What’s behind the weakness in U.S. housing?

Marie M. Schofield, CFA, Chief Economist and Senior Portfolio Manager | March 24, 2014

  • Existing U.S. home sales have been weak across all regions and this weakness pre-dates this year’s tough winter.
  • Skyrocketing home prices, the surge in interest rates, and meager income growth have hit affordability and dented demand.
  • Housing is no longer the accelerator for economic growth that it was earlier in the cycle.

While the jury is out on just how much cold weather has impacted economic activity in recent months, we should keep in mind two important items. First, almost all data releases incorporate seasonal adjustments in an effort to even out the month-to-month wiggles due to poor weather. Second, not all of the U.S. suffered under the cold, wintry conditions. Indeed, areas to the west and southwest enjoyed warmer and drier weather—and much economic activity happens there too despite our proclivity to view things with a regional mindset. I am not dismissing the weather effect, but do believe there are other headwinds, particularly for housing, that will not reverse in coming months. Housing has been key to the multi-year economic recovery and has served as an accelerator for growth. Poor weather often impacts homebuilding activity and homebuyer demand in certain areas, but existing home sales have been weak across all regions including western regions—and this weakness pre-dates winter. Permits, which only measure intentions to build a home and are not impacted by weather, have also stalled out across almost all regions. And housing starts are weaker on an annual basis across all regions. Of more importance to this slowdown in housing is reduced affordability due to the combined effects of higher interest rates and escalating prices in the last year in combination with tighter lending standards and new regulatory constraints. The weather will improve, the latter conditions will not.

There is some evidence of a two-tiered market as well, with most of the slowing seen in the single-family sector against a firmer multi-family segment, particularly in new home construction. Over the last year there has been a marked slowing in single-family permits and single-family starts across all regions, not just those areas suffering through a miserable winter. The reduced pace of construction is particularly noteworthy in the west, where weather was good despite tight home inventories. However, the multi-family segment has been less affected, experiencing only slower gains, except for the Midwest (see table 1). The multi-family segment measures construction of condos and apartments either for sale or for rent, and demand for the latter has been brisk. Condos typically are less expensive than single-family homes (for a given region) and this speaks again to the affordability issue. So there is some evidence housing demand began to soften well prior to the weather-induced slowdown.

Table 1

Schofield1

Affordability is a now a challenge to the strength of the housing recovery. Home prices began their lift-off in mid-2012 and then surged last year, rising by almost 14% based on Case-Shiller home price indexes and over 10% based on National Association of Realtors (NAR) sales data. Based on the NAR’s median single-family existing home price index, this alone raised the necessary down payment by over $3,000 leaving some homebuyers short of funds. Further, in the last year mortgage rates have jumped by a full 1%, which in combination with higher prices raised the monthly mortgage payment by 25% or more. This left some marginal buyers short of the minimum income level to support the higher monthly service payment of their desired home (see table 2). On top of this, income gains have been mediocre this cycle, further impairing the purchase ability of households. Many have shifted into even lower-priced homes, confirmed by data that show a big jump in the share of homes sales in lower-priced tiers. First-time homebuyers are a key to sustaining the housing recovery and their share (as a % of total home sales) is at the lowest point this cycle, indicating they are being priced out of the market. Tighter homeowner financing rules also came into play recently in conjunction with new regulations emanating from Dodd-Frank, which will further limit affordability. In the aftermath, the MBA’s Mortgage Applications Purchase Index has recently fallen to a new cycle low, indicating weaker intentions to buy a home. Finally, new regulations have doubled the costs of flood insurance in some cases. The NAR estimated flood zones represent 9% of sales overall and that 30% of transactions were cancelled in January as a result.

Table 2

Schofield2

As reduced affordability has dented demand on the margin, recent data on home price trends are pointing to some slowing in the pace of the gains particularly in the steamier markets. Some of this is related to the reduction in distressed inventory and sales, as investors have already scooped up most of the bargains. The periodic gains in those hot markets that drove the higher prices have started to level off now. This means home price increases will slow in the period ahead and move toward more modest gains of 5% to 7% in the next year. Obviously this is a healthy development in the long run, but even this gain will price out some buyers absent growth in wages.

Housing wealth has vastly improved in the past three years with fewer underwater homeowners and net equity improving. But housing is no longer the accelerator for economic growth that it was earlier in the cycle—residential investment actually detracted from growth last quarter. Housing always has important multiplier effects on growth, both stronger and weaker, particularly single-family housing which has a higher multiplier than multi-family housing. Skyrocketing home prices, the surge in interest rates and meager income growth have hit affordability and dented demand. The recent weather disruptions are a negative but less important factor in the weaker data. The spring will see some bounce in housing data related to this of course, but the housing multiplier to growth will be less robust—and will be very sensitive to any further jump in interest rates.