House Prices - An Orderly Decline in Appreciation or a Crash Landing?

House prices are looking increasingly frothy. Thus, rental vacancy rates and price-to-rent ratios are setting new records every quarter and the gap between house price inflation and overall inflation is also at a record. A moderation in house price inflation is inevitable. But could it be a precipitous decline? Strong fundamentals suggest that an orderly moderation in inflation remains the most likely scenario; outright declines in national home prices are unlikely.

The national rental vacancy rate surged to a new record in Q1. At 10.4%, the vacancy rate was up 0.2 percentage points from Q4’s 10.2%. The average vacancy rate over the past ten years was a little over 8%.

Elevated vacancy rates and home sales continue to push house price-to-rent ratios, which are essentially P/E ratios for homes, and home ownership rates to new highs.

Soaring price to rent ratios and a record gap between house price appreciation and core inflation portend a significant slowdown in house price inflation once interest rates rise and the inevitable moderation in housing market activity gets underway. Indeed, the imbalance measured by these factors alone would suggest outright decline in national home prices.

But we believe several factors will provide a cushion against such a decline. First, improving labor markets and income growth will off set some of the adverse impact on affordability from rising interest rates.

Second, despite an up tick in April, builder expectations remain well-anchored. With home builders correctly anticipating the inevitable slowdown caused by rising rates, the supply–demand balance should hold steady. This is turn will preclude the need for sharp corrections.

Finally, the historical evidence sheds a favorable light. Recent U.S. economic history suggests a gradual deceleration in prices following a housing market boom. National prices have rarely declined outright except for very short periods, and even episodes of rapid deceleration have typically only occurred during recessions.

We certainly expect house price appreciation to decline markedly in the quarters ahead. However, we expect the moderation to be an orderly one, cushioned by the factors discussed above. Outright decline in national house prices, as opposed to prices in specific regions, is unlikely.