The Extraordinary and Unexpected Pandemic Increase in House Prices: Causes and Implications
This past December 23rd, the Federal Housing Finance Agency (FHFA) announced that, despite the severe pandemic-induced economic downturn, its index of house prices had risen a strong 10.2 percent in the 12 months leading up to October 2020, and 1.5 percent in just the single month of October – a per annum rate of an even higher 18 percent. During downturns, the expectation is that house prices will decline, not increase, and certainly not increase at such extraordinarily high rates.
This is a major event that should not be shrugged off or ignored. While it could simply be a pandemic-period distortion that will disappear as COVID vaccines are broadly distributed, it could also reflect a new normal for the dynamics of housing and housing finance. For this reason, anyone in housing should have a view on this issue, as house price appreciation is fundamental to the economics of how families develop wealth, how much risk there is in mortgage lending, what the right business strategy is for mortgage and home construction companies, and also for government policymaking.
Causes: In trying to understand this unexpected development, we know some things that are not causing the extraordinarily high house price increase rate.
- Tight labor markets. The unemployment rate, after peaking at 14.7 percent in April, came down to the still-weak level of 6.7 percent in November, with significant room to improve. The rate was at the unusually low level of 3.5 percent just before the pandemic hit.
- High inflation. The consumer price index (CPI) has been running low for years, and was only up about 1.1 percent in the twelve months ending November 2020. Therefore, strong house price increases are not simply reflecting inflation – they are extraordinarily high on a real (inflation-adjusted) basis too.
- A loose-lending mortgage bubble. The average national leverage of a single-family home (mortgage debt divided by the market value of the home) is extremely low at only 34 percent and risky products (e.g. mortgages with teaser rates) have been kept to a very small share of the market (well under 5 percent) by post-2008 financial reforms. Net, this is not a repeat of 2008.
By contrast, there are several reasons that, cumulatively, seem to be causing this unusual dynamic of sharp house price increases during an economic downturn. These include:
- Ultra-low interest rates. The Federal Reserve pushed down interest rates to very low levels in early 2020, with a promise to keep rates ultra-low for years to come. As a result, mortgage rates have dropped to a record-low level of under 2.7 percent, a full 100 basis points lower than a year earlier. While in decades past pushing rates this low would likely have generated inflation, in recent times the US and other developed economies seem to have no bias towards inflation at all (if anything, it may be towards deflation), giving their central banks plenty of maneuvering room to keep interest rates extremely low for so long.
- Housing production shortfall. Prior to 2008, housing production was cyclical, with volumes that went significantly above a long-term trend line in good times, and equally below in bad, but averaging enough through the cycle to accommodate growth in the number of households (and also the loss of units due, e.g., to dilapidation). Since 2008, however, this dynamic has been broken: after declining severely in the financial crisis, the number of housing unit completions has yet to fully recover, and has never even reached—much less surpassed—its long-term trend line. Cumulatively, the shortfall in the number of units produced since 2008 is estimated to be at least 3 to 5 million. (A recent increase to about 1.4 million completions per year is encouraging, but would need to be even higher – more like 1.6 million units a year – to meet current growth in household formation, never mind the backlog from years of underproduction.) This production shortfall naturally leads to a bias towards higher house prices.
- Fewer houses for sale. The pandemic has been noted for the low level of houses for sale. Potential sellers do not want to risk infection with buyers wandering through their homes for showings and open houses. In recent years, there is evidence that the baby boomer generation is holding onto homes longer than their predecessors, further reducing the inventory for sale. This is on top of the production shortfall referenced above. Add it all up, and everyone in the industry has noted an imbalance where supply is clearly too small to meet demand. There is no more fundamental economic rationale for prices to go up than that.
- A shift in family spending towards housing. Economists who study consumers have noted how, during the pandemic, households are shifting their spending patterns: less for travel and vacations, concerts and shows, eating out, entertaining, and commuting, and more for housing, especially if more space is needed to work from home. It is unclear how long-lasting this shift in household spending preferences will be, but anecdotal evidence suggests that it will not completely reverse in the immediate post-pandemic years, especially as working from home seems likely to play a larger and more permanent role in office life. Additionally, the pandemic has pushed more millennials into homeownership, ending their well-documented delay and putting additional pressure on home prices.
- A pandemic-induced acceleration in the purchase of second homes. There is also anecdotal evidence that the pandemic has accelerated several years’ worth of anticipated second-home purchases by wealthier households, creating a bulge in demand. This may also be true for near-retirees, hastening their purchase of a retirement home while not quite giving up their primary residence. It is unclear how long this bulge will last while, in the meantime, it creates further upward pressure on house prices.
All of this creates a perfect storm, where long-term pressures are joined by short-term ones to push the prices of houses higher at an unusually rapid pace, easily overwhelming the downward pressures that come from increased unemployment during the pandemic.
Implications: House prices – their current level and their expected path in the future, both on a national average level and in local market areas – are at the core of many key issues faced by the housing and housing finance industries, as well as government policymakers. Below are four questions which examine the importance of prices, and why a view of whether we are merely in a short-term distortion or undergoing more fundamental change is needed by decision-makers.
What should foreclosure expectations be?
There is a great deal of speculation about a forthcoming tsunami of foreclosures, but this doesn’t take into account the rapidly increasing equity of homeowners. With a greater cushion of equity, troubled homeowners have dramatically improved options: a greater ability to access funding (e.g. home equity lines) to keep paying monthly expenses until family finances might recover, improved ability to qualify for and support a loan modification, and, if push comes to shove, the ability to sell the home and monetize their increased net worth while reducing monthly payment obligations. So, what should lenders and servicers expect: a large number of foreclosures or only a modest increase? I believe the latter. This will impact, for example, how much servicers need to increase capacity to deal with foreclosures, which are notoriously labor intensive or, alternatively, if they might sell the servicing on troubled loans to specialty firms. It also impacts how much lenders will have to put into loan loss reserves.
Do very low interest rates help homeownership?
As mentioned above, the Federal Reserve dramatically increased monetary ease when the pandemic hit to aid the economy with lower rates, including record low mortgage rates. Unfortunately, in terms of homeownership, this has produced mixed results, with clear winners and losers. On the winning side are existing homeowners, as the rate reduction has enabled a record wave of refinancings to reduce mortgage interest costs and thus increase monthly discretionary household cashflow. This helps the economy, as expected. Unfortunately, the dynamics are very different on the losing side, as prospective first-time homebuyers have seen their purchasing power decreased, not increased. First, a required downpayment is higher, right in line with higher house prices, so would-be homeowners need more cash to enable a first-time home purchase. Second, the monthly payment on the average potential purchase has increased rather than decreased: while the 100 basis points drop in the interest rate on a mortgage would lead to a typical monthly payment declining by about 5 percent, this is more than offset by house prices going up by the FHFA-reported 10 percent. In other words, housing has become so much a “tradeable asset,” with prices moving up and down to reflect supply and demand, that expansive monetary policy is turning into asset inflation, which hurts first-time homebuyers, and thus reduces at least somewhat the hoped-for impact of rate reductions to help the economy.
Will traditional housing policies be effective?
The Biden administration would like to improve housing affordability and promote homeownership. While both are worthy goals, how can they do so? The usual homeownership-related programs, developed over decades, focus on lowering mortgage rates for more marginal-credit borrowers, increasing downpayment assistance amounts, and loosening credit requirements (e.g. allowing higher loan-to-value ratios). This all works to increase the demand for owned housing. However, as discussed above, the production and supply shortages combined with the fact that housing has become a tradeable asset is likely to channel such additional demand more into higher house prices than would be expected, and not so much into the hoped-for improved affordability. The intended beneficiaries (i.e. first-time home buyers with less than pristine credit) might even, on average, end up further behind, which would be an unfortunate result. Housing officials who take office after the inauguration should think carefully about this, as different and non-traditional programs may be required to minimize this unwanted outcome.
Is mortgage credit risk being accurately measured?
In examining an existing portfolio of mortgage loans, or potential new ones, predicted losses will depend significantly upon today’s level, and the future path, of the loan-to-value (LTV) ratio. To measure credit risk accurately, then, one must take a stand and assume a certain path of future house prices. Should one assume today’s LTV remains unchanged far into the future? Or one based upon a per annum growth in house prices of 2 percent, 4 percent, or even more? Prior to 2008, assuming mildly rising house prices seemed reasonable after decades of such growth; unfortunately, this blew up in the financial crisis, when house prices declined, in many locations, by 20 percent or more. Given where we are today, what is reasonable to expect? Just moving from 2 percent to 4 percent, for example, could have a major impact. If one picks too low a rate of assumed future house price growth, good credit opportunities are passed up and more marginal-credit borrowers are denied a mortgage; if one picks too high a rate, it will put more marginal borrowers into being over-leveraged and unable to carry their mortgages long-term, as well as likely lead to excessive future credit losses, which calls into question a lender’s ability to do the most basic of its functions.
These four questions are just examples among many more as assumptions about house price increases are so pivotal to housing and housing finance. Today’s high rate of house price appreciation builds upon supply and demand imbalances that have been growing for years, and the pandemic seems to be introducing and accelerating changes in fundamentals about the economy that add to the momentum. Therefore, I see today’s downturn-defying, strong house price growth not solely as a cyclical distortion that will quickly go away when the pandemic does; I see it, at least to a significant degree, as a more fundamental change than that. Everyone in housing and housing finance needs to determine what this new normal should—or should not—change about business models, business actions, and government policies so they can be as effective and successful as possible in the future.