Housing Affordability: Why This Downturn Is Different
We are currently in a housing downturn that will likely be followed by a recession. The Federal Reserve, which was slow to react to inflation, is now playing catch-up, launching an all-out effort to tamp it down by raising interest rates. And while those efforts seem to be working, a pause to assess the effectiveness of the rate increases seems prudent. Continuing to raise rates will send our economy into a recession.
By traditional metrics, we’re already in a recession, but I predict it will get much worse … and be different from those in the past.
A Different Type of Housing Downturn
One could argue the Fed should have been quicker to raise interest rates and end quantitative easing. One could also argue that the Fed should pause and let the data catch up in order to assess whether it has already done enough to hamper inflation. Business is boom or bust, and a lot of home builders are frustrated that the market can’t maintain equilibrium. Regardless of how you feel about it, this housing downturn will be different.
There are a lot of people who feel the housing market will be OK because we’ve been undersupplying the market for so long. While I agree that we’ve undersupplied the market, that viewpoint misses one important point: Look at all of the completed spec homes that don’t have a buyer. If it was as simple as undersupply in the market, why aren’t these finished homes sold? The reason is affordability.
If you’ve followed me for a while, you’ve probably heard about my affordability pyramid. On the horizontal axis is the U.S. population; the vertical axis represents home price, or more specifically, the monthly payment on a house. If a new home was free, then everyone could afford one. However, as the price of a new home has increased, so has the monthly payment. Right now, we’re pretty far up the pyramid, to a point where the horizontal axis has narrowed considerably. In short, we are suffering an affordability crisis.
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I have friends who have 2.8% fixed-rate, 30-year mortgages. Yes, they may have paid top dollar for their homes, as home prices are expected to ease in the current slowdown, but the monthly payment is affordable given their low interest rate. They couldn’t purchase the same home today with mortgage rates more than double what they were a short time ago. Let’s look at an example to illustrate just how much home prices would have to come down for my friends to have the same monthly payment.
For ease of calculation, let’s say the purchase price for the home was $400,000 with 20% down. The mortgage is $320,000. At 2.8%, their principal and interest payment is $1,315 per month, property taxes are $375 per month, and their homeowner’s policy is $89 per month for a total of $1,779.
Now let’s look at how much lower the home price would have to be in order to have the same monthly payment at today’s rates. At the time of this writing, 30-year, fixed-rate mortgages are hovering around 6.5%. My friends would save money on property taxes and homeowners insurance if the home value was less. For the purpose of this illustration, let’s assume a straight-line reduction in both their taxes and insurance. So, to equal a monthly payment of $1,779, the home value would have to drop to $286,100. That’s roughly a 28% drop. To achieve that type of a reduction, we need to roll back some of the massive increases we have seen in the past several years.
Yes, most builders had good margins throughout the post-pandemic building boom, but they’re cashing those chips in now through mortgage rate buy-downs, rate extension locks, free or deeply discounted design studio credits, and even base home sales price reductions. Let’s face it, builders weren’t the only companies to see their margins improve during the last two years; take a look at the public building product companies and look at the trucks our trades are driving. It’s been a difficult couple of years, but most everyone in the supply chain did make a profit.
What Will It Take to Achieve Housing Affordability?
Reaching a level of affordability will take more than just builders lowering their margins. We need to renew our focus on material utilization and labor efficiencies.
I typically spend two to three days a week on construction jobsites and have been shocked to see the efficiencies many of us worked so hard to achieve simply evaporate. If you haven’t looked in a construction dumpster lately, take a peek. You may be surprised by how many perfectly good materials you see in there. Keep in mind, not only did you pay for those materials, but you’re about to pay for them to be hauled off as well.
Next, walk some homes under construction. Don’t be surprised if you see house after house without any construction activity. From an efficiency standpoint, those homes under construction are piles of deployed cash that’s either costing you interest or there’s an opportunity cost in which you could be making a better return on that capital. Continue your walk … See any broken windows, damaged drywall or cabinets, doors, trim, etc.? All rework. As I often tell people, we do it right or we do it over. There is so much waste on construction sites these days, and we must reign it in if we’re going to get out of the current affordability crisis.
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We’ll need to rethink the supply chain as well. Right now, there are too many inefficiencies in how materials are sourced, stored, and transported, and there are too many companies involved, each requiring a margin—too many SKUs, too many options, and too much variability. I am not suggesting we go back to post-World War II ranch-style homes that all look the same, but there is a happy medium from there to where we are now. Also, too many fees and government mandates erode affordability. Land sellers need to reset expectations as well. Lot costs are more than what a finished home cost years ago.
Home builders, trades, distributors, and manufacturers, federal, state, and local governments need to work better together. We are a nation of innovation; let’s use those skills to solve the housing affordability crisis.
