This Is What an 8% Mortgage Means For the Housing Market

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1:23Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, did you see that National Association of Home Builders survey? It was bad. I actually didn't see the number, but I think it was bad, right? Yeah, it wasn't great. So the sentiment of the home builders is falling, which is kind of noteworthy because towards the beginning of the year, we saw a little bit of a pickup, a little bit of optimism. And we did see some new construction and that started to feed into overall housing supply. But fast forward to October 2023, rates are going up again.

2:04And it seems like this is finally starting to have something of a negative impact on how homebuilders are actually feeling. Well, we are recording this, as you say, rates going up. We are recording this on October 17th. Just today, we have the 10-year yield back over 4.8 % right at the time we're talking. That is basically at the highs of the cycle. We had dipped for a little while. And yeah, you mentioned that homebuilder sentiment number. And that was like the interesting story with housing has been resilience, right? Resilience in prices, et cetera. Even the homebuilders had picked up a bid in the first half of the year.

2:40But we were actually really heading back down not far off those lows that we saw at the end of 2022. Yeah. And meanwhile, mortgage rates, which of course are sort of priced off of treasuries, are getting close to 8%. That's the highest level, I think, since something like 2000. So we have to discuss this. And, you know, the last couple of times we dug into the housing market, we spoke with Morgan Stanley's U.S. housing strategist, Jim Egan. In fact, we spoke to him for the first time in October of last year in an episode that we called Here's What 7 % Mortgage Rates Will Do to the Housing Market.

3:15So now, 12 months later, we're just going to do, here's what 8 % mortgage rates will do to the housing market. Here we go. Yeah, we just do 1 % at a time. We'll just keep having Jim back on. That's right. But actually, on a serious note, one of the reasons we like talking to Jim Egan is that he was a bit of an outlier when we first had him on. You know, when mortgage rates were shooting up, a lot of people were predicting this really big housing crash. And meanwhile, Jim was forecasting a slight dip basically followed by a rise, which is exactly what we saw happen. And he was kind of early to that whole lock-in idea that you see everywhere now.

3:52So the notion that people who are lucky enough to have locked in mortgages when rates were at essentially zero are now going to be very reluctant to move and take on a higher mortgage cost. And so that basically helped provide a floor on prices. So we like talking to Jim and we thought even though we spoke to him once over the summer, given that rates are shooting up even more, we should definitely do it again. I'm excited about it. Let's do it. All right. Jim, welcome back to the show. Thank you so much for having me. It is an honor to be asked back. Third time's the best time. OK, so, you know, we've spoken a lot to you about what higher rates mean for housing in the short term.

4:33And as I said in the intro, you were early to that whole lock in idea. But I guess let's just jump into it. If we assume that higher for longer is here to stay for the foreseeable future, what does that mean for housing over a longer term horizon? Sure. And I think that the way that you're characterizing this is important, right? We have to disaggregate the short term impact of this most recent increase in rates versus a longer term impact here. Now, what I will caveat some of these comments by saying is that currently we're not forecasting rates to remain at these elevated levels for the longer term.

5:13We do think that the 10-year will come down through the middle of next year, and we think that mortgage rates will come down as part of that. But given what's happened to rates, that is a very important question right now. And I think this starts with affordability, right? We talked about affordability on this podcast when I was able to visit previous to this. And one of the things that characterized 2022 was just an historic, at least through the history of our data, a decline or a deterioration in affordability that we hadn't seen. Year over year changes were three times worse than what we witnessed during the great financial crisis.

5:47And earlier this year, affordability stopped deteriorating at those paces. Some shorter term affordability metrics, if we look at it over three months, over six months, affordability was actually improving. That's no longer the case. Right. It was a blip, basically, along with the tiny, tiny dip in house prices. Exactly. And if mortgage rates were to stay at 8 % for a longer period of time, affordability deterioration would return back to a place that we haven't seen in decades, the 2022 period notwithstanding. It's pretty incredible. Talking percentage points can sometimes be abstract, but our colleague Michael McDonough regularly posts this chart.

6:30And this was about a month ago, so we're even higher than we were before. But he posted this chart showing like a median house with a 30-year mortgage, just sort of really standard. You know, a few years ago, a monthly payment might be like about$1 ,000. It's up to$2 ,300 according to a typical 30-year mortgage rate versus March 2020 when we were at the lows and probably not a lot of people got mortgages. Nonetheless, like when you put those numbers in, I mean, it's just extraordinary affordability shock. It's incredible. Like one of the numbers that we were looking at recently, not relative to March 2020, but to put it into context, the extent to which we've seen mortgage rates increase, the payments up over 120 % since the lows in mortgage rates that we saw in the early part of 2022.

7:13And you've mentioned the lock-in effect. That is kind of a well-discussed topic at this point in time. And yes, it's still present. But when we think about the longer-term impacts of this move, the move from 2022 saw almost a 400 basis point increase from 3 % to 7 % when the first time you invited me onto this podcast. that took a lot of homeowners, a lot of mortgaged homeowners from sort of at the money around the prevailing mortgage rate to deeply out of the money, locked into their mortgage payment. The move now up to 8 % mortgage rates, it's not capturing the same quantum of marginal homeowner.

7:53And so the impact on things like supply, the impact on demand, especially the rate of change is not going to be the same this time around than it was in 2022. Sorry, can you explain that a little bit further? Right. So as borrowers were moving further and further out of the money in 2022, we saw specifically the listings of homes available for sale fall to far and away the lowest level we have on record. Right. Where we have that data going back over 40 years, never lower by our metrics, hit a low in May of 2022. Right. Now, as rates kind of held flat, maybe improved a little bit at those levels, you started to see inventory pick up a little bit.

8:31as rates have gone back to 8%, we're testing those lows again. But it's going to be difficult given that you're not moving hundreds of thousands or millions of homeowners out of the money. So the lock-in effect is just, like, that still exists, it worsens it, but the change is not as dramatic and as significant as supply curtailing as that initial move was. It's like reverse convex. Exactly. And I would also say the lock-in effect, while it's enormous, it's bigger than we've seen in a long time, and it's still with us, it is going to be slowly eroding as we move forward, right? Mortgages pay down.

9:08Right now, about every year, two to two and a half percentage points of these low rate mortgages are paying off. They're amortizing. And some of these low coupon borrowers, for reasons other than economic incentives, we call it turnover, like they are refinancing. So they're coming down. This is a point, Tracy, that like Connor Sen has been making in some Bloomberg opinion columns, which is that like every year we get, even if it's marginal, we do get a little bit further away from that sort of peak refinancing period. And so you do have a little bit of marginal pressure. So, you know, that supply constraining pressure, it does fade eventually.

9:46But I mean, just on the actual mortgage rate, Jim, you have a great chart in your research report, your latest one. I don't have it directly in front of me, but I'll try to describe it, where you show the effective mortgage rate versus, I guess, the rate of new mortgages being made. And there's just a huge gap at the moment. So most people who have a mortgage in the U.S. are not paying 8 % currently or anywhere near it, really. I mean, that seems like a pretty big gap. And even if some of those mortgages are rolling off eventually, it just seems really, really slow. Correct. The effective rate of mortgages in the United States, the outstanding balance, is somewhere between 3.6%, 3.7 % right now.

10:30As we've said in this podcast, the prevailing rate is approaching 8%. That is a gigantic gap that we haven't seen in decades, over 40 years at this point in time. And so even though it's eroding, you're right, Tracy, it's eroding on the margins. We don't think that what you're going to see is an increase in inventory. You're certainly not going to see a significant increase in inventory, but the rise in rates in 2022 led to a significant pullback in inventory. Right now, what we think you're going to see is much more of a marginal pullback. That is one of the shorter term impacts that we're seeing right now.

11:06The shorter term reaction to this, you mentioned the home builders confidence index this morning. There was a lot of weakness there. Supply has pulled back a little bit after easing in the later parts of 22, the early parts of 23. We do think in the very short term that provides a little bit of upward pressure on home prices. Our base case for the end of the year was 0%. Our bull case was plus 5. We're moving towards that bull case. That's where we think we're going to end up. But that's just the short term. That's not the longer term. It's where to stay here. So obviously we want to get into the longer term.

11:35But just one more sort of question on the short term. So on the supply side, the move from 7 % to 8 % is not nearly as dramatic as say the move from 3 % to 7%. We are maybe moving for every day we get a little bit further away from the low in yields. What is the short-term demand side impact? And just right now, today, October 17th, 2023, what does 8 % mortgage mean for demand? It's going to mean that demand is weaker. We just talked about the percentage increase in the monthly payment on those mortgages. But the question is, how much weaker can demand get. In the same way that the increase in mortgage rates isn't going to have the same marginal impact on supply, we also think that it will be hard for it to have the same marginal impact on demand.

12:24There is a modicum of people that will need to buy homes even at this challenged level of affordability. When we look at, again, kind of the turnover rates of the housing market, one way that we estimated that in recent research was existing home sales versus the total ownership stock of the housing market, that rate has already fallen to the lows that we experienced during the great financial crisis. The existing home sales are higher than that low point, but the housing stock is also larger. And so while that doesn't mean that sales can't fall further from here, we think that the sharp declines that we witnessed in 2022, those are behind us.

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14:53Is there the potential for home builders and people in general, I guess, just to get used to it and to, you know, have confidence that they can start building again? I guess another way of asking this is what sort of decisions go into home builders on whether they decide to ramp up construction and supply? So I think that one thing that we're going to need, and I think you're alluding to this, is just less volatility in the rate and market overall. We need more certainty in where this is going to be on a go-forward basis. And I think when we think about single unit starts, housing starts in general, but single unit starts, kind of home building in particular, I think we're dealing with kind of a big headwind and a big tailwind at the same time.

15:43And we're trying to figure out how those two opposing forces are going to move forward. We've been talking about the headwind. Affordability is incredibly challenged. The tailwind piece of this is that there is a pretty significant shortage of housing in the United States. That's more than just the listing of homes for sale. We don't believe that we've been building enough homes over the course of the past 15 years. I can be conservative with my assumptions and get to roughly a 2 million unit shortage. I can be more aggressive and say that we might be 6 million units shy. We think that the truth lies somewhere in that range.

16:18And by the way, that's a total of single unit and multi-unit housing. But that shortage should theoretically be a tailwind in a world in which maybe not affordability starts improving, but at least the marginal volatility in that metric comes down. Or maybe it stabilizes so that people can at least make decisions about their longer term finances. That's a good way to put it. What are the factors in your model that would say like, okay, it could be 2 million, 6 million? What are the variables that go to that range? So if I started on the higher end of this, right? We think a lot about the marginal demand for shelter.

16:58We forecast household formations. We've discussed the dynamics of that in the past. You've taught me what these words mean. Headship rates. Headship rates and household. Do we need a headship rate problem? I learned from Jim Egan. No, people got to go back and listen to the last time, which is when he explained to me what he explained also on the first time. We're going to make you go back and listen. But so we have that marginal demand. Okay. And then we have marginal supply, right? It's the addition of both single unit and multi-unit housing, all new units that come on on an annual basis. You control a little bit for the obsolescence of old housing.

17:31Yeah. And the difficulty with an equilibrium calculation is I could cherry pick and start in 2009 at the bottom of the GFC when home builders were really pulling back and saying that the shortage is enormous. Or I could go back to 2000. I could go back to 1990. I don't know exactly where to start that calculation. But going back over several decades, you get to roughly a 6 million number. But on the shorter end of this, if we're saying that the marginal demand for shelter has exceeded the marginal supply of shelter, one way to prove that would be, are vacancy rates coming down? People are living somewhere.

18:01The households are forming. And so vacancy rates have, both owner vacancy rates and rental vacancy rates have come down significantly throughout this. But if I were to look at that and say, well, what would it take, how much shelter would it take for us to get back to a long run equilibrium vacancy rate or a long run average vacancy rate, if you will, and that's more like 2 million units across the board. And so we think that the truth lies somewhere in that range. I know it's a pretty big range, but they're both pretty big numbers for an overall supply shortage. Actually, this reminds me, since you mentioned vacancy rates, one of the interesting things that happened over the past year or two was this idea that maybe buying a house is an inflation hedge.

18:45So if you can lock in your costs, you know that your landlord isn't going to send you a letter once a year and say, I'm raising rent by 5 % or 10 % or whatever. And so that was said to be driving some of the demand. As mortgage rates continue to go up, would you expect people to maybe start to go back to renting? Although I realize that rent itself might not necessarily be a great option. But if inflation is starting to cool a little bit, then maybe some of that dynamic begins to reverse. I like the way that you phrased that juxtaposition from the household or the consumer's perspective. And I do think that as rates go up, look, even as rents have climbed, And in most places, most geographies across the country, it's still more affordable to rent than it is to own a home.

19:36And the climate mortgage rates is contributing to that as well. And so could on the margins you see more households elect to remain renters than buy into the, as you put it, the inflation hedge, the locking in of that shelter payment as opposed to receiving those every 12 or 24 month rent increases? Sure, on the margins, that would make sense. But anecdotally... It's probably a small percentage, yeah. But it is true that right now, like the rent versus buy calculators, like at various times in some market, like, oh, you should rent or sometimes buy, like, they're way in the dial towards rent right now, right?

20:21Yes. Okay. So what else? I mean, what changes the dynamic? I mean, the other thing that, of course, could change, but none of us really know. I mean, there could be like the sort of miraculous disinflation, right? And suddenly it's like, oh, it was all transitory and everything's fine. And then the Fed like cuts rates and then mortgages. But let's just say, you know, we can all dream that that would be the scenario. But outside of that, like what gives? So. So the soft landing scenario off the table, rates coming down and otherwise. healthy economy. What we're trying to figure out is just where could supply come from?

21:02Yes. Right. I think we've referenced the longer term impact of 8 % mortgage rates, and I haven't spoken to any potential impacts from a quantitative perspective. But if we think that it's going to keep demand capped, right, the drops can't be as significant as they were in 2022, or at least we don't think they will be. But we do think that you can talk about a higher for longer rate environment in terms of just kind of preventing sales from really climbing, then we have to become super focused on this low inventory, this low supply environment, because a growth in supply for any reason will lead to weakness in home prices.

21:40If we look at our models and just put in a 5 % increase for next year, and we were increasing by more than 5 % in that period after May 2022 that I mentioned, just a 5 % increase, if we assume no growth in sales or no growth in transaction volumes, our models would say that home prices are down 5 % by the end of next year. That's not our forecast. As I stated, higher for longer is not our base case. Our mortgage rates at 8 % for the entirety of next year is not our base case. But that means that that inventory becomes something that we have to be hyper-focused on. And so where could that come from?

22:15Could it come from potentially the erosion of the lock-in effect that we discussed? Maybe on the margins. Tracy, as you pointed out, we're still very, very far away from prevailing mortgage rates. So that would just be on the margins. I believe I've discussed older homeowners on this podcast before. One out of every three homes is owned by somebody over 65. Over 50 % of those homeowners bought their home before the year 2000. They have a lot of equity there. Perhaps they could be listing. The general trend has been more towards aging in place. So we don't think it's going to come from there. But that's what we're trying to figure out.

22:45If rates are going to stay elevated, We think that demand will remain tepid. And if that's the case, any marginal supply would weigh on home prices. Oh, yeah. That reminds me. There was actually a very interesting Barclays note from one of your competitors. I'm sorry we're cheating on you with other banks. But the headline was basically – well, this was the headline. This is your headline. This is my headline. Okay, well, whatever. It captured the thrust of the note. The headline of the summary that I wrote was Barclays says blame the boomers for surging house prices. And the idea here was that you have a lot of this older generation who are choosing to stay in place.

23:27They don't want to move in to nursing homes. And then that is also affecting Joe headship rates and helping provide a floor on house prices. I don't want to ask you to talk about a competitor's research, but maybe you can talk a little bit more about that dynamic. How much of the current resilience in housing is coming from a large generation of people who want to stay where they are? It might even be downsizing, but still moving into new houses. I think it is an incredibly important point. We talked so much about headship rates and household formations, and it drives the conversation towards millennials and Gen Z because they're the ones that are moving through their late 20s, their early to mid 30s, and those age cohorts that have been so significant in driving the marginal demand for shelter.

24:21I think the reason that we haven't been as focused on older age cohorts as an industry is because historically they just haven't been that large. The boomer generation moving into this age cohort is really driving kind of differentiated housing dynamics. If we look at the percentage of homes that are owned by people over 65 from 1980 to 2012, it is a very consistent 25%. The oscillations are really small. As I mentioned a little bit earlier, it's gone up to 33 % from 2012 to today. Given some of the demographic forecasts from our economics team, it's only going to move higher right now. And that trend has been aging in place.

25:07While older homeowners do move from time to time, when they do move, they tend to move to very similar places, Florida, Arizona, South Carolina. For the most part, they do stay where they are. They age in place. They are the least mobile age cohort in our population. I talked about listings being at the lowest levels we've seen in 40 years. The truth is in 2018, 2019, they were close to 40 year lows. And one of the reasons behind that, we think, is this aging boomer population? What share of housing they're taking up now from 2020 to now? It has dramatically fallen and very much reset those lows.

25:43But this was a conversation we were having pre-COVID.

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