U.S. Housing Outlook
Modest growth ahead, policy reform needed
THE REAL ECONOMY |
Housing demand in the United States remains brisk even as issues with supply and affordability mount, particularly in the West. We continue to forecast solid sales and consumption throughout the economy this year. We expect housing starts to be sustained near their current level of 1.25 million at an annualized pace. The late-cycle fiscal boost linked to the 2017 Tax Cuts and Jobs Act, as well as the recent budget agreement, will help to stoke aggregate demand through increased household spending and a tight labor market heading toward 3.7 percent unemployment. In short, we have a perfect recipe for strong housing demand.
It is a misnomer to label the housing outlook as “weak.” Given strong housing demand driven by a solid labor market, modest growth and demographic changes that favor risk-taking in the real estate development community, instead we see supply constraints and policy challenges preventing a breakout in housing toward the long-run equilibrium level of 1.6 million starts at an annualized pace. We are also concerned about the negative impact to new and existing home sales in large metropolitan areas along the coasts and the Upper Midwest due to the elimination of state and local tax deductions.
While the overall macroeconomic outlook remains strong, the housing market is constrained by four fundamental issues: a lack of available lots, a shortage of available workers, high regulatory costs and federal tax law that is damping construction and sales activity in some areas of the economy.
MIDDLE MARKET INSIGHT: In our travels around the United States, a tale of lost development opportunities due to concerns about federal oversight linked to Dodd-Frank is a consistent narrative from the middle market.
Two policy constraints are generating headwinds for the housing market. The first is tier one capital ratio requirements faced by banks with at least $250 billion in assets under management. This represents a lost opportunity: These banks do not have the capabilities nor capacity to address increased regulatory oversight that accompanies funding investment opportunities that would burst through their tier one capital ratio limits. Thus, residential development in many areas where it is desperately needed simply isn’t taking place.
The U.S. House of Representatives has put forward, and passed, legislation providing relief for the banking cohort with less than $250 billion in assets under management. While leadership in both parties in the U.S. Senate has signaled it is favorably disposed toward that legislation, it has yet to act on this specific reform so critical to the housing and residential investment outlook.
Second, soft sales in the first part of 2018 are likely linked to the 2017 Tax Cuts and Jobs Act, which significantly reduced the preference in the tax code previously conferred on home ownership. To date, both California and New York have seen slowing sales of homes primarily targeted at upper-middle-class and wealthy buyers. Given that much of the new housing stock in recent years has been built to attract that segment of the market, it is only natural that there may be a period of adjustment for homes priced at $500,000 and above in many metropolitan and suburban areas along the coasts, as well as in and around Chicago.
While not much can be done to address these real estate development hurdles in 2018, the large states that sit in the new economy, and are linked to global trade, will likely need to address the $10,000 deduction cap on state and local taxes tied to the new tax policy.
"...WE ARE FORECASTING A STRONG REBOUND IN THE CURRENT QUARTER, LIKELY BEGINNING WITH MAY REPORTING DATA."
The first quarter of 2018 saw no growth in residential investment after a 12.8 percent increase during the final three months of 2017. However, that lack of growth deserves to be put in context. First, the double-digit growth late last year was primarily due to the recovery after the three large hurricanes hit the Gulf Coast region and Texas and devastating fires that impacted California. Second, speculative activity in the housing market was damped by rising interest rates and the aforementioned policy constraints.
Even so, we are forecasting a strong rebound in the current quarter, likely beginning with the May reporting data. We expect that momentum to spill over into the second half of the year. Through the end of the first quarter, the six-month average of housing starts stood at 1.287 million at an annualized pace. The forward-looking permits imply a move upward to 1.35 million starts at an annualized pace.
Meanwhile, household formation through the end of the first quarter stood at just over one million, which is well above the 900,000 average seen throughout the current business cycle. With the employment-to-population ratio of those aged 25-54 reaching 79.2 percent—well above the cyclical low of 74.8 in 2009—there is ample room for upside in both housing starts and permits. The rising employment-to-population ratio of the median worker also supports the elevated reading of 55.5 in the National Association of Home Builders (NAHB) Remodeling Index, and 57.8 in the Future Remodeling Index.
In the United States, currently 1.125 million housing units are under construction; 504,000 are in the single-family residence category, and 621,000 are in the multifamily category. Given the decline in affordability, we expect to see a sustained increase in multifamily construction. The March data reported the completion of 1.21 million units, in line with the 1.2 million six-month average. On a regional basis, the South was responsible for 48.9 percent of all starts, the West 29.7 percent, the Midwest 12 percent and the Northeast 9.4 percent.
Homebuilder sentiment remains strong with the NAHB sentiment measure standing at 69, just below the cyclical high of 74 posted in December 2017. This sentiment index, which during the current cycle has a strong correlation with new housing starts, implies that the trend in residential investment is likely to remain in place. The most-recent NAHB Housing Market Index suggests that prospective buyer traffic will ease modestly, while sales should remain stout.
Supply constraints continue to be a major impediment to overall growth. There are roughly 3.6 months of supply in the existing home category with a 3.5-month supply in the single-family category and 3.9-month supply in the multifamily category. In the new home category, there are roughly 301,000 units available, or 5.2 months at the current sales pace.
There are 1.125 million units under construction, with 504,000 falling in the single-family residence category and 621,000 in the multifamily category. Given the decline in affordability, we expect to see a sustained increase in multifamily construction. The March data reported the completion of 1.21 million units, in line with the 1.2 million six-month average. On a regional basis, the South was responsible for 48.9 percent of all starts, the West 29.7 percent, Midwest 12 percent and the Northeast 9.4 percent of starts.
Homebuilders have been adding supply as fast as they can, given the previously mentioned constraints. Higher material costs, zoning requirements that have led to an environment where one out of every four dollars dedicated to each unit goes toward regulatory costs, and, most importantly, a shortage of labor to build new construction, all continue to damp overall residential investment. Thus, the inventory of existing homes on the market stands at 1.67 million, which is 7.2 percent less than it was a year ago. It is the 34th consecutive monthly decline of supply. This has caused an increase in pricing and a decline in affordability.
Home prices using the Case-Shiller and Federal Housing Finance Agency (FHFA) home price indexes as the primary benchmarks saw strong increases during the last reporting period in February. The FHFA saw a 0.7 percent monthly increase, 7.2 percent above year-ago levels. The 20-city Case-Shiller index increased 0.8 percent, 6.7 percent above year-ago levels. The median price of a new family home is now $337,200 while the median price of an existing home is $250,000.
It is clear that demand has outstripped supply as prices increase to clear the market. In our estimation, unlike the bubble that formed prior to the 2007-2009 recession, housing prices are a function of low unemployment, wage gains and an overall tightening of the supply of homes on the market.
Sales of existing homes rebounded by 1.1 percent to an annual pace of 5.6 million in March, after a weather-induced slowdown during the first two months of the year. New home sales also jumped by 4 percent to a 694,000 annualized pace. Pending home sales, which are a leading indicator (typically by two months) of overall home sales, increased 0.4 percent in March after a 2.8 percent increase in February. All of this implies a solid kickoff to the traditional buying season. Homes for sale through the end of March spent an average of 30 days on the market, compared with 34 days in March 2017, and 47 days in March 2016.
Interest rate outlook
The long-term interest rate outlook implies that potential homebuyers should anticipate higher policy and mortgage rates in the near-term. The 30-year fixed mortgage rate stands at 4.44 percent, which is 132 basis points above the yield on the 30-year U.S. Treasury bond and 149 basis points above the yield of the U.S. 10-year Treasury.
The consensus forecast is that the 10-year yield will stand at 3.1 percent at the end of 2018 and 3.47 at the end of 2019. This would imply a 30-year mortgage rate near 5 percent heading into 2020. Given the likely increase in the policy rate by the Federal Reserve to 2.5 percent in mid-2019 and 3.5 in mid-2020 from 1.5 to 1.7 percent today, either the yield curve will invert—implying a recession within 18-24 months—or fixed income investors will have to adjust their expectations on rates upward, carrying with them the risk that mortgage rates moving toward 5.5 to 6 percent by the end of 2020.