“Las Vegas is one of the leading indicators for” [home] price action in the housing market, as we saw in 2008 and the recent frenzy. We definitely feel the heat here. The buyers’ pool has dried up for the most part,” Kristen Riffle, a Las Vegas real estate agent, told Fortune.
But it’s not just bustling markets like Las Vegas and Boise that are feeling the pain: This downturn in the housing market is gathering steam across the country. Since last week, mortgage purchase applications have even fallen by 38% on an annual basis. That is the lowest level since 2014.
Simply put, housing activity is collapsing.
Let’s be clear, though: this “crash” in housing activity — or as Fed Chair Jerome Powell calls it a “difficult correction” — didn’t come out of the blue. It’s designed. The Federal Reserve launched a campaign against inflation this spring in the hopes that higher interest rates would slow activity in interest-rate-sensitive sectors such as housing.
The Fed’s reasoning for slowing the housing market boils down to two words: destruction of demand. Historically, mortgage interest rates rise as soon as central banks begin to fight inflation. This mortgage interest shock is causing the sale of both existing and new homes to fall. As builders cut back, the demand for both raw materials (such as wood) and durable goods (such as refrigerators) is declining. It also causes layoffs in real estate and construction. That economic contraction then quickly spread throughout the rest of the economy and, in theory, help weaken the labor market and contain high inflation.
“The most common way we get into a recession is for the Fed to raise interest rates to fight inflation. The leading indicator of this kind of recession is housing,” Bill McBride, author of the economic blog Calculated Risk, told Fortune this summer. “It [housing] is not the goal, but it is [housing] is essentially the goal.”
Of course, we are already seeing this housing-induced economic contraction. Homebuilders are cutting back. Real estate companies are cutting their workforce. And some regional housing markets, such as Boise and Seattle, have already entered a home price correction.
“Realtors are also feeling it tremendously. I called the Greater Las Vegas Association of Realtors and the employee I spoke to said they were getting an average of about 300 new members each month. This month she had an estimated 120; however, she has about 30 broker withdrawals per day,” says Riffle. That means that in Las Vegas alone, about 30 brokers shut down every day.
Now let’s rewind to the intro of this article. When analysts say “the Fed will push through until something breaks,” they are implying that the Fed’s inflation campaign will continue until inflation subsides or something pushes the economy into recession. That ‘something’ could be problems in the bond market, or perhaps liquidity problems at large financial companies. But there is also a growing concern that the “something” could be the housing market.
1981 and 2008
There is nothing unusual about a housing crisis triggering a recession. Look no further than economist Edward Leamer’s 2007 article entitled “Housing Is the Business Cycle”. Leamer found that 80% of post-World War II recessions were the result of “significant” housing shortages.
But when analysts talk about housing ‘breaking’, they’re talking about a downturn in the housing market that’s not just causing the recession, but the underlying cause. The most infamous historical examples of this are 1981 and 2008.
In the early 1980s, Fed Chairman Paul Volcker tackled the famous inflation that had started in the 1970s. The central bank achieved its goal, but it was only after mortgage rates rose – rising to 18% in 1981 – that the housing market deteriorated to such an extent that the entire economy plunged into recession. While home sales and construction levels hit both crates, house prices actually remained fairly stable throughout the 1981 housing crisis.
The housing crisis in 2008 was of course a different story. In contrast to 1981, the housing crisis in the 2000s was caused by a housing bubble. That slowdown started in 2005 after a series of rate hikes by the Fed. In the following years, it would escalate into a full-blown housing crisis that triggered the Great Recession. Unlike 1981, the housing crash of the 2000s was supported by a perfect storm of rampant overbuilding, deteriorating household finances, historic levels of overvaluation and toxic subprime mortgages.
While the 2022 housing market decline doesn’t quite fit the 1981 or 2008 camp, it does share characteristics of each. As in 1981, the housing market deteriorated in 2022 due to a historic shock in mortgage rates. And just like in 2008, the 2022 housing market has again become detached from the underlying economic fundamentals.
A historic affordability shock. That’s the best way to describe why the housing market could be the “something” to break.
The Pandemic Housing Boom – with US home prices rising 43% in just over two years – coupled with the 7% mortgage rate has simply pushed affordability farther than many potential borrowers can afford. Relative to income, it is actually more expensive to buy now than at the height of the housing bubble.
Whenever mortgage rates rise, some potential borrowers — who have to meet lenders’ strict debt-to-income ratios — lose their mortgage debt. When the mortgage interest rate rises from 3% to 7%, it means that millions of people lose their purchasing power.
There is no doubt about it: the housing market entered a downward spiral in the summer. That said, the economic contraction is not yet at the level you would expect for a Fed-induced recession.
Something stands in the way: housing.
On the one hand, the number of single-family homes has fallen by 18.5% year on year. On the other hand, homebuilders remain busy. A combination of supply chain constraints and an eagerness to monetize the Pandemic Housing Boom led homebuilders to massively ramp up production over the past two years. The backlog is so great, they are still working on it. And as long as builders and contractors stay busy, it will slow the spike in construction job losses, which normally come before a Fed-induced recession.
Economists and analysts alike believe the housing market will continue to deteriorate.
This year, Wells Fargo forecasts sharp declines in new home sales (-10.5%), existing home sales (-7.4%), single-family home start-ups (-7.3%) and residential GDP (-10.1%). Then, in 2023, Wells Fargo expects another decline in new home sales (-6.5%), existing home sales (-13.1%), single-family home start-ups (-12%) and residential GDP (16%).
If Wells Fargo’s forecast — which also predicts a 5.5% decline in U.S. home prices in 2023 — comes true, it would mean the downturn in the housing market will reach levels that have historically only occurred during a recession.
While the housing market downturn appears to be on a trajectory that could push the US economy into recession, nothing is certain. If inflation declines, the Fed could reverse policy before a recession looms. There is also the theory that a significant drop in housing investment – which accounts for 4.6% of GDP – would not have much of an impact on the current less housing-dependent economy. While it is true that private investment had a much higher share of GDP in 2005 (6.7%), in reality we are slightly above the 1981 share (4.4%). In other words, don’t underestimate housing.
But “recession” or “no recession”, the housing sector is clearly feeling the squeeze of the tightening cycle. It’s hard to see that changing anytime soon.
“I literally have nothing under contract. I’m a long-distance runner, but I’d be lying if I said I wasn’t nervous,” Kira Mason, a Philadelphia real estate agent, told Fortune.
Want to stay informed about the housing shortage? Follow me on Twitter at @NewsLambert.