The Housing Market Should’ve Been Killed Off. Here’s Why It’s Still Standing – And How Long That’ll Last.

Aggressive interest rate hikes have pulled mortgage rates up with them – and really, that extra expense for homeowners should’ve killed the housing market. But get this: home prices are sticking to their lofty heights and aren’t showing any signs of coming down. Here’s what gives in the world’s biggest asset class.

What’s happened to house prices?

House prices have fallen since last year, as we predicted – but they haven’t collapsed. Just look at the long-term chart of US house prices: the recent drop appears like a mere blip.

The recent drop in US house prices appears like a mere blip. Source: Fred

It’s a bit worse on a global basis, but that hasn’t exactly been a bloodbath either. House prices are down 6% compared to last year, but that’ll partly be leveling out a 16% rise the year before.

Global house prices are down about 6% on average compared to last year. Source: Morgan Stanley

Check out the chart below. The latest house prices (black dots) might be sitting below their 2022 highs (gold bars), but both points are still well above their pre-Covid levels. What’s more, house prices are already trending upward again in many markets, and plenty of investors expect that trend to continue.

House prices are below their highs, but remain well above their 2019 levels. Source: Morgan Stanley

That’s only going to make houses even less affordable than they already are. Look at the chart below: higher incomes (green bar) have done their bit to make prices easier to swallow, but they’ve been more than outdone by mounting prices (gold bar) and the effect that higher interest rates have had on mortgages (blue bar). So affordability – basically how much of your paycheck is eaten up by housing costs – has deteriorated a fair whack since 2019. To paint a picture, the monthly mortgage payment for an average "middle-of-the-road" house in the US has blown up from $1,640 to $3,330. You’d think that would turn hopeful homebuyers off, winding down demand and, in turn, prices. But clearly, that hasn’t happened.

Rising prices and interest rates made houses increasingly unaffordable. Source: Morgan Stanley

Why haven’t higher mortgage rates tripped the housing market up?

Supply isn’t matching demand

When demand lights a fire under prices, more supply usually comes along to cool them down again. But because the pandemic stopped industries like homebuilding in their tracks, 2021’s house price rally wasn’t matched by an increase in supply. And this year, eye-watering interest rates and inflation have made key elements of construction – think materials and labor – more expensive. And with leading indicators of supply (for example, the number of sales and housing permits) still looking weak, don't expect builders to get off the bench anytime soon.

Demand’s holding up

No one factor can explain why demand for houses has held up, so let’s look at a few of the major contributors. Some are scrambling to buy because of high rental prices or in case building new houses gets even pricier, while the pandemic taught others that they can’t deal with small apartments or annoying roommates. And more structural changes are buoying up demand too: more Millenials are eyeing up their first homes, widespread migration is pumping up developed countries’ populations, and savvy investors are using residential real estate to shield their portfolios against inflation. Remember, prices are on the up, but there are still plenty of buyers with thick wallets out there. And because most sellers are looking to climb up the ladder, they’re straight into the buying market too.

It’s not 2008

Today's housing market is stronger than it was before the crash in 2008. Lenders are stingier with approvals, the recent price surge can be directly tied to pandemic-fueled demand rather than speculation, and fewer homeowners are on short-term, rate-sensitive variable mortgages. Put simply, housing markets are less wobbly than they were back then.

So, what next?

Unless demand slips or supply hardens up, we’re unlikely to see a price plunge à la 2008. That said, the economy would need to stabilize a lot more for a strong bull market to rear its head. Here are the swing factors:

Affordability: Persistently high interest rates, job losses, income dips, or resurgent house prices could make homes even less affordable than they already are. (And heck, the sharpest bite from those bumped-up interest rates might still be on its way.) In that case, demand may be knocked off its perch. So although helpful government policies and a potential dip in interest rates are on the horizon, I'd wager this affordability abyss will cap any rise in prices.

A soft or a hard landing: If inflation falls back in line without the economy hitting a brutal recession, house prices could see another lift as homebuyers and investors get back in the game. But a harder economic crash (which unfortunately, I think is a real possibility) could have an outsized effect, not just denting demand but also stirring a risky wave of sales as homeowners scramble to cash out while the prices are still in the clouds. That might just be the tipping point for market sentiment and another leg down in prices.

Supply: Supply’s likely to stay tight in the short term, but don’t count out a surprising ramp-up in construction – one that could coincide with a dip in demand. Good ol' economics usually dictates that (higher prices and demand prompt more supply), but this time governments are also likely to implement supply-lifting measures to reduce unaffordability, particularly for the lower income brackets.

Are there any opportunities?

To me, the housing market is still on shaky ground, but a 2008-style crash still looks unlikely. But because I have a cautionary stance on the economy and housing in general, I'm not exactly waving a flag for housing as a top-tier investment right now. For those a tad more optimistic, though, Morgan Stanley has two tips.

The first is to be choosy about your market. Right now, the US seems to offer the most attractive risk-reward combo: supply remains tight and demand looks more robust than in other regions. That’s at least partly thanks to its long-term fixed mortgages, which make the country’s market less sensitive to changes in interest rates than other regions. Tread carefully around Europe, the UK, and speculative hotspots like Australia, Sweden, and Canada – they might be in for a rougher time. After all, not only are they generally wrestling with a trickier mix of growth and inflation, but their higher proportion of variable-rate mortgages also makes them more exposed to higher rates.

The second is to consider betting on developers and homebuilders. Unlike real investment trusts, “REITs”, they can benefit from a rise in volumes rather than prices – exactly what might happen as low affordability puts a ceiling on demand and a shortage of houses encourages construction. They could also benefit from a fall in financing and construction costs, and from the rampant demand for new houses. Their stocks have already been lit up, mind you, and there's a cliff edge if the economy comes to a screeching halt.