Housing Affordability Has Plummeted, and It Ain’t Over Yet

The National Association of Realtors tracks the cost of homeownership through its Housing Affordability Index (HAI), which it created in 1986. According to Bloomberg, the index, “…tracks the affordability of housing, typically based on a mix of median home prices, median income and mortgage rates. When the index measures 100, a family earning the median income has exactly the amount needed to purchase a median-priced resale home using conventional financing. An increase in the home affordability index means that a family is more likely to be able to afford the median-priced house.”   

NAR reported earlier this month that its HAI plummeted to the lowest level on record (since 1986, when mortgage rates were over 10%) in the second quarter of this year. The 2Q23 reading came in at 92.7, compared to 101.8 in the 1Q23 and to a recent high of 180.4 in the 1Q21. Incredibly, housing is now less affordable, according to NAR, than it was prior to the Great Financial Crisis, when a complete breakdown in lending standards led to a frenzy of speculation that ended in a 33% peak-to-trough decline in housing prices (based on S&P Case-Shiller 20-City HPI) from July 2006 to April 2009. Should this make us nervous? 

The decline in housing affordability has obviously been highly influenced by the huge increase in mortgage rates, which are now around 7.2% (according to data from Freddie Mac), compared to an average of 4.0% from the end of the Great Recession in 2009 until the end of 2021. In fact, current mortgage rates are nearly triple the level they were at the end of 2020 and beginning of 2021, when they bottomed out at around 2.7%. Not coincidentally, the first quarter of 2021 turned out to be the peak in housing affordability. Since that time, housing prices are up 28% despite the massive increase in interest rates. Median household income, which is currently growing at roughly the pre-COVID rate, has not grown nearly fast enough to offset the spike in mortgage rates and the increase in housing prices. The consequence has been the massive drop of housing affordability to new lows.

I know all the arguments. A Wall Street Journal article on Wednesday by Justin Lahart entitled “How High a Rate Can Housing Take?” read, “On Wednesday, the National Association of Realtors reported that there were just 980,000 existing single-family homes for sale last month. That was the fewest during the month of July—normally a time of year when a lot of homes are on the block—on record stretching back to 1982.” Housing prices remain elevated because there is an extreme lack of supply. Inventories of homes for sale are very low because nobody wants to move and give up their 3% mortgage. The trend toward “work-from-home” is another factor causing homeowners to remain in place, therefore suppressing housing inventory. It will take years to bring housing supply back in line with demand because new home construction has been insufficient since the GFC. Lending standards have improved dramatically since before the GFC. The typical homeowner has much more equity than in the past. Interest rates should start coming down next year as it becomes clearer that inflation is on a sustainable path down to the Fed’s 2% target. And on and on. 

All of this is likely true. But still, housing affordability is as low as it’s been since at least 1986. Many prospective first-time buyers are at risk of getting locked out of the market forever if something doesn’t change. Can insufficient supply, alone, keep housing prices elevated in the face of such a big increase in borrowing costs? Is it realistic to think everyone will remain in place indefinitely just to keep their low mortgage rate, thereby preventing a flood of supply hitting the market? Will political pressure on the Fed compel the central bank to cut rates more quickly, thereby improving affordability? 

These are all important questions, and I don’t have all the answers. My suspicion is that some combination of labor market softening, tighter bank lending standards, capital markets volatility and rising mortgage rates will bring an end to the Fed’s interest rate hikes sooner rather than later. Since as long as I can remember, the Fed has always chosen the path of least pain, and I don’t think this time will be any different. 

If this means that the Fed will implicitly adopt an inflation target above 2% for a short period of time, then I think that’s what is likely to happen. But ultimately, I continue to believe that the Fed’s interest-rate hikes to date will prove more than enough to slow the economy, reduce inflation to target and potentially induce a recession. The “long and variable lag” has proven longer than expected, in no small part because homeowners wisely locked in super-low mortgage rates when they had the chance. But fixed-rate mortgages won’t be enough to nullify the impact of 525 basis points of interest-rate hikes in a historically short period of time. 

Given its importance to the wider economy, a robust housing market will likely be a precondition to achieving a relatively seamless transition to long-term economic expansion. The housing affordability crunch is, and looks to continue to be, a risk factor that could not only hold back the economy’s growth potential but also cause a financial crisis if left unchecked. So add another ball to the Fed’s juggling act.