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U.S. Housing Market Adjusts to a New Normal

By Steve Hovland, Director of Research

The slow but steady growth of the U.S. economy will continue through the end of 2017, while hiring is expected to hasten. Annualized GDP growth accelerated to 2.6 percent in the second quarter, after lackluster first-quarter numbers. Since the current expansionary period began during the third quarter of 2011, GDP growth has averaged 2.2 percent, well below the robust gains witnessed during previous cycles. The relatively slow recovery is generating expectations that the current growth cycle has several more years before another recession. However, the economy has been growing for eight years, just two years short of the longest period since the second world war.

economy june

Low inflation and modest GDP growth are the only indicators that the economy is not booming. Employers have added 16 million jobs over 81 consecutive months of positive payroll additions, more than double the number of positions eliminated during the Great Recession. Furthermore, the equity markets are at all-time highs and the unemployment rate is below the full-employment threshold of 5 percent. As a result, the once-dovish Fed is pursuing a more aggressive normalization of interest rates, which remained near crisis levels for far longer than necessary. On some level, the Fed should assume some responsibility for the prosperity gap. Well-positioned borrowers could take advantage of low interest rates whereas little of that benefit trickled down to the millennials coming out of college that needed it to establish new households.

An improving employment market while interest rates are favorable should begin to level the playing field over the next few quarters. After 1.1 million jobs were created in the opening half of 2017, we expect another 1.4 million new spots during the final six months of this year. Amazon is expected to hire 100,000 workers by next year, helping take the sting out of retail store closings that dominated headlines over the last few years. Another rosy outlook for the job market is a narrowing skills gap. As college graduates enter the market with the skills companies are seeking, particularly technology firms, companies will compete for workers. This will begin to push wages higher for the millennial generation and help establish a solid foundation for the economy over the next decade.

Housing Market Facing Identity Crisis
The housing market is adjusting to a new normal, which will reshape conventional wisdom and the “American Dream” for years to come. In the second quarter, the homeownership rate was 63.7 percent, up 80 basis points in the last 12 months. After falling to a multi-decade low, the rate is slowly emerging from the trough and searching for a new equilibrium. Several factors are applying pressure on the rate, though headwinds outnumber tailwinds and they are getting stronger.

Factors encouraging higher homeownership include low interest rates, a mature recovery and loosening lending standards. According to Freddie Mac, average mortgage rates have hovered just below 4 percent during most of the second quarter. At this level, the cost of borrowing is very affordable compared to historical averages. In fact, mortgage rates likely have a floor in the low-3 percent range due to the costs of transactions, so borrowers are in an advantageous position on the debt side of the equation. Interest rates are within a few basis points of the level recorded in December of 2015, when the Fed first began to lift the federal funds rate off the “zero-bound” target. The lack of movement in mortgage rates is a testament to how much slack exists in the capital markets. After four hikes from the Federal Open Market Committee (FOMC), bond and interest rates are relatively unimpressed. Thus far, action by the FOMC has been akin to pushing on a string.

The other factor propelling the housing market is weakening and could prove to be a noticeable headwind within the next few years. The mature economic recovery is enabling homebuyers to replenish coffers and save for down payments. However, a recession is on the horizon, though it remains three to five years down the road. Depending on the depth of the next economic downturn, vulnerable workers could face a setback at the exact moment they’re ready to participate in homeownership. Furthermore, borrowers that are stretching due to today’s high home prices could find themselves in dangerous territory when the economy eventually sours.

Attractive interest rates and looser lending standards aside, the housing market does face strengthening headwinds. Home prices, particularly in many coastal areas where a substantial share of the population lives, have far outpaced wage growth during the recovery. The gap between affordability and prices has climbed so high in some areas that even a sizeable correction will leave many would-be homebuyers on the sidelines. Combined with low first-time homebuyer activity, competition from investors for entry-level homes, and shift in the psyche of many residents, the homeownership rate is unlikely to reach 65 percent during this current expansion.

 

Income Now

Single-Family Investments Remain Competitive and Attractive
Red-hot equity markets, the mature economy, and a potential bond bubble has investors scrambling for attractive alternatives. Former FOMC chair Alan Greenspan recently warned investors that the bond market might be in bubble territory, and equities generally get battered during a recession. Real estate, meanwhile, can act as a bond through a recession. The supply-demand equation is most imbalanced in the single-family rental sector, which has investors increasingly willing to move capital into the asset class. According to the National Association of Realtors, investment home sales reached 1.14 million in 2016, up 4.5 percent from the preceding year. HomeUnion’s Research Services tracked average cap rates of 5.3 percent during the second quarter of this year, enticing investors to rearrange their portfolios into real estate. Higher returns are available in other areas, including Texas, Georgia and Florida. Until homebuilders shift their focus to entry-level homes, upward pressure on prices and rents will persist in the rental market.

Sources: HomeUnion Research Services, BLS, Freddie Mac, National Association of Realtors, U.S. Census Bureau

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