2017 Housing-Market Strength to be Challenged by Rising Mortgage Rates

October starts surge and financial markets’ post-election strength lift Wells Fargo’s 2016, 2017 and 2018 housing-starts forecasts even as falling home affordability shifts dynamics

Wells Fargo Economics Group
October’s housing-starts surge caused Wells Fargo to slightly boost its 2016 housing-starts forecast, and raise its 2017 forecast to 1.17 million units and its 2018 forecast to 1.22 million units.
October’s housing-starts surge caused Wells Fargo to slightly boost its 2016 housing-starts forecast, and raise its 2017 forecast to 1.17 million units and its 2018 forecast to 1.22 million units.

Stock prices rallied with president-elect Donald Trump’s surprising victory on expectations that tax cuts, increased infrastructure spending and reduced regulation will boost long-term economic growth.

Interest rates have also risen, as investors now anticipate slightly higher inflation, larger budget deficits and, with a stronger-than-expected economic outlook, higher opportunity costs. According to Freddie Mac, the average 30-year fixed mortgage rate is up about half a percentage point since the election to 4.08 percent during the week ended Nov. 30, marking the highest rate since July 2015. Higher interest rates likely will create challenges for the still slowly recovering housing market.

Housing affordability, while near historic highs, has been falling as home prices have risen much faster than incomes in recent years. The sudden rise in conventional mortgage rates will reduce affordability further in coming months. Moreover, the abrupt strengthening in the dollar, particularly since the presidential election, will further depress sales to international buyers, which had already slowed considerably in many East Coast markets.

Recent housing data remain encouraging. The big surprise was a huge, 25.5 percent surge in October housing starts, which showed single-family starts rising 10.7 percent and multi-family starts leaping 68.8 percent. Wells Fargo says it believes that much of October’s outsized gain results from unseasonably mild weather allowing more construction to begin.

Within starts, Wells Fargo detects a subtle shift toward less-expensive homes. Builders, particularly in the South, are focusing more on homes priced at or below the median new-home sales price, which is currently near a historic premium relative to existing homes.

Builders remain fairly optimistic, particularly in the West and South, where sales are strong and inventories low.

October’s housing-starts surge caused Wells Fargo to slightly boost its 2016 housing-starts forecast and raise 2017 and 2018 numbers.

  • 2017 housing-starts forecast: 1.17 million units
  • 2018 housing-starts forecast: 1.22 million units

The more upbeat outlook mostly reflects base effects and a shift toward lower-priced homebuilding, so the residential-construction spending forecast has not changed as much.

Wells Fargo explains that its forecast is cautious due to the accelerated rise in long-term interest rates since the election, and the slightly higher interest rate environment expected over the coming couple of years.

Return to a more normal interest rate outlook is particularly perplexing to a housing sector starting from such unusually low-rate mortgages. A 50-basis-point rise in conventional mortgage rates, coupled with a 4 percent rise in home prices, pushed the monthly principal and interest payments up roughly 10.5 percent on the median-priced existing home. That increase is quite a lot for households to absorb, as they are seeing incomes rise at only about 4.5 percent a year.

If interest rates were higher, buyers could avoid much of the immediate hit from rising rates by shifting to an adjustable-rate loan. Such a strategy yields little savings at today’s still-low rate and is not the route many would likely choose when they expect interest rates to rise. Shifting to less expensive homes is also a less-viable option in this market because inventories of both new and existing homes are so low.

Wells Fargo doesn’t anticipate a repeat of the taper tantrum in 2015, when an even more abrupt and sharper rise in mortgage rates led to a surge in sales cancelations that set back the housing recovery.

Higher interest rates pushed the value of the dollar higher against the currencies of key U.S. trading partners, making it more costly for foreign buyers to purchase homes in the United States. The pullback of foreign buyers was already apparent in New York City and Miami but is likely to become increasingly evident along the West Coast and parts of the South, where foreign buying has pushed prices higher than the underlying fundamentals justify. Coupled with increased construction, Wells Fargo expects home-price appreciation to moderate, with the S&P CoreLogic Case-Shiller 10-City index rising 4.4 percent next year, after rising an estimated 4.5 percent in 2016.

Growth in the median price of a new home is expected to decelerate even more dramatically, with prices climbing an estimated 3.6 percent this year and 3.2 percent in 2017. Moderation in new home prices largely results from the changing mix of construction, with building activity shifting to less costly suburban locations.

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