What’s Raising Housing Prices? It’s Not Just Higher Rates.

By Dr. Charles Lieberman, Co-Founder & Chief Investment Officer

** This article was published on Barron’s website on Feb 09, 2024.

Many people believe that homeowners’ reluctance to move and give up their low-cost mortgages is behind the recent rise in housing prices. Get more people to place their homes on the market and home inflation will moderate or reverse.

This analysis isn’t quite correct because it fails to recognize that a severe housing shortage is the problem, not low supplies of existing homes. Only a sizable increase in new construction can relieve the shortage and boost housing activity. It will take some years to bring housing back into balance.

The seeds for today’s housing shortage were planted during the credit crisis of 2007-08, when an excess of housing supply triggered a collapse in housing prices. New construction added more than two million units at an annual rate when household formation required roughly 1.5 to 1. 7 million units. New housing supply outran demographically led growth in demand for several years by a significant margin. The result was a housing glut.

Why were so many units constructed? Too many people bought houses to make a quick buck by flipping them at what seemed to be ever-rising prices. Builders were happy to build to accommodate demand, since they made more money with each home they built. But home flipping failed when the speculators an out of buyers, which led to a collapse in home prices.

Owning a home for the purpose of flipping is rather expensive. Speculators must cover property taxes, utilities, yard maintenance, and loan costs while the home is vacant and producing no income whatsoever. Flippers need to sell. And when they lack buyers, their only solution is to cut the price, even if it means taking a loss. That may solve the carrying-cost problem of that specific speculator, but it exacerbates the carrying-cost problem of every other flipper. Like the game of Old Maid, the Queen of Spades was simply passed to another unhappy home flipper, who was, in turn, also forced into deeper price cuts. That caused a downward cascade in home prices in 2007-08 that ensnared mortgage lenders, banks, and certainly anyone who owned a home but lost a job or couldn’t meet their mortgage payments.

The Federal Reserve did what it could by cutting interest rates to reduce mortgage costs, but it couldn’t make households materialize out of thin air. The only way to absorb the excess inventory was for housing construction to collapse and allow normal population growth to absorb the overhanging inventory. The collapse in housing values rippled through the economy with widely spread adverse effects. Housing construction contracted by more than 75% from a peak of about 2.25 million at an annual rate in early 2006 to 500,000 units by the beginning of 2009. New construction activity reached 1.5 million units only in 2020, an extraordinary long period of underbuilding.

Having been burned so badly during the credit crisis, mortgage lenders became far more demanding, behavior that was reinforced by regulators. There were also fewer builders, since many had gone bankrupt. The pandemic initially obscured the brewing housing shortage. But it soon exploded into view as people sought to get out of cities into the suburbs or decided they needed more space, driving up housing prices.

Since sellers don’t move to Mars, every seller becomes a buyer or a tenant elsewhere. They might want a larger unit, to downsize, or to become a renter, but they are taking one unit out of the market for each unit they place onto the market. Every seller actually represents zero net demand for housing units. Net demand comes from a growing population (net of deaths), divorces (net of marriages), and demand for second or vacation homes.

Estimates of the current housing shortage range from 1.5 million to several million units. Those upper estimates aren’t plausible. But even the low estimates represent a severe shortage that will take years to eliminate. New construction is currently running about 1.4 million units at an annual rate, close to growth in underlying demographic demand, but still far short of what’s needed to reduce the shortfall.  That’s why housing construction stopped falling in 2023, despite the ongoing rise in interest rates over the year.

If people can’t afford to buy, they must rent. That rising demand for rentals in a tight housing market drives up rents, of course, which incentivizes builders to construct more apartments. Eventually, the housing shortage will be alleviated by new construction, both single family and multifamily units, but there must be a period of construction that exceeds the rate of household formation, a condition that hasn’t yet been met. But conditions are very ripe. The recent sharp decline in mortgage rates is likely to unleash a surge in demand for new construction, regardless of whether more existing owners are willing to sell and move. Large gains in employment and rising wage rates provide households with the wherewithal to enter the housing market. So, housing construction is likely to enjoy several years of robust activity, whether more existing units are put on the market or not. This will benefit home builders and suppliers for years to come.

About the author: Charles Lieberman is the former head of the monetary analysis staff of the Federal Reserve Bank of New York and the former chief economist of Chase Securities. He is a cofounder and managing partner of Advisors Capital Management, a registered investment advisory firm.

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