.

Construction activity has surged amid elevated prices and tight supply, although bottlenecks have delayed the completion dates of these projects. As a result, the total number of housing units under construction, including flats, rose to 1.75 million at the start of the year, the highest level since data collection began in 1970. But the problem is that developers have focused on the higher end of the market, with nearly 70% of homes sold over the last year above the median house price of around $380k. According to the NAR affordability index, the median household can barely afford such a house, and according to a University of Michigan consumer survey, this is one of the worst times to buy a house in 50 years. As a result, there is a good chance once these new houses are built, they will not find buyers as quickly as they have so far, particularly if the economy slows down, as we expect. In turn, this mismatch between supply and demand is likely to delay the construction of new units.

Further reductions in house prices may be necessary to achieve equilibrium. While house prices have undergone modest adjustments of around 3-6% from their peak, metrics such as the price-to-rent ratio indicate that prices could still drop by an additional 10-15% from their current levels. The market has been relatively dry, with sellers having little incentive to sell and transactions occurring primarily at the upper end of the market. However, if the economy enters a recession later this year, individuals may be forced to relocate in search of new job opportunities, leading to an increase in the stock of existing homes on the market. Price discounts would be required to attract potential buyers. Similarly, developers and housebuilders, who have increasingly focused on the higher end of the market, will likely need to lower their selling prices.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin