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Economic and Market Commentary

Mind the Supply: The Counterintuitive Impact of Higher Rates on U.S. Housing

The dearth of homes for sale has underpinned the housing market’s surprising resilience and may further lift home prices despite reduced affordability.

Rather than causing home prices to tumble, the sharp rise in mortgage rates over the past two years has bolstered the U.S. housing market by curbing the supply of homes put up for sale. That supply-demand imbalance is likely to continue, in our view, supporting further home price appreciation and rental inflation.

Several factors have constrained supply, including the "lock-in effect" by which homeowners with low mortgage rates are reluctant to sell to buy another home at a much higher rate. We believe this effect will persist. The construction of multifamily housing is also expected to decrease over the next few years, exacerbating the housing shortfall.

We are monitoring several gauges of incoming housing supply for signals about market health. PIMCO sees attractive opportunities in bonds backed by residential mortgages, given our expectation that home price appreciation will remain resilient. We believe U.S. home prices could rise by low double-digit percentages in total over the next three years in the current higher-rate environment.

Higher rates act as a supply constraint

U.S. housing market dynamics have changed drastically since the start of the pandemic, when monetary stimulus pushed mortgage rates to historic lows, spurring a wave of home purchases and refinancings. In subsequent months, fiscal stimulus supported the U.S. economy while Americans broadly reconsidered where they wanted to live and work, leading to unprecedented home price surges in many areas.

Since then, the Federal Reserve has hiked interest rates steeply to fight inflation, and mortgage rates have spiked to 20-year highs. With home affordability sharply reduced, mortgage purchase applications have fallen to historic lows. The seasonally adjusted annual rate of existing home sales fell to 3.79 million in October, from a pandemic peak of 6.5 million, according to the National Association of Realtors. We expect a further decline to about 3.5 million to 3.75 million.

Yet this reduced activity has not translated into a large drop in home prices. After decreasing by about 3% from 2022 peaks, home prices are now back at all-time highs nationally and in most parts of the country, according to CoreLogic. Paradoxically, in addition to a stronger-than-expected consumer, higher rates have supported the resilience in home prices, through reduced supply via the following mechanisms:

1. Lock-in effect

Homeowners are enjoying both strong price gains and home loans financed at negative real rates. Figure 1 shows the difference between market mortgage rates and the rates at which households financed their homes. During normal periods, this gap is less than half a percentage point. Today, it is close to four percentage points.

Figure 1 is a line chart, covering the years from 1994-2023, with a single line representing the difference between prevailing market mortgage rates and the rates at which existing households financed their homes. During most of this time period, this gap has been less than half a percentage point. Prior to 2022, the gap had never been more than about one percentage point – a level reached in 1994-1995 and again in 1999-2000 – or less than about minus two percentage points, a level reached in 2012. It is close to four percentage points today, after rising steeply since 2021.

Any homeowner with a mortgage rate around 3% has a large economic disincentive to sell that home and buy another at a rate over 7%. In theory, this “staying in place” market should affect supply and demand equally, given that the same people who would have moved but haven’t also don’t create additional demand.

Yet we believe the disincentive of giving up a low mortgage rate also affects the number of homes that would have been placed on market due to life events (e.g. deaths, relocations, divorces), or for a move to the rental market, therefore decreasing net supply. Historically, available supply has been a key predictor of home price appreciation, leading us to expect strong appreciation given current low supply levels.

2. Construction and multifamily

High multifamily supply has been a silver lining in the housing market, especially for renters. This year is on pace for record delivery of new multifamily units, alleviating some rental price pressures.

However, deliveries are expected to start normalizing in 12-15 months as higher rates hinder financing of new multifamily construction (see Figure 2). In 2026 onward, this multifamily supply is slated to drop sharply, which could worsen the secular housing shortage.

Figure 2 is a bar chart showing new and expected new deliveries of multifamily housing units, from 2013-2028. It shows 2023 is on pace for record delivery of new multifamily housing, with just over 500,000 units expected, up from about 200,000 in 2013. However, deliveries are expected to start declining after this year, to about 450,000 units in 2024 and to less than 200,000 in each year from 2026-2028.

3. Housing and recession

In past recessions aside from the global financial crisis, the housing market has generally held up well (see Figure 3). This is in part because the U.S. Federal Reserve typically cuts interest rates in a recession, while investors seek out bonds, pushing yields lower. That passes through to mortgage rates and acts as a shock absorber for housing.

One could argue that, if a recession were to occur, the increase in supply due to an easing lock-in effect would outweigh additional demand arising from affordability gains. However, we think this is unlikely given how far out of the money current market-rate mortgages are: If mortgage rates fall to 5%, affordability for the marginal buyer would greatly improve, yet potential sellers with a 3% mortgage would remain reluctant to give that up.

Figure 3 is a line chart showing the rate of home price appreciation, as plotted on the y-axis, during the months before and after the start of a recession, as plotted on the x-axis. Each of the chart’s five lines represents a past recession: the 2020 COVID-19 pandemic, the 2007 financial crisis, the 2001 dot-com bust, the 1990 savings and loan crisis, and the 1980 recession. The lines converge at a level of 100 on the y-axis at the point on the x-axis that represents the beginning of a recession. Four of the lines rise then above that starting level by the time they reach 36 months after the start of a recession, with the line representing the COVID-19 crisis climbing to the highest level of the four at just below 140. The only line that is below the starting level at the 36-month point is the one representing the 2007 financial crisis, which fell to a level of about 80 at that point.

4. Monitoring the supply

In this environment, we believe it is important to monitor sources of additional supply. For existing homes, we carefully watch inventories of homes for sale, the number of new listings, absorption rates, and other metrics such as the frequency of price reductions and transaction prices compared with listing prices, including at the regional and metropolitan statistical area levels.

For new homes, we favor watching inventories of homes for sale at different completion levels, as well as the rate of completions versus starts and expected household formation. Results and comments from home builders and single family rental operators can also provide useful information on the pace of supply.

Implications: Both home price gains and rental inflation can continue to defy higher rates

Considering these factors, we believe the U.S. housing supply-demand imbalance could continue to create a strong environment for home price appreciation. Rental inflation may also remain elevated relative to the pre-pandemic period, as the structural shortage of shelter continues and as affordability challenges push more households toward renting.

At PIMCO, we continue to favor bonds backed by residential mortgages. We expect home price appreciation to remain “higher for longer,” making residential credit a robust all-weather strategy, in our view.

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