How is it possible for housing prices in the USA to continue rising

The ownership of a home regularly ranks high in studies on what Americans want most in their lives. Alas, this part of the American dream has rarely been harder to attain. Those looking to enter the real estate market face the triple blow of high prices, expensive mortgages, and limited choices. Together, these factors have made homes extremely inaccessible, with no signs of relief on the horizon.

Yet, indirectly, the housing crisis helps explain one of the most pressing economic mysteries at the moment: why American growth continues to remain stable and unaffected by recession forecasts.

Higher interest rates do not harm. For now.

Although housing is typically one of the most interest rate-sensitive sectors, things in America are not so straightforward. Over the past two years, as the Federal Reserve began implementing a stricter policy, mortgage rates sharply rose from less than 3% to over 7%. According to the National Association of Realtors, for the median family buying a home with median value, mortgage payments doubled from around 14% of household monthly income in 2020 to nearly 29% in June - the highest value since 1985.

Surprisingly, the surge in mortgage rates did not lead to a drop in housing prices. They did dip briefly when rates began to rise, but then rebounded to record levels reached earlier last year, after COVID-19 stimulus measures were introduced to the economy. Data published on August 29 showed that this recovery may be gaining strength: housing prices in the second quarter of the year increased by 15% on an annual basis according to the S&P Case-Shiller index, a benchmark for U.S. property prices.

What explains this impressive resilience? For a market the size of the American real estate market, where annual sales amount to around $2 trillion, spread across an economy the size of a continent, with some regions thriving and others contracting, there inevitably is a nuanced answer.

There are still buyers.

Still, a good summary was made at the end of August by Douglas Yearley, CEO of Toll Brothers, one of the largest American homebuilders, during a financial report. "There are still buyers. They have very few options," he explained.

While the demand for housing has decreased with the increase in interest rates, the supply of properties has decreased almost simultaneously. Homebuyers typically receive mortgages with fixed interest rates for 30 years - something unheard of in most countries, but in America, it is almost considered a constitutional right, thanks to the role of Fannie Mae and Freddie Mac, two government-backed giants that buy mortgages from lenders and securitize them. By allowing lenders to offer long-term fixed interest rates, they aim to make it easier for people to buy homes. But now, long-term interest rates serve as an obstacle, as homeowners who have received low-interest mortgages before the Fed raised interest rates have no desire to give them up and therefore do not want to sell their homes.

The Redfin property platform calculates that 82% of homeowners have mortgages with interest rates below 5%. Charlie Dougherty of Wells Fargo Bank calls the result a "state of suspended animation" for the housing market.

Under equal conditions, a decrease in transactions should harm the economy, as less money is spent on remodeling, new construction, furnishings, etc. However, things did not unfold that way. Unable to acquire nicer homes, locked-in property owners invest more in renovating their current homes. The rise of remote work reinforced this trend, as people added additional office space to their homes. Renovation spending in 2022 reached nearly $570 billion, or about 2% of GDP, which is 40% higher in nominal terms compared to 2019, according to the Joint Centre for Housing Studies at Harvard University.

Many of those daring to buy homes on the market choose new construction rather than existing housing stock. One advantage of newly built homes is that they are actually available. This means they account for about one-third of active listings this year, compared to an average of 13% in the two decades before the COVID-19 pandemic, according to the National Association of Home Builders. As Daryl Fairweather of Redfin says, "Builders are benefiting because they don't face competition from existing homeowners.

Builders also boldly offer incentives to buyers. The most visible one is that they 'buy down' up to 1.5 percentage points of the interest on mortgages by paying a one-time fee, which reduces future interest payments. This allows their own mortgage companies to offer rates of around 5%. For homebuilders, these reductions are equivalent to reducing the sale price by about 6%, which they can easily afford given the stability of their balance sheets. For buyers, lower mortgage rates are a welcome relief in the current environment, resulting in an increase in both purchases and construction. In July, construction starts increased by nearly 10% compared to the previous year.

How Sustainable Will Prices Be?

Now real estate experts wonder if the stability of prices will continue. The market is facing a test as mortgage rates continue to rise even further. For most of the past year, interest rates seemed stabilized around 6.5%, but starting in early August, investors concluded that the Fed will maintain its tightening policy for a longer period, pushing mortgages towards 7.5%.

"The higher the rates, the more demand will decrease. This will hit homebuilders fairly quickly," believes John Burns, a real estate consultant. To counteract the slowdown, some lenders may offer riskier deals. The real estate platform Zillow started offering down payments as low as 1% for homes in Arizona, once a large market. If prices fall, owners with a small stake in their homes may be among the first to face insolvency.

However, if the real estate market remains stable, the Fed's policies will be put to the test. Strong activity in the housing market contributes to overheating the economy. Sustained price recovery would complicate prospects for inflation. The connection is not entirely clear, as housing is included in inflation indices with rents, not purchase prices. In addition, core inflation metrics typically lag high-frequency rent measures by at least six months. For most of the past year, these metrics were decreasing, and the decline is only now reflected in official inflation indices—a process likely to continue until early 2024.

What will happen after that is much less certain. On one hand, a record number of apartments are currently being built, and this supply should help hold rents. On the other hand, housing unaffordability is forcing more and more potential buyers to turn to the rental market, which could lead to higher rents and increased inflation. One thing is clear: until interest rates lower again, millions of Americans will have no choice but to delay their dream of owning a home.

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