When examining the global housing market, U.S. real (adjusted for inflation) housing price appreciation, adjusted for inflation, remains lower than in the other countries. Global real housing prices have outpaced the United States, exceeding their pre-crisis peak. The global comparison becomes starker when evaluating housing price-to-income ratios over the past 20 years. Since 1997, the United States has lagged other western nations on price-to-income growth (see chart). In other words, housing prices have not nearly increased at the same rate as other countries.
Fundamentals indicate that the average U.S. consumer remains healthy. A healthy labor market, strong consumer confidence, and modestly rising wages amid a backdrop of a positive U.S. economic outlook with low medium-term recession risk, all point to a continuation of the positive trends.
U.S. households have not substantially re-leveraged themselves and are in a much better position servicing their debt today than in any other period since the early 1980s. The total household debt service ratio remains well below its 2007 peak as well as its long-term average. A large part of the improvement has come from a marked decline in the mortgage debt service ratio whereas the consumer debt service ratio has been slowly trending toward the long-term average due to increasing levels of student loan and auto debt.
Favorable supply/demand dynamics remain a strong tailwind for home price appreciation. The demand-side shows rising levels of household formations. There has been a noticeable pickup in formations since 2009, having recently exceeded a year-over-year rate of 1 million. We expect this rate to be sustained as the millennial population ages into home ownership. More importantly, formations have also recently begun tilting more toward owning than renting.
The U.S. homeownership rate increased to 64.4 percent in third quarter 2018 and is up meaningfully from a post-crisis low of 62.9 percent. Demographic trends are shifting as homeownership rates among those under 35 have begun moving higher. These younger generations represent a swath of potential homebuyers who have been placed on the sidelines or left out entirely because of economic and social changes. Going forward, we expect millennial demand to make an impact on the housing market. Demographics tell only part of the story as bottoming interest rates may also be a cause for increased ownership. As interest rates begin to move higher, the incentive to purchase before rates rise further has likely become a meaningful factor for prospective purchasers.
Supply remains constrained. Existing home inventories peaked in 2007 and have remained in a downward-sloping range ever since. Leading up to the housing crash, there had been years of rising inventory culminating in a surge around the peak of the bubble. Today’s inventory patterns show no signs that there is any equivalent behavior in inventory. During an economic expansion, we would usually expect the market to become oversupplied at some point. On the contrary, we are seeing the worst shortage of homes for sale in at least three decades.
With respect to housing starts, single-family starts have lagged significantly behind multifamily starts, which have exceeded pre-2006 levels. Single-family starts have been lackluster as pre-crisis levels have yet to be reached, let alone surpassed. Labor shortages, higher material costs, and land usage restrictions have all played a role.
The cost to produce new homes is beginning to creep up as residential construction inputs become increasingly expensive. Residential construction supplies and materials have begun to move up meaningfully, signaling that new inventory may still come to market, but at a slower pace and at higher prices. The Employment Cost Index tells the same story. There has been a substantial recovery in construction-related employment, which has bled into the cost for labor.
There has been increasing pressure on affordability from higher home prices and rising mortgage rates. The affordability index hit extremely elevated levels following the housing crisis when home prices declined at an unprecedented rate and as interest rates fell sharply. Now that nominal housing prices have surpassed their pre-crisis peaks, and as mortgage rates begin to move higher, we are witnessing a return of the Housing Affordability Index to a more normalized range. We expect housing affordability to continue moving lower due to higher forecasted mortgage rates. Holding the rate of income growth constant at the current rate, and assuming a 3 percent nominal housing price growth, a 2.6 percent inflation rate, and a mortgage rate of 5.0 percent given our projections for a 3.3 percent 10-year U.S. Treasury yield, monthly payments as a percentage of income are expected to rise to 17.2 percent in 2019 from 15.7 percent in 2017. Despite the increase, this would bring affordability in line with the average pre-bubble experience.
Nominal housing prices have recovered substantially since the global financial crisis, surpassing their 2006 peak; however, the rate of home price appreciation has slowed in the past several months. Price growth is down from 2018’s peak of 6.5 percent but remains robust at just under 6 percent. We expect home prices to continue growing at a slower pace now that affordability is approaching more normalized levels and there is potential downward pressure from housing and local tax-related reforms. We believe that despite some of these headwinds, supply/demand dynamics and a strong U.S. macro backdrop should remain supportive of growth in the medium term.
Mortgage debt credit quality remains solid and thus far has not experienced the same level of loosening that we saw during the years leading up to the financial crisis. Subprime lending, which was rampant prior to the crisis, has largely disappeared from the mortgage market.
Mortgage originations to borrowers with FICO scores below 659 peaked in first quarter 2007 at $192 billion, representing 26 percent of the total share of originations. The subprime bucket today represents only 8 percent of mortgage originations, or $37 billion in volume.
Moreover, the average credit score at origination remains near the highest level in two decades.
The non-agency RMBS market benefits from the same supply/demand dynamics as the housing market: strong demand and limited supply. Demand for non-agency RMBS is fueled by the general sentiment that the housing sector and consumers at large are in better conditions fundamentally than many other fixed-income sectors. On the supply side, the legacy market continues to contract at a rapid rate and is now less than $500 billion, down from a pre-crisis high of more than $2.5 trillion. Strong sector technicals have resulted in significant spread tightening of legacy assets.
While non-agency new-issuance volume remains low compared to the pre-crisis market, it ramped up rapidly in 2018, during which issuance exceeded $100 billion.
Poorvi Dholakia, Jun Jiang, Alexander Villacampa and Scott Waterstredt are executives with MetLife Investment Management.