House prices are rising again in the US, which is often taken as an argument that the economic recovery is strengthening. Mortgage rates near historically low levels and continuing quantitative easing have helped the housing market, and this is reflected in house price trends. The main question, however, remains what is driving the housing market recovery. Notably, home ownership rates, the major fundamental driver of a sustainable recovery in the housing sector, are in decline. This article suggests that housing recovery is more likely to be driven by speculative elements rather than strong underlying economic fundamentals, indicating the likelihood that a new housing bubble may be in formation.
Figure 1: Strong House Prices Often Seen as Indicative of a Strong Economic Recovery
Source: Euromonitor International from Federal Reserve Bank of St Louis
How Important is the Residential Housing Market to the US GDP?
The direct contribution of US housing market activity to GDP growth is significant but not extremely large (see Figure 2). At the height of the last decade’s housing boom (from 2002 to 2005), residential investment directly contributed around 0.4 percentage points to annualised GDP growth figures. When housing market activity contracted in the period from 2006 to 2010, declining residential investment dampened annualised growth rates by 0.7 percentage points. From 2011, amid the housing market recovery, the contribution again turned positive and averaged 0.3 percentage points.
Figure 2. Contribution of Residential Investment to US GDP Growth
Source: Euromonitor International from US Bureau of Economic Analysis
Nevertheless, the housing market is much more important to the overall US economy than can be inferred from the above figures. First of all, a large number of domestic industries depend on housing activity. Household spending, especially on durables, is positively related to housing acquisition. Affordable housing is key to ensuring societal stability and well-being. On the other hand, rising house prices may produce so-called wealth effects as homeowners feel wealthier and become more inclined to spend. During the boom years it was common practice to finance consumption through additional borrowing against rising house values, which is referred to as home equity withdrawal. Very importantly, residential properties serve as the collateral in the US$9 trillion residential mortgage debt market. Thus, the value of housing directly affects the value of mortgage-backed securities, and more generally the quality of financial intermediaries’ balance sheets and the pace of credit expansion.
Housing Affordability Becomes More Sensitive to Interest Rate Hike
The widely cited housing affordability index helps to shed further light on the recent recovery in the housing market. A value of 100 implies that a household with a median income has exactly sufficient income to qualify for a mortgage loan on a median-priced home (with a 20% down payment). Higher values indicate greater affordability, while lower values indicate lower affordability. As can be seen from Figure 3, affordability has improved and house price correction and lower mortgage rates during the crisis pushed the housing affordability index up, with it reaching record highs at the beginning of 2013.
Figure 3. Dependence of Housing Affordability Index on Mortgage Rates
Source: Freddie Mac, National Association of Realtors
There is an important caveat, however. High house prices and historically low mortgage rates make housing affordability extremely sensitive to mortgage rate movements. For example, the increase in mortgage rate by one percentage point since May 2013 following the Fed’s announcement about possible tapering of its quantitative easing programme has resulted in a quite dramatic plunge in housing affordability, which in turn has had a negative impact on house prices, sales and homebuilder sentiment.
Home Ownership is Declining
While house prices are rising, the home ownership rate is in steady decline and has fallen to a level last observed in 1996 (see Figure 4). This is the main reason why housing activity may not be the best indication of economic recovery. A number of market reports further confirm that housing market activity is driven to a large extent by investors rather than private households. For instance, in September, 19% of house sales were associated with investment activity, and about three quarters of these transactions were settled in cash, according to Wall Street Journal.
Figure 4. Home Ownership Dynamics
Source: Euromonitor International from Census Bureau.
In an environment of extremely low interest rates and more restricted investment opportunities, the “buy to rent” motivation appears more attractive than during an environment of high interest rates and strong economic growth, when investment opportunities are more plentiful. Considering that home ownership is not improving, it remains more likely that the resurgence in the US housing market is being driven by a relatively small core of investors and not a broad base. Notably, this is also a classic precondition for housing bubble formation where investment demand outweighs fundamental demand from people looking to move into houses. This can then become a self-reinforcing loop where high house prices push non-investment buyers out of the housing market and towards the rental market. In the process, it tends to inflate house purchases well beyond the actual necessity for housing, eventually creating bubbles.
Housing Market may be Recovering but the Recovery is Far from Strong
Looking over the recent past, there is little surprise why housing market is watched so closely. Both the Great Recession and the preceding 2003-2007 economic boom had one thing in common - the housing market played a major role in both. The current US housing market recovery, however, does not appear to be spread across a wide base of buyers, and may have another bubble element in it.