Oregon Office of Economic Analysis

There’s a basic story I like to tell when giving presentations on the housing outlook. It goes like this. After years of significantly underbuilding housing, new construction activity continues to pick up. Supply is increasing. After years of acceleration, population growth and migration trends are ebbing. Demand is stabilizing and set to slow. The housing market is moving toward better balance. Couple this with continued household income gains and affordability should improve in the coming years. It’s a neat, concise story. However, the real world is messier and uneven across different regions of the state.

To this end, the housing market is not yet rebalancing statewide as far as I can tell. When I comb through rental reports and local realtor statistics, inventories and vacancies remain low nearly everywhere. It is still a landlord’s or seller’s market throughout much of Oregon. That said, the tide is turning a bit in the Portland region, which has seen the biggest increases in new construction (both in absolute terms, but also relative to population gains). Rents are flat or down, see Joe Cortright at City Observatory for the latest. And the ownership market is cooling just a bit as well. Sales of homes are stable to down, and inventory is rising. The market is clearly shifting. Buyers have a few more options relative to the breakneck pace of recent years. Elliot Njus had a good summary in The Oregonian on this the other day. Inventory remains lean, yes, but it is rising which brings somewhat better balance.

However, underlying these topline trends, different factors are at play. Rising interest rates make the financing costs of carrying a mortgage more burdensome for households, as do higher home prices. As the market rebalances, will the adjustment be on the buyer or on the seller? Meaning, will buyers continue to spend a larger share of their income on housing, or will the adjustment come in the form of slower price appreciation? My bet is on the latter. At some point rising borrowing costs will have to come out of the selling price as households max out their budget. For every one percentage point increase in the mortgage rate, purchasing power falls by about 10 percent. Meaning if you can afford a $400,000 home at a 4% interest rate, you can afford a $360,000 home at a 5% interest rate. That said, at least so far in recent years, it has been the buyer doing the adjusting and spending more. Sellers have reaped the benefits, as have all owners in terms of home equity.

Leonard Keifer, Freddie Mac’s deputy chief economist, is a great follow on Twitter in general for housing stats and data visualizations created in R. He does this periodic update that highlights what happens to different housing measures when we see a big rise in mortgage rates. Below I do my best impersonation of Len’s work but for the Portland market.

Essentially we have experienced three separate run-ups in mortgage rates (and other long term interest rates) in recent years. The taper tantrum back in 2013, another following the 2016 presidential election, and again in recent months. It is pretty clear in the data that the one percentage point increase in mortgage rates during the Taper Tantrum cooled the housing market in 2013 and 2014. Price appreciation slowed considerably, and home sales fell around 10% nationwide (12% in the Portland market). As interest rates declined in 2014, 2015, and 2016, price appreciation and home sales revived. Rising mortgage rates in the last couple of years result in a similar pattern, although less pronounced.

I think the reason for that is affordability is worsening, at least based on available data today*. The combination of higher interest rates and home prices mean households have to devote a larger share of their income to housing, if they want to buy. For much of the recent past this was less of a problem given low interest rates and strong gains in household income. The rise in housing costs reflected more of a return to normal following the record affordability in the aftermath of the Great Recession, if you had the money and could get credit that is.

However this recent upward movement in housing costs pushes affordability beyond where it was throughout the 1990s and early 2000s. This is why moving forward I would expect to continue to see home prices slow to something more inline with income gains, or even slower if inventory continues to build. The reason is higher mortgage rates are here to stay, and should largely move sideways or up between now and the next recession.

Of course there are myriad factors that can alter this outlook, including to what degree does new construction and household formation differ from forecast. Furthermore, in the worst case scenario, the stage is now set for another bubble where supply increases, and yet households devote an increasing share of their income toward housing in the belief that rising prices will save them. We’re still a long way from that, and mortgage debt remains tame, but given the past 15 years it, unfortunately, cannot be ruled out entirely even if it is unlikely.

*Our office’s affordability measure is based on costs relative to median family income. We are assuming relatively strong income gains in both 2017 and 2018, but not quite as strong as Census data showed for 2015 and 2016. If gains continue at those paces, housing costs would be about 1 percentage point lower in 2018 than what is shown in the chart. Better, yes, but not enough to offset rising prices and mortgage rates.