By Michael Canter and Monika Carlson

With interest rates rising, the once hot US housing market is finally showing signs of slowing down. But while rising mortgage rates have dampened demand, they have also contributed to an already shortage of single-family homes. Until housing construction picks up, supply constraints should continue to provide some price support, even if demand moderates.

A torrid real estate market brought back to normal

The US housing market is emerging from a period of price inflation not seen since the escalation of the global financial crisis. In 2021 alone, U.S. house prices jumped nearly 20% year-over-year, driven by low mortgage rates, growing demand — especially from millennials — and the flexibility of working from home caused by the COVID-19 pandemic.

But perhaps the main driver of housing inflation has been the lack of supply. In recent years, the United States has seen some of the lowest levels of home inventory on record. This has led to frenzied bidding wars, with properties in hot markets regularly selling above asking prices.

Home affordability took a hit

With the Federal Reserve on a quest to stifle inflation, the era of ultra-low mortgage rates is over, with the national average for a 30-year fixed-rate mortgage hovering north of 6%. This is more than double the level recorded in January 2021, and the Federal Reserve is predicting more rate hikes to come.

New homebuyers are bearing the brunt of tighter monetary policy. Coinciding with rising rates and rising prices, housing affordability quickly rose above its historical average. Since the mid-1990s, just under 18% of median family income in the United States has gone to mortgage payments, on average, with much of this figure due to housing inflation before the global financial crisis (Display). Today, new homebuyers are spending nearly a quarter of median U.S. family income on mortgage payments, a dramatic increase in the past nine months alone.

Rising rates put pressure on home affordability

Mortgage payments as a percentage of median family income in the United States have risen sharply.

Current analysis does not guarantee future results.

Until June 2022

Source: Bloomberg, National Association of Realtors, S&P/Case-Shiller Home Price and AllianceBernstein (AB)

Deteriorating home affordability has, in turn, dampened demand, although numbers vary widely by region and price. Nationally, existing home sales fell for six consecutive months from February, while further cracks in the demand picture can be seen in the 7.7% of sellers who lowered their prices bidding – a marked departure from last year’s bidding wars.

Limited supply keeps house prices high

But as the supply of new homes begins to climb, the inventory of available homes, which make up most of the US housing stock, is hovering at historic lows. This has supported the housing market by keeping prices high. In June, more than a third of all listed U.S. homes sold in two weeks, with a median of 23 days on the market (Display). This reflects more of a boiling housing market than a declining market.

Rising interest rates slow housing demand

Various indicators of market health, including percentage of homes sold in two weeks (37%)

Current analysis does not guarantee future results.

Potential Buyer Traffic is a seasonally adjusted index where any number above 50 indicates that more builders consider conditions to be good than bad. Affordability is represented by the Fixed Mortgage Homebuyer Affordability Index. Mortgage buying demand is represented by the US MSA Buy Index. Household formations are represented by US Household Formations, which tracks annual changes in owned dwellings.

Affordability is from January 1999 to June 2022; mortgage purchase applications are from January 1, 2009 to August 19, 2022; the traffic of potential buyers is from January 1999 to July 2022; % price drop, % sale in two weeks, median days on market are January 1, 2019 to August 14, 2022; household formations are annual and from January 2001 to June 2022.

Source: Bloomberg, Mortgage Bankers Association, National Association of Homebuilders, Redfin and US Census Bureau

In our view, higher rates could exacerbate the national home inventory shortage. Indeed, rising mortgage rates generally discourage homeowners from listing properties financed at below-market rates.

The numbers speak for themselves: 99.5% of mortgage holders in the United States have locked in more attractive rates than they could find if they sold their home and borrowed at prevailing rates (Display).

Home inventory at historic lows, most borrowers locked in lower rates

Months of supply approaching 2.5 months as more than 99% of borrowers are locked into low rates.

Historical analysis does not guarantee future results.

Left display until July 31, 2022; right display through August 26, 2022 Percentage of blocked borrowers is represented by (1 – Morgan Stanley Truly Refinanceable Index). The Morgan Stanley Truly Refinanceable Index represents the percentage of borrowers with an incentive of at least 25 basis points to refinance.

Source: Morgan Stanley, US Census Bureau and AB

Housing fundamentals are strong

With changing housing market dynamics, it’s tempting to go back to the global financial crisis, when subprime mortgages and skyrocketing defaults finally burst the housing inflation bubble. Could a similar collapse occur this time around? Unlikely, in our view. This largely reflects improving credit conditions and lessons learned from the global financial crisis.

On the one hand, stricter lending standards have prevented low-income and credit-stressed borrowers from buying homes that are too expensive relative to their income. Low lending standards contributed to the housing crash of 2008-2009. Currently, 30-year fixed-rate loans make up the lion’s share of mortgages in the United States, exposing fewer existing borrowers to rising rates, while lenders have increased adjustable-rate mortgage standards.

Additionally, today’s higher prices have significantly increased homeowners’ equity, providing a strong incentive for homeowners to stay current on their mortgages. And, despite stubborn inflation, wages have continued to rise, while real income in the United States is still positive, further supporting borrowers’ ability to make monthly mortgage payments.

The result is historically low mortgage delinquency rates, a far cry from the years following the global financial crisis, when delinquencies soared and cottage industries sprang up around dealing with mortgage defaults.

Pockets of weakness could persist

That’s not to say we won’t see pockets of weakness. If home affordability remains challenging, we expect the monthly supply of existing single-family homes to increase from around 2.5 months today to five months by the end of 2023. national home price appreciation, we expect few price declines year over year.

As always, demand – and the resulting impact on prices – is likely to vary significantly by region and price level, but we expect the U.S. real estate market as a whole to be taken in a continuous showdown between rising rates and limited supply.

The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the opinions of all of AB’s portfolio management teams. Views are subject to change over time.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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