Economic Indicators Are Positive, But Developments In Washington May Be Taxing On The Housing Market

Our 2017 forecast pondered whether last year would continue the “red-hot recovery” of the post–Great Recession years, or, instead, would be the year that the housing market started to come back down to earth after years of consistent gains.  Looking back, it is clear that 2017 was another very strong year for the residential market.  Driven by, among other things, low interest rates, strong demand and a continued inventory shortage, average home values increased by over 6% nationally in 2017 (well above 3% “normal” growth) with values rising each month of the year according to the S&P Corelogic Case-Shiller National Home Price NSA Index.  California home values jumped an estimated 7.2% in 2017, according to the California Association of Realtors (“CAR”).  Housing starts picked up toward the end of 2017 after a slow middle of the year, with single-family starts reaching a decade high in November of 2017 (though multi-family starts continued to slump). The homeownership rate continued to rebound in 2017, reaching 63.9% in the third quarter after falling to a four-decade low of 62.9% in the second quarter of 2016.  And in November 2017, according to the National Association of Realtors (“NAR”), existing home sales reached their highest level since 2006, while new home sales reached their highest level since 2007.  

As we turn to 2018, many economic indicators are positive for the housing market: the unemployment rate is at a decade low of 4.1%, the second and third quarters of 2017 saw stronger GDP growth than any quarter in the previous two years, the stock market reached record highs and looks set to continue climbing, and by some measures, 2017 was the best year for wage growth since the Great Recession.  Homebuilder confidence, as measured by the National Association of Homebuilders (“NAHB”)/Wells Fargo Housing Market Index for December 2017, is at its highest level in over eighteen years.  NAHB Chairman Granger MacDonald credits homebuilder optimism in part to a more favorable regulatory environment for the homebuilding industry.  In turn, a positive outlook from the homebuilding industry may ultimately be reflected by an uptick in housing starts, although it appears likely that demand will nevertheless continue to significantly outpace supply in 2018, extending what Svenja Gudell, chief economist at Zillow, refers to as a “straight up inventory crisis.”  

Despite these positive indicators, several factors are at play which threaten to slow the market’s momentum in 2018.  While anticipated interest rate increases did not ultimately materialize in 2017, many analysts believe that interest rates will increase to between 4.5% and 5% by the end of this year (still well below historical averages), with most estimates falling closer to 4.5%.  Construction labor shortages are also expected to continue into 2018, increasing the cost of construction and slowing the pace of new development.  The recently passed Tax Cuts and Jobs Act (the “Act”), is likely to play a large role in shaping the 2018 housing market.  Among the changes contained in the Act are the imposition of a $10,000 cap on the deductibility of state and local taxes (“SALT”), the doubling of the “standard deduction,”  the lowering of the corporate tax rate from 35% to 21%, and the reduction of the mortgage interest deduction principal loan amount from $1,000,000 to $750,000.  Although it will take time to assess the market’s long-term reaction to the Act’s changes to long-standing tax policy, there appears to be consensus among experts that the Act creates a less favorable environment for homeownership. 

There is little doubt, for example, that the imposition of the $10,000 cap on the deductibility of SALT will make homeownership a more expensive proposition for many homeowners in high tax states (where property taxes alone often exceed $10,000), or that the lowering of the cap on the mortgage interest deduction will make homeownership more costly for some homeowners in all markets.  Since the tax benefits of homeownership were “built into” home pricing in these markets, it is reasonable to expect that an increase in tax obligations will lead to a decrease, or slowed growth, in home values.  Many analysts believe that the Act will in fact pump the brakes on price growth, with Mark Zandi of Moody’s Analytics opining that the Act will slow price growth by 4% by the middle of 2019. The National Association of Realtors initially estimated a 10% drag on growth, but most analysts’ estimates appear to have come in significantly lower than that. Redfin’s Chief Economist, Nela Richardson, believes that the reduction in the SALT deduction may serve to increase a migration from expensive coastal markets to more affordable markets elsewhere.  While the Low Income Housing Tax Credit program was not eliminated by the Act, some speculate that the lowering of the corporate tax rate is likely to make Low Income Housing Tax Credits less attractive to corporations, which could slow development of low income housing and exacerbate an already significant shortage.  

Some analysts believe that there has been a bit of an overreaction to the Act from the residential real estate community, at least to the extent that the focus has been on the provisions that directly impact real estate (such as the cap on the SALT deduction and the lowering of the mortgage interest deduction) as opposed to the impacts of the Act on the economy as a whole.  For example, Alexander Casey, Policy Advisor at Zillow, explains, “the health of the housing market is and will continue to be dependent upon the after-tax incomes of households on the margin between renting and buying.  If the tax bill puts more money in their pockets, they may lean toward buying.  If it takes some money away, they may choose to rent.”  

Prior to the passage of the Act, most analysts were predicting moderate (though still strong) growth in home values in 2018.  Zillow predicted that home prices will grow 4.1% this year, and the Realtor.com 2018 National Housing Forecast predicted price growth of only 3.2%, each lower than the over 6% estimated growth in 2017.  NAR, in a projection made taking the Act into account, predicted home value growth between 1% and 3% for 2018, with decreases in value in high tax states impacted by the Act.  Prior to the passage of the Act, CAR predicted that the median home price in California will increase by 4.2% in 2018, which would cause values to exceed record highs set during the last housing bubble.  

The inventory shortage has persisted for over two years and actually worsened in 2017.  The shortage seems to be self-perpetuating; inventory is so limited, homeowners are wary to sell their homes for fear that they will not be able to find a suitable replacement.  As a result, entry-level homeowners are staying in their homes instead of moving up in the market, leading to a particular shortage of entry-level homes.  Consistent with the national shortage, according to CAR, California’s shortage is also more pronounced at lower price points, and is causing potential homebuyers to look inland or out-of-state for their home purchase.  According to Zillow’s Gudell, there were 12% fewer homes for sale in November 2017 than in November 2016, and inventory shortages will continue to exert pressure on home prices this year.  Some analysts believe that the inventory shortage may begin to ease slightly in 2018.  The Realtor.com 2018 National Housing Forecast projects an inventory recovery, particularly in the middle to upper price points, in the latter part of the year.  According to Samantha Sharf of Forbes, a slight pickup in inventory is anticipated, if for no other reason than that the current state of affairs (high prices, low inventory) cannot go on forever.  Zillow’s Gudell believes, in 2018, that developers will finally heed the call for more entry-level homes and capitalize on strong demand from first-time buyers.  However, as Sharf notes, the reasons for slow housing construction—“the high cost of land, skilled labor and building material, lack of buildable space and local regulations against density”—are unlikely to change for the better anytime soon.  

Affordability will likely continue to be a concern in 2018, since, as noted above, much of the existing for-sale inventory is at price points too high for young, first-time buyers who don’t have the benefit of sale proceeds to finance a new purchase.  According to Zillow, as of September 2017, over half of the homes on the market were in the upper one-third of home values.  Rising interest rates are likely to add to affordability concerns as, according to Redfin’s Richardson, a buyer is expected to pay, on average, between 15 to 20% more for the same house in 2018 than if they had purchased in 2017.  According to CAR, only 26% of Californians will be able to afford the median-priced single-family home in 2018.

Millennial buying activity is another market force that will play a significant role in the 2018 housing market.  With 39.8% of mortgage originations in 2017 according to Realtor.com, Millennials (who were relatively slow to enter the market compared to previous generations) accounted for the most originations of any age group, overtaking Generation X for the first time as the group with the most origination activity.  With Millennials accounting for so much market activity, developers would be wise to focus on Millennial preferences in formulating their development strategies.  Zillow’s Gudell expects that the lack of affordable inventory will lead Millennials to move to the suburbs. Redfin’s Richardson explains that Millennials have shown a preference toward a new type of neighborhood— the “Urban Suburb”—which offers city-like amenities, high walkability, and strong public schools.  In other words, Millennials want the city lifestyle without the city price tag.  

The overall economic environment is positive for housing in 2018.  Demand is expected to remain strong, and interest rates are expected to remain relatively low for the coming year.  However, there are several forces at play that may ultimately result in 2018 being the year that we finally revert to more “normal” price growth.  Several changes brought about by the Act, particularly the capping of SALT deductions at $10,000, the doubling of the standard deduction, and the lowering of the cap for the mortgage interest deduction, are expected to result in slower price growth in 2018 and beyond.  The inventory situation is expected to improve somewhat later in the year, which may lead to a slowing in price growth as well.  However, even if the market does cool off in 2018, analysts do not expect a “rough landing”.  According to the ULI/PWC Emerging Trends in Real Estate 2018 (“Emerging Trends”), most do not see the current market cycle as a “boom or bust” cycle.  Rather, Emerging Trends explains, many in the market believe that the deliberate pace and moderate scale of the post–Great Recession recovery is predictive of what the other side of the market peak will look like—a slow, measured descent to the beginning of the next cycle.