Home prices recently reached levels not seen since the housing crash of 2008. Some investors are concerned. But home prices today are not the product of exuberance. Instead they reflect solid fundamentals—namely, tight inventory, carefully calibrated supply, and rising demand underpinned by the strength of the US consumer. And the ongoing economic expansion is an important part of this optimistic view.

ECONOMIC ENVIRONMENT

The economic environment has been and continues to be supportive of housing performance. Labor markets are improving, as rising employment and wages, especially among younger workers, are aiding household formation. We expect that this economic growth will persist in 2018, despite the Fed moving towards a less accommodative stance. The Fed is starting from a crisis period framework and moving towards a more normal rate environment. Even though our forecast is for four interest rate increases this year, we do not expect rates will become restrictive in the immediate future. Consumers have strong balance sheets, which are remarkably healthier from those before the housing crisis, so they are more able to withstand these higher rates.

Of course, it is hard for central banks to unwind the stimulus put in place during the financial crisis without causing a disruption. Credit spreads are currently at very tight levels, heightening the risk of increased volatility. In addition, the uncertain political environment may create disruptions in markets. But overall, strong fundamentals are driving the optimism around the housing market.

TIGHT INVENTORY PERSISTS

Tight inventory underpins the foundation for housing. The number of existing homes for sale per household is at an all-time low as is the months’ supply, which recently fell below historical trend averages indicating tight housing conditions (Display 1).

Despite the tight inventory, developers remain cautious, building only to visible demand and not speculatively, which should keep inventory in check. While single-family housing starts have been rising, they are below levels seen pre-crisis. As a result, home prices should again rise this year, as they have done over the last few years, including last year’s 6% boost.

DEMAND REMAINS HIGH

Along with encouraging supply dynamics, demand for single family homes should also be strong in 2018. A rising stock market and a favorable employment environment paint a conducive backdrop for housing demand. The improved employment outlook for younger Americans who were disproportionately impacted by the crisis is encouraging. The number of 25–34 year-olds living at home has been growing since 2003, reaching an all-time high last year. With improving employment prospects, these younger Americans will move out of their parent’s basements and create their own households, contributing to increased demand for homes. But could rising rates derail this demand?

We don’t believe so. Affordability is driven by income levels, home prices, and mortgage rates. We analyzed home affordability and found if home prices and incomes remain unchanged, then mortgage rates could rise by 45 bps and housing would remain affordable. When incomes rise 6%, and home prices rise by 10%, housing could still be affordable even if mortgage rates increase by 7 bps. But if home prices rise by 10% while incomes increase by only 3%, affordability would decline and mortgage rates would need to decrease by 22 bps to keep housing affordable (Display 2).

However, wages are not falling, they are rising. Together with improving credit availability, higher wages should counteract the impact of rising prices and mortgage rates, keeping houses affordable, unless another force disrupts the market. Could the new tax legislation cloud this favorable demand picture?

TAX LAW EFFECT

Probably not. We expect that the average homebuyer will have more disposable income from lower tax rates, which could support the housing market. For more expensive homes, however, this benefit may be offset by the reduced mortgage interest deduction, which may slow homeownership growth in higher-priced markets and disincentivize existing homeowners from moving because they still receive the higher deduction limit on existing loans. Overall, we expect this will have minimal impact.

Another change in the tax code that may impact housing is the limit on the deductibility of state and local property taxes (SALT) of $10,000 from unlimited earlier. This change may have an impact on more expensive homes in high-tax states such as California, Connecticut, Illinois, New Jersey, and New York. We anticipate the potential buyers in these states will stay on the sidelines until they see the true effect of these changes on their purchasing power.

None of these changes, however, will be enough to offset the positive demand dynamics or the overwhelming lack of supply that has been pushing housing prices consistently higher over the last five years.

A ROSY PICTURE

Basic economics of low supply and strong demand point towards a strong environment for housing in the near term, despite rising rates and changes to the tax code. These dynamics are expected to drive home prices moderately higher and reward investments that are based on these strong housing fundamentals in the near term.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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