Shambling towards affordability, January 2023

Well it’s more of a “lurch” than a “shamble”, but I’m going to stick with the traditional naming convention.

This first chart shows the ratio of home purchase prices to a combination of rents and incomes. That boost in valuation has made a very rapid turnaround since it peaked last spring, but it has only retraced about 40% of its post-Covid surge.

The second chart shows the ratio of home monthly payments to rents and incomes. While off the recent highs, this proxy for monthly payment affordability remains quite uncomfortably on the “unaffordable” side of things. (Un-fun fact: this ratio has increased by 67% since the post-Covid lockdown low point in July 2020).

Here are some potential outcomes, in descending order of how likely I think they are to happen:

• The monthly payment index will decline. This seems pretty likely, because I just don’t think this level of monthly payment affordability is sustainable.

  However, this is not a particularly useful forecast, because this could happen via any or all of the following: rising incomes/rents, declining prices, or declining mortgage rates. We’ve already seen a decent amount of the first two, and now, a tiny bit of the third. All three are likely to continue playing a role, but the proportion of each is, I think, highly dependent on economic developments (which I believe to be very hard to predict with any reliability). 

• The valuation index will decline further. I also see this as pretty likely, but I’m less confident of this one than the prior one.

  I think it’s likely to happen because the only times valuations got to this level, there was something “special” happening. The first time was a huge speculative bubble, and affordability doesn’t matter during bubbles, at least for as long as the party keeps going. The second was a dramatic decline in interest rates that kept monthly payments reasonably affordable despite the high purchase price valuations. Without a special factor like that, I would expect valuations to return to more normal territory over time.

  I am less confident about this outcome than the prior one because I’m allowing for the possibility that rates drop substantially enough that monthly payments become affordable again. (That’s not my base case, but I don’t want to rule it out, either… see above about predicting such things. And this uncertainty cuts both ways: If mortgage rates were to stay here or even go higher — also not my base case, but also not unthinkable — valuations would have to decline even more than I am expecting to get payments back into line).

• Nominal home prices will decline further. This seems likely to some degree, but the extent of it is highly uncertain in my view. This is because it could be headed off not only by much lower rates (as in the last bullet), but also by an increase in rents/incomes that is large enough to allow valuations to normalize without prices coming down too much.

  Duration becomes fairly important here… given sufficient time, the inexorable rise of rents and incomes could lower valuations quite a bit without prices moving at all. But if the adjustment is to take place more quickly, it seems likely that price declines would have to do some of the work. Which of these paths is taken is anyone’s guess. But I do think that a recession in the near term would increase the likelihood of nominal price declines.

  My view that price declines are “likely to some degree” is based on the fact that mortgage rates are still high, and the move towards greater affordability has happened pretty quickly so far. That implies some degree of downward price pressure, but that could change (and based on the lack of inventory hitting the market, it may already have started to change) — so it is a weakly-held view. 

And so the shambling, or lurching, towards affordability seems likely to continue… but how this might be accomplished is much less certain.