In this episode of the REconomy podcast from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi examine the supply and demand dynamic in the housing market to explain why home sales are declining.
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“There’s a lot of conversation around rising prices and falling quantity in the housing market, and there’s this concept, or this idea, that it's a demand-side problem. Affordability, or the inability to afford to buy a home because of rising prices and lower house-buying power, and that the affordability crunch is there, and that's a demand-side scenario. But, if demand were falling dramatically, we would actually see less price pressure, less home price growth along with the quantity supplied.” – Mark Fleming, chief economist at First American
Odeta: Hello, and welcome back to another episode of the REconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American. And here with me is Mark Fleming, chief economist at First American. Hey, Mark. In today's episode, we're going all the way back to Econ 101. Are you ready?
Mark: All the way back? That was a long time ago for me, what are we discussing? Opportunity cost? Scarcity? Utility? User preferences?
Odeta: Even more basic than that, believe it or not. Supply and demand. And I think the reason that it's so important for us to go back to this very basic concept is because I think there's sometimes a little bit of confusion about what's going on in the housing market. We're currently experiencing a decline in home sales. We keep hearing the housing market is so hot. And yet we've seen four consecutive months of declines in existing-home sales as of May. Also, more timely weekly mortgage applications data shows that purchase mortgage applications have declined seven out of the last 10 weeks as of July 2. So, in the context of supply and demand, we would call this a reduction in the equilibrium quantity, or the even fancier label, Q*. But, before we get into the mechanics, maybe a little bit of background on supply and demand would be helpful.
Mark: Yeah, because if we’re going to talk about Q* now, this is getting tough. Odeta, I wonder also why I am the one who always has to paint the visual picture for everybody? But let's give this a shot. Yeah, this is going to be good. Okay, so supply and demand. Let's talk about supply first, right? The higher the price, the more a supplier is willing to supply. Think about iPhones or something like that. If I can charge $5,000 for an iPhone, and it only costs me $500 to make it, I'd be more than willing to sell lots and lots of them. If things are low priced, I may or may not necessarily be as willing to supply as much of them. So, supply is what you've heard of as upward sloping. On the flip side of it, there's the demand curve. And that's the exact opposite, because the more expensive something is, the fewer the amount of people who will want to buy it. So, supply and demand are upward-sloping and downward-sloping curves respectively, and of course, price and quantity are set at where those two curves cross. And that basically is the fundamental premise by which we try and create all of our economic theories after that.
Odeta: Yep. Sounds about right.
Mark: Now, the important part here is when we analyze markets, and now I'm having flashbacks to my undergraduate Econ courses, where we have to draw pictures. Are you shifting along a curve? Or are the curves themselves moving around? Because what we observe in the market is price and quantity. As you said, we know how many homes were sold last month. And we know the average price of those homes sold. Price and quantity. And that's sort of the result of the equilibrium between these two curves, which by the way, don't really exist in reality anywhere. And, so the question then becomes, are we moving along a curve? Or are these curves shifting around? So, with that context, we'll get into the supply and demand curves and what's going on with them in the housing market.
Odeta: Exactly. See you painted a great picture. I have a supply and demand curve visualized now. While Q has declined, quantity, the number of homes sold, has declined, and the price of homes actually continues to go up. So, the S&P Case-Shiller national home price index increased 14.6% on a year-over-year basis in April. That was the highest annual rate of price growth since the index began in 1987. So, the quantity of homes sold is going down, while prices are going up. How do we explain this from a supply and demand context?
Mark: Well, I like to really break it down into a couple of basic premises. We'll take the example of the global financial crisis. We saw both price and quantity go down in the global financial crisis. And that would be driven largely by a shift in the demand curve. All of a sudden, there was a lot less demand for housing relative to supply. By the way, in the housing market, the supply curve doesn't really move around that much because it's really difficult to make more homes all of a sudden. So, it's a relatively fixed location, but we'll talk a little bit about what is generally moving it. We observed a decline in price and quantity because there was a significant curtailment of demand. The other way you could go is you can have prices rise, even if quantity demanded goes down. But, in this context, it would seem that supply, if it contracts, would also yield rising prices and lower quantity. So, the question really becomes, have we observed a contraction in the supply curve? Has it shifted? We would observe higher prices, lower quantity, or are we observing something going on with the demand side of the equation?
Odeta: Right, and it's possible to have a little bit of both, but we think this is mostly a lack of supply story, and a little bit of affordability causing some would be buyers to back out of the market. But, luckily, we have a model that can tell us a little bit more about what might be going on. And it's called our Potential Home Sales Model. We publish our Potential Home Sales Model analysis and results every month. And our Potential Home Sales Model actually measures what we believe a healthy level of home sales should be based on current market fundamentals, like economic, demographic, and housing market fundamentals. I ran the data for June, and it does show that potential home sales increased on a month-over-month and year-over-year basis. So, this model is based on housing market fundamentals, such as supply, which we measure by looking at average tenure length, so how long people are staying in their homes, and demand, or house-buying power, because more house-buying power drives demand for homes, among those other variables, but we'll just be focusing on these two. So, when we ran those numbers, what did we find for the month of June?
Mark: Before we get to the month of June results, I have to make a point here. In the housing market, we tend to have a lot of information about what's driving demand, and a lot less information about what's driving supply. And Odeta, as you know, we love to point out the fallacies of conventional wisdoms. There’s a lot of conversation around rising prices and falling quantity in the housing market, and there’s this concept or this idea that it's a demand-side problem. Affordability, or the inability to afford to buy a home because of rising prices and lower house-buying power, and that the affordability crunch is there, and that's a demand-side scenario. But, if demand were falling dramatically, we would actually see less price pressure, less home price growth along with the quantity supplied. So, even then it doesn't seem to make that much more sense. Maybe this is a supply-side issue much more than a demand-side issue. We tend to focus on the demand relative to supply, largely because it's much harder to measure what's going on with the supply side. But, we believe that the supply-side scenario can be well measured, especially when it comes to how long people live in their homes. Why does that matter for the supply side? Because the vast majority of housing supply is delivered by those people who are living in their homes, and if they choose to sell their home, supply is created. But, if they choose not to sell their home, they'll stay longer. Tenure length will go up, as we say. But, there must be some reason why one might be choosing to stay longer in their home and not sell and, therefore, create a restriction in supply. Well, you know, this is the first time in a long time where mortgage rates are beginning to go up. And so, I've gone and got my 3% mortgage rate and, if I were to sell my home, I'd lose that low mortgage rate and pay a higher mortgage rate. We call this the financial lock-in effect, it would cost me more to get the same mortgage again. And of course, the dynamics of choice and where we are in our lifestyle preferences and everything else. And so, there's a number of reasons why at the moment, we fundamentally believe that supply is contracting. And that's what's causing the market to have more problems.
Odeta: And if you look to the data, you can see exactly that. Tenure length is going up. Interestingly, before the housing market crash in 2007, the average length of time that someone lived in their home was about five years. And that increased to about eight years in the aftermath of the housing crisis between 2008 and 2016. And the most recent data from June shows that average tenure has reached 10.6 years and that is a historic high. So, homebodies are staying in their homes, which is restricting supply. And in June, that meant that the potential for existing-home sales declined by 11,000 potential home sales. So that's how much increasing tenure length contributed to a decline in potential home sales. That’s what's going on with the supply side. The supply side is resulting in fewer home sales. What's happening on the demand side?
Mark: Well, on the demand side, yes, rising mortgage rates are cutting into house-buying power. And that's decreasing affordability. And, effectively, we’re sort of sliding along the demand curve, rather than moving the demand curve. But, as you said, oh, my gosh, so both things are happening. This is getting really difficult. Well, if we look at the numbers on a year-over-year basis, the impact of a loss of house-buying power on sales is about 150,000 potential sales. But, as you noted with the tenure length numbers, people are staying in their homes twice as long as they were prior to the global financial crisis. And that's actually reducing potential home sales by about 160,000 more than the demand-side influence. So, the net is it's more of a supply-side problem, than it is a demand-side issue that's driving quantity down today. And, as a result, prices are rising.
Odeta: And that's really the takeaway, and that's why we took this trip back to Econ 101. I hope you enjoyed reminiscing with us. I'm sure all of you love your Econ 101 courses. And it's important to consider the fundamentals and dig a little bit deeper than the headlines, which will tend to focus on the demand side over the supply side. The decline in home sales does seem to be more of a lack of supply than a lack of demand. Though demand is pulling back a bit as fast-growing house prices outpace the benefit of rising income and low mortgage rates. So, sometimes it is helpful to go back to the basics of supply and demand. Thank you for joining us on this episode of the REconomy podcast, be sure to subscribe on your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, please follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.