Skip to Content
Stock Strategist Industry Reports

Rising Rates and Prices Won't Doom the U.S. Housing Market

But more-affordable homes will be needed to realize millennials' ownership potential.

Mentioned: , , ,

The housing market has been a bright spot for the U.S. economy during the pandemic, as demand for new and existing homes reached levels last seen during the mid-2000s housing boom. More time spent at home and more workplace flexibility have caused many households to re-evaluate their living situations, which has spurred demand for larger suburban homes. Record-low mortgage rates in 2020 and elevated personal savings from lower discretionary spending during the pandemic and government stimulus have facilitated more home purchases, while a limited supply of existing homes for sale has made new construction an attractive option for prospective buyers.

However, a supply/demand imbalance has caused home-price appreciation to far outpace wage growth, mortgage rates are back on the rise, and construction costs are higher, especially for lumber, which haven’t helped affordability. Even so, mortgage rates are still historically low, we expect high lumber prices to moderate, and homebuilders continue to increase production of entry-level homes that take less time to build and are more affordable. While affluent buyers were very active in 2020, more-affordable homes will be needed to realize the millennial generation’s homeownership potential.

Over the next 10 years, we project approximately 15.4 million cumulative housing starts. We expect total starts of 1.475 million units in 2021, up about 7% year over year, with production increasing to over 1.6 million units annually by 2025. We continue to see increased headship and homeownership rates among the millennial generation as a significant source of future housing demand. Relaxed immigration policies and housing affordability programs under the Biden administration could also bolster demand.

In our view, the recent surge in housing demand and repair and remodel spending and the specter of increased infrastructure spending have caused market expectations for many housing-related stocks to get ahead of themselves, and most of our housing-related coverage is overvalued. However, Lennar (LEN) (homebuilding), Masco (MAS) (building products), Lowe’s (LOW) (home improvement retail), and AvalonBay (AVB) (multifamily REIT) are more reasonably valued than other stocks in their respective sectors, even though they all currently trade above our fair value estimates.

We Expect Resilient Housing Demand Even With Higher Mortgage Rates

Some market observers have cautioned that rising mortgage rates and home prices could be a harbinger of a housing market slowdown. And while there’s a recent instance of rising rates and home prices stifling demand (2018), back then, the 30-year average rate increased 100 basis points in less than a year to 4.94%, which is well above current levels. In addition, supply/demand is more imbalanced than it was back then. It’s been difficult for many households to secure a new home without outbidding competing buyers with above-asking-price offers and waived contingencies. We expect rising borrowing costs will price some would-be buyers out of the market, which could moderate home-price appreciation as bidding wars subside. However, in our view, there is still plenty of pent-up demand from households that can shoulder higher, but still palatable, mortgage rates.

The median mortgage payment/income ratio is still below the long-run average. At current home prices, we estimate that the 30-year fixed mortgage rate could rise to 4.0% before this ratio would reach the long-run average of about 22%. However, Fannie Mae forecasts that the 30-year fixed mortgage rate will reach only 3.2% in 2021 and 3.6% in 2022, which we still view as attractive.

More-Affordable Homes Are on the Way

Strong housing demand amid a dwindling supply of homes for sale has caused surging home prices. We calculate that the median sale price for existing homes has increased about 14% since August 2020, compared with a 3.5% average increase in wages over the same period.

Homebuilders are doing their part to address affordability concerns. Many continue to shift more of their production toward smaller, more-affordable homes, which also take less time to build. For example, D.R. Horton’s Express brand, which accounts for nearly 40% of the company’s volume, has an average selling price of $241,000. More homebuilders are also partnering with third-party property managers to build single-family rental communities. We believe an increased supply of affordable single-family homes will help support continued gains in headship and homeownership rates.

The Biden administration’s $2.3 trillion infrastructure plan would allocate $213 billion to address housing affordability. Specifically, the plan seeks to build or retrofit more than 2 million affordable and energy-efficient housing units and eliminate exclusionary zoning laws. Homebuilders would certainly applaud zoning reform, since difficulty obtaining zoning approvals has been a challenge for many homebuilders. But we think other more pressing supply constraints, such as high building material costs and the construction labor shortage, will also need to be addressed for the administration to achieve its ambitious plan. In our view, programs that support vocational training would be part of the solution because such programs would help alleviate the construction labor shortage while also creating good-paying jobs that would support household formation and homeownership. President Joe Biden’s proposal faces an unclear path in its current form, as Republicans will likely oppose the plan and progressive Democrats don’t think the proposal goes far enough. If attempts to compromise with Republicans bear no fruit, Democrats could use budget reconciliation to pass it along party lines, boosting our confidence that Congress will pass something this year.

Added Lumber Capacity and Tariff Relief Should Ease Prices

The lumber and panel industry, which sells predominantly into residential construction markets, was caught with a wide swath of its production capacity off line in anticipation of a pandemic-induced slowdown. Lumber prices have skyrocketed as production has not kept up with strong demand from the residential construction and repair and remodel markets.

The substantial price gains this year are unlikely to be sustainable, however. Even Weyerhaeuser CEO Devin Stockfish recently said that current prices are not the new normal. Today’s economics are too compelling to avoid inviting competition. We expect a swath of mill expansions and new mills to come on line over the coming year, which should better balance supply with demand. Additionally, in December 2020, the U.S. Commerce Department reduced tariffs on Canadian lumber to 9% from 20%; the National Association of Home Builders has asked the Biden administration to remove tariffs entirely, which could further ease lumber prices.

Relief Programs Should Avoid a Foreclosure and Eviction Crisis

According to the latest survey data from the U.S. Census Bureau, approximately 15% of renter households (equating to about 6% of total occupied households) reported that they were behind on rent. This figure has changed little over the course of the pandemic, and the Urban Institute estimates that unpaid rent could amount to $13 billion-$53 billion. However, the federal government has appropriated over $45 billion for rent assistance, which we believe will help some struggling renters catch up, although it will take some time for these funds to be disbursed.

The Mortgage Bankers Association’s most recent update on mortgage loan forbearance rates showed that just 4.5% of mortgages are in forbearance plans--approximately 2.3 million households, or about 3% of owner-occupied homes. The forbearance rate has been declining since its June 2020 peak of about 8.6%. We don’t see a looming foreclosure wave for a couple of reasons. First, federally sponsored mortgages, which account for most mortgages, can be placed into forbearance for as long as 18 months, and households only need to modify their mortgage to exit forbearance, not make a lump-sum catch-up payment. Such modifications include increasing the loan’s term or deferring missed payments until the mortgage matures or the home is sold or refinanced. Second, the Consumer Financial Protection Bureau has proposed a simpler loan modification process and a foreclosure review period that would prevent foreclosure proceedings until after Dec. 31, 2021. All homeowners, including those with mortgages from private lenders, would be eligible for these protections. Finally, we think there’s enough demand to quickly absorb foreclosed homes, avoiding a material adverse effect on housing fundamentals.

We Project Annual Housing Starts to Reach 1.6 Million Units by 2025

Over the next 10 years, we project approximately 15.4 million cumulative housing starts. We expect total starts of 1.475 million units in 2021, up about 7% year over year, with production increasing to over 1.6 million units annually by 2025. Thereafter, we moderate our projections as supply and demand become more balanced, with a midcycle forecast of 1.46 million starts.

Two key factors drive our forecast:

  • More household formations among the working-age population.
  • Population growth.

Our thesis has long assumed that the maturation of the large millennial generation would lead to increased housing demand, and this trend continued in 2020. However, headship and homeownership gains for this cohort far exceeded our expectations. We believe that some of the factors that caused these gains, such as changing housing preferences during the pandemic and workplace flexibility, will continue to bolster household formations and homeownership among this cohort. We also expect increased immigration under the Biden administration, which would boost population growth. According to the Joint Center for Housing Studies, during their first five years in the United States, over 80% of immigrant households rent. As such, we expect that increased immigration will also bolster demand for rental units.

The pandemic caused many urban renters to move or consider moving to suburban apartments or single-family homes. We believe this shift in sentiment will likely pressure urban rent growth and subdue new urban projects over the near term as more rent concessions are needed to maintain occupancy rates. However, as vaccines become widely distributed and the economy recovers, we expect demand for urban rental units will recover. While we expect elevated demand for single-family homes over the next few years, more multifamily units will also be needed to address the U.S. housing shortage. Indeed, over the next 10 years, we forecast that 3.8 million multifamily units will be built, or about 380,000 annually.

We forecast that 2021 will be another strong year for single-family construction, with single-family starts increasing about 13% year over year to 1.115 million units. However, we expect construction growth will moderate after thereafter. While we expect homebuilders will boost production to address the undersupply of single-family homes, we don’t think the homebuilding industry has the capacity for housing starts to sustain the levels seen in the mid-2000s. We see the construction labor shortage as the most significant supply constraint, and this issue will take time to address.

Brian Bernard does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.