In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi delve into three spooky facts about the housing market and explain whether they are more trick or treat.

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Listen to the REconomy Podcast™ Episode 49:

“So, the rate for the common 5-1 hybrid ARM is currently at 5.36%. Compare that to the prevailing 30-year, fixed mortgage rate during the same time period at 6.75%. So that's more than a percent difference of benefit in a lower interest rate. An ARM increases consumer house-buying power by approximately $53,000. Not an inconsequential amount compared with a traditional 30-year, fixed-rate mortgage. So, yes, a little less spooky, right?” – Mark Fleming, chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 49 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hi Mark. It's almost Halloween and in today's episode, we'll talk about whether the housing market is likely to give tricks or treats this season.

Mark Fleming - Hi, Odeta. Happy almost Halloween, wasting no time jumping into today's topic. I see.

Odeta Kushi - Well, we got a lot to cover. Today we're going to discuss three spooky facts about the housing market. Or maybe I should say the haunted housing market.

Mark Fleming - Was that the last of the Halloween quips or have we got more to come?

Odeta Kushi - Witch-ful thinking? That was the last one. I promise. It's no surprise to anyone that the housing market is cooling and cooling fast. And it has both buyers and sellers a little spooked. In fact, the top housing-related search phrases have been: 'real estate housing market crash,' 'will home prices drop in 2023,' 'when will home prices go down,' and 'will house prices go down.' A little repetitive there. And, 'how much house can I afford.' You get the point? And it's no wonder. The 30-year, fixed mortgage rate is up approximately 3.7 percentage points relative to one year ago. That's the biggest annual jump since 1981.

Mark Fleming - Wow, that's got me really spooked. Nope, not done yet with the Halloween quips.

Odeta Kushi - Oh, eye roll, since I can't actually provide one on film. That affects both buyers and sellers. Which brings us to our first, or maybe second for you, spooky fact. Care to take a guess?

Mark Fleming - Well, you led with mortgage rates. So, number one must be the rapid decline in affordability because of those fast-rising mortgage rates.

Odeta Kushi - Correct. According to our latest Real House Price Index (RHPI) data from August 2022, housing affordability has declined by 66% since its recent peak. We're looking back to 2020. In June 2020, as the 30-year, fixed mortgage rate increased by two percentage points. That decline in affordability is further reflected looking at annual data. The RHPI is up nearly 50% on an annual basis and this includes the most recent month in the RHPI when rates dipped a little bit on a month-to-month basis, providing just a tiny bit of relief. That decline was short lived, as rates have since resumed their incline. But why is this scary?

Mark Fleming - For home buyers, there are a few options to mitigate the loss of affordability caused by higher mortgage rates and rising prices. One way to offset the decline in affordability is with an equivalent, if not greater increase in household income, and that is hard to come by. Another option is choosing an adjustable-rate mortgage, an ARM as they say, which typically has a lower rate than the 30-year, fixed-rate mortgage. But, unfortunately, even though higher income, higher household income and ARMs have helped to increase consumer house-buying power, they're not enough to offset the loss of buying power from those higher rates and fast-rising nominal prices.

Odeta Kushi - So, I want to touch on a point there. ARMs, adjustable-rate mortgages, can make something that is really scary, like the fast decline in affordability, less so, right?

Mark Fleming - That's right. As mortgage rates continue to rise, more and more buyers are choosing to apply for those ARM loans. The ARM share of applications at the end of September reached 12% by loan count, which is the highest it's been since 2008. The average contract interest rate for a 5-1 ARM - let's explain what 5-1 is, the first number is the number of years that the rate is initially fixed and the second number is how many years it takes for that rate to adjust to the prevailing market rate at the time. So, the rate for the common 5-1 hybrid ARM is currently at 5.36%. Compare that to the prevailing 30-year, fixed mortgage rate during the same time period at 6.75%. So that's more than a percent difference of benefit in a lower interest rate. An ARM increases consumer house-buying power by approximately $53,000. Not an inconsequential amount compared with a traditional 30-year, fixed-rate mortgage. So, yes, a little less spooky, right?

Odeta Kushi - Yeah, that's a game changer. $53,000 is a lot, particularly during these times. The option of an ARM can also incentivize some of those rate locked-in homeowners to sell, which brings us to spooky fact number two - sellers aren't selling. While inventory has moved up a bit, new listings are down compared to one year ago. What's up?

Mark Fleming - Yes, that's a sellers' strike. I love that phrase from Bill McBride at Calculated Risk. They're acting quite rationally in that sense though. Data from the FHFA national mortgage database for the second quarter of this year reveals that 93%, so practically everybody who has an outstanding mortgage, have rates somewhere below 6%. Yes, practically all of them. That's a spooky fact. 85% have mortgage rates below 5%. 65% below 4% and 24% below percent below 3%. So, more than half of all outstanding mortgages today have rates that are more than two percentage points below the current 30-year, fixed mortgage rate. That is far, far, as we say, 'out of the money,' air-quoting there, as they say in high mortgage finance.

Odeta Kushi - Oh, wow, that is a spooky fact, indeed. Well, first, that really makes it clear why refinance demand is down nearly 90% compared to last year. And, second, to your point about home sellers acting rationally, if you're one of those 85% of homeowners with a mortgage that is locked into a rate below 5%, what is your financial incentive to move and potentially lock into a rate that's approaching 7%?

Mark Fleming - Well, rationally, not much of an incentive, but, irrationally, as we know, maybe something else. Although, again, that ARM has a lower rate and could be one option to close that 'out-of-the-money' gap.

Odeta Kushi - All right, so let's recap here. Our number one spooky fact is the rapid decline in affordability, which reduces demand for homes. Spooky fact number two is that the rate lock-in effect is keeping homeowners from selling. That tells me we should continue to see a contraction in sales and slower house price growth.

Mark Fleming - Yes, a continuation of the cooling we've already been experiencing. House price appreciation has slowed relative to the peak in all of the top 50 markets that we're tracking. And that's a trend that's likely to continue for as long as rates remain elevated.

Odeta Kushi - But, of course, home sales are still happening. We can't ignore all of the equity that's built up over the last few years. Our analysis shows that homeowners have an average of $317,000 in inflation-adjusted equity in their homes as of the second quarter. That's a historic high. So, for some of those equity-rich homeowners, that means moving and taking on a higher interest rate isn't a huge deal, especially if they're moving to a more affordable place.

Mark Fleming - That's a great point. And then there are always other reasons for moving - downsizing, changing jobs, or moving to that less affordable or affordability-scary market.

Odeta Kushi - Exactly. Alright, so we get to our third spooky fact. And that is rents. Rents are high and that matters because, rent or own, you need a place to live. So what's going on with higher rents and when will they maybe start to come down a little bit.

Mark Fleming - The rental and purchase markets are actually inextricably...inextricably, that's a tongue twister...tied together. In economics, we call them substitute goods. You can live in a home that you rent or live in a home nearby, but the service that you're getting is shelter. A household chooses either to rent to get that shelter, substituting one for the other, based on market conditions, cost effectiveness, lifestyle preferences. The rental market is currently benefiting, actually, from extra demand from those who otherwise would be homeowners right now, but have been priced out of the purchase market, or can't find something to buy because of that sellers' strike that we just talked about. In other words, high mortgage rates and reduced affordability is preventing renters who are hoping to be homeowners from transitioning into homeownership.

Odeta Kushi - And general inflation, in addition to rising rents, could cut further into a renter's ability to save up for a down payment. But going back to the original question, what drove the double-digit rent growth and what could be contributing to its current deceleration?

Mark Fleming - Well, the obvious contributions, such as higher wage growth. As wages grow, people can afford to pay more that drives up the rental rates that people are experiencing, but perhaps less obvious and more difficult to measure here is the impact of household formation, or lack thereof. But hey, rather than me being the one who always has to explain these econ-wonky terms. Odeta, care to explain?

Odeta Kushi - Darn. You caught on that I always leave that to you, but fine. The official definition of a household, according to Census, is - quote, a household includes all the persons who occupy a housing unit as their usual place of residence. A housing unit is a house, an apartment, a mobile home, a group of homes or a single room that is occupied as separate living quarters, end quote. So, if you're in a college dorm or in your parents’ home, you're either not considered a household or you're part of your parents household. But, if you're currently renting an apartment with roommates, you are collectively a household. If you decide to move out on your own because you're tired of doing your roommates dishes, you would form a new renter household. Hgher wages, or what you might need to move out of your parents house or leave your roommates, encourages more household formation.

Mark Fleming - Lazy roommates with dishwashing phobia. I feel like maybe you're speaking from experience here.

Odeta Kushi - Not me.

Mark Fleming - That would definitely do it for me. What we suspect happened over the pandemic is roommates decoupled - that's the term we use for when you get sick of those roommates and move out, right - and people who moved out of their parents homes as well put all the extra pressure on rental demand. So, you have this surge of household formation, additional households wanting to rent. But, on the contrary, what we suspect is happening now is, given all of the economic uncertainty that we're facing, is that that rate of household formation is actually slowing.

Odeta Kushi - That makes sense. If you're not feeling confident in the economy and your job, then you're less likely to get your own place. This takes some of the pressure off of rental demand, likely what we're experiencing now.

Mark Fleming - So this is a classic, ahem, on one hand, and on the other.

Odeta Kushi - How predictable of an economist.

Mark Fleming - It's kind of scary, how predictable. See what I did there. See?

Odeta Kushi - Yes, that was fang-tastic. See what i did there? Fangs, vampires. Kudos. Okay. Continue with the economist thing.

Mark Fleming - Okay, I'm so flabbergasted right now. Okay. On one hand, higher mortgage rates have made it difficult for renters to purchase a home, that keeps those people renting for longer and demand high for rental properties. And, on the other hand, we're likely to see slowing household formation, which will take some of the pressure off of rental demand, likely putting downward pressure on prices. On one, and on the other.

Odeta Kushi - One than the other. But we can't forget the supply side. There are the highest number of multifamily units under construction since 1973. Those will eventually be net-new supply added to the market, which should also help to pull down rent growth. All right, well, those are our three spooky facts about the housing market. But, just as Halloween will come and go, so will the hard times in the housing market. Housing is not immune to the business cycle. And we know that the business cycle has peaks and valleys. What goes down, will eventually come back up. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as economists, you know we love our metrics and data. So, if you enjoy listening to the podcast, please make sure to give us a rating on your favorite platform. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

This transcript has been edited for clarity.