“Activity in the housing sector has been slow in 2018 despite growth in the broader economy. This may have been due to higher mortgage rates and tax liabilities. As the market adjusts to these headwinds, several trends are supporting future real estate activity—which should ultimately help the housing sector find stability.
While broader economic growth accelerated this year, housing activity began to slow. New housing construction has contributed virtually nothing to GDP growth in 2018, and brokers’ commissions are falling as sales of existing homes soften. The headwinds facing the housing sector are clear: rising interest rates are making mortgages more expensive, and recent legislation has capped deductions for state and local property taxes, raising the cost of home ownership.
But these headwinds are blowing against what should be an increasingly favorable backdrop for the housing market. New household formation, the fundamental driver of demand for homes, is accelerating. Rebuilding in areas hit by recent hurricanes will also provide support for the sector, and rising household wealth is sparking a remodeling boom. As the market adjusts to higher mortgage rates and tax liabilities, the sector will likely regain its footing.
The Sources of the Housing Slowdown
The housing sector’s slowdown has been most pronounced in sales of existing homes. This is likely due to the longer time frame for new construction projects—housing developments take years of planning before they reach the market, and builders can modify housing projects if needed to account for slowing demand. Sales of existing homes, however, may be deferred if offers come in too low.
Multifamily construction is also down slightly from last year, falling short of the historically strong 400,000 new units averaged over the past five years. But the sector is inherently volatile, and it’s too early to tell whether this year’s slide marks the start of a durable trend. A handful of large complexes entering the market next year could push that figure back up to its recent highs.
Two Headwinds…
Weakening demand for homes is largely due to higher mortgage rates, which are effectively reducing the purchasing power of buyers. Over the past two years, the average 30-year mortgage rate has climbed a full percentage point to 4.5 percent as the Federal Reserve normalizes interest rates. Although rates are still quite low by historical standards, the total mortgage any given buyer can qualify for has fallen by approximately 10 percent.
Even modestly higher interest rates will substantially erode a mortgage’s total principal. Lenders customarily limit monthly mortgage payments to around 25 percent of the buyer’s gross income. Two years ago, a buyer who could afford a $2,250 monthly payment would have qualified for a $500,000 mortgage. Today, the same buyer would likely only qualify for a $443,000 loan. Falling purchasing power means that buyers are making lower offers, which is weakening sales of existing homes and cutting into brokers’ commissions.
Changes in the tax code have also raised the cost of home ownership. Last year’s Tax Cuts and Jobs Act capped the deduction homeowners can take for state and local property taxes at $10,000. In markets with high property taxes, the deduction cap could significantly diminish home values. Homeowners in states like New Jersey and Illinois could see their annual tax liability rise by almost 1 percent of their property’s value; over the course of a lifetime, this could effectively increase the cost of home ownership by more than 20 percent.
As the market adjusts, these headwinds are temporarily depressing demand for housing. The potential pool of buyers for any given listing will shrink as mortgage rates go up, and buyers are likely to reduce their offers in response to the rising tax burden. Sales have slowed as the owners of existing homes keep their listings on the market longer, waiting for a higher bid.
…And Three Tailwinds
Despite higher borrowing costs and tax liabilities, the household formation rate is accelerating, and a wave of pent-up demand may soon begin to lift home sales. During the recession, millions of young people delayed moving out on their own, choosing to live with roommates or relatives while waiting for their financial situation to stabilize. Now that full employment is at hand, these young adults are on stronger financial footing and are eager to move out on their own. The rate of new household formation has accelerated to 1.25 million annually, nearly doubling its lowest point during the recession.
Rebuilding following Hurricanes Florence and Michael will also support construction activity. The storms destroyed billions of dollars of residential property along the Gulf Coast and Eastern Seaboard; while the economic losses from natural disasters can never be fully recaptured, the affected regions should see a construction boom over the coming year.
Home improvement should also continue to be a bright spot for the sector as household finances continue to strengthen. Money spent on remodeling is at a record level, currently accounting for a full 36 percent of residential real estate activity. Remodeling has been relatively insulated from the impact of rising interest rates. As the bull market helps households reach their savings goals, rising stock portfolios should increasingly result in refurbished living spaces.
Home sales will likely rebound as the market adjusts to the new interest rate environment. Mortgage rates may continue to climb in tandem with long-term interest rates, but the backdrop of full employment and higher wages should produce a surge of pent-up demand for new housing. Rising demand will likely more than absorb the challenge of modestly higher borrowing costs.”
If you’re interested in buying or selling an apartment building, please call Anie Mayelian at 818.915.9118 or send us an email!