The U.S. Housing Market: Risks, Realities, and the Road Ahead

The post-pandemic period saw rapid, often unsustainable, housing price appreciation. From 2020 to 2022, national home prices surged by approximately 20%, compressing what would have been 3-5 years of price growth into just 12-18 months. This rapid escalation in housing prices presents a risk of price corrections in the near future, as the market attempts to reconcile these inflated values with the broader economic environment.

The following graph illustrates the changes in the median home sales price since 2000 and projects potential price moves based on the recent trend. After the housing boom of the mid-2000s turned into a bust, the median home sales price fell to below the historical trendline and took some time to recover. However, we think that the current scenario is much different. While home prices may stagnate nationally and each region has its own dynamics, a collapse on the scale of what occurred during the housing bust is unlikely in our opinion.

Unlike the prelude to the 2008 housing crisis when excessive speculation, high-risk lending practices, and overleveraging by consumers set the stage for a national bust, the current market appears much more stable. Lending standards today are significantly more stringent. The lax credit conditions of the mid-2000s, which allowed for the widespread issuance of risky subprime mortgages, have largely been replaced by more responsible lending practices. The era of no-money-down loans, adjustable-rate mortgages, and financial instruments like collateralized debt obligations (CDOs) that masked the risk of these loans is over. Now, borrowers typically have skin in the game, requiring substantial down payments and greater equity in their homes. As a result, walking away from a mortgage – especially in an environment where home equity is a primary financial asset – has become more costly and less common.

Moreover, consumers are generally less leveraged than in the years leading up to the 2008 crash. The average debt-to-income ratio is lower, and many households have been more cautious about taking on excessive debt. This significantly reduces the risk of widespread defaults that could precipitate a market collapse.

While there is little risk of a nationwide housing bust, it is essential to recognize the diverse conditions across different regions. Nationally, the U.S. is facing a significant housing shortage, with an estimated shortfall of 3 to 4 million homes. This shortage stems from years of underbuilding, especially in the years following the mid-2000s housing boom. After the housing bubble burst, the homebuilding industry reduced its output substantially. This underproduction of homes has been exacerbated by the ongoing growth in household formation, with approximately 1.1 million new households being created annually.

As a result, while some regions have seen a rush of new construction, other areas – particularly high-demand urban centers – remain significantly underbuilt. The effects of this shortage are most acutely felt in areas where demand for housing has outpaced supply, leading to higher prices and reduced affordability. 

Affordability remains one of the most significant challenges in the housing market today. Higher interest rates, which have climbed to around 7%, roughly the levels seen in the mid-1990s, are a key factor in pushing monthly mortgage payments higher. While these interest rates are not historically high, they feel burdensome when compared to the ultra-low rates experienced in the aftermath of the Global Financial Crisis (GFC) and during the pandemic. The normalization of interest rates after a period of unprecedented low rates is contributing to the current strain on affordability, particularly for first-time homebuyers.

In addition, the size of new homes has increased substantially, with the average size rising from less than 2,000 square feet to about 2,500 square feet. This trend, driven in part by consumer preferences for larger living spaces, has increased the cost of new homes significantly. The larger homes require more materials, more labor, and more capital, all of which push prices higher. While larger homes may still appeal to many buyers, this shift in demand may not be sustainable if affordability continues to erode.

Furthermore, rising insurance premiums, a consequence of increasingly frequent natural disasters and higher repair costs, have added another layer of financial strain for homeowners. Together, these factors contribute to the notion that housing affordability is in crisis, particularly for middle- and lower-income buyers.

The current housing market is marked by several competing dynamics. On the one hand, there is a shortage of homes, which should, in theory, support prices and stave off a market collapse. On the other hand, the rapid price appreciation of recent years and the rising costs of homeownership present challenges to affordability and sustainable market growth.

One potential outcome is a gradual return to a more balanced market. It is plausible that the size of new homes will begin to shrink, as demand for larger homes decreases. If builders return to constructing smaller, more affordable units, the overall affordability of the housing market could improve. Additionally, a slowdown in price appreciation, or even a modest price correction, could help restore a more stable equilibrium to the market.

However, this reconciliation is unlikely to happen quickly. The housing market is inherently slow-moving, and the imbalances that have built up over the past several years, especially the effects of underbuilding and rapid price inflation, will take years to resolve. Therefore, while the current market is not at risk of a dramatic crash, it may experience periods of volatility as it adjusts to these long-standing structural issues.

While the U.S. housing market faces significant challenges, it is not on the brink of a national collapse. The conditions that led to the 2008 crisis, such as rampant overbuilding, high-risk lending, and excessive consumer debt, are largely absent from the current environment. Instead, the market faces a complex array of regional disparities, affordability concerns, and the need for long-term adjustments to housing supply and demand.

In the near term, we are unlikely to see a housing bust. However, the market will need to reconcile the conflicting pressures of rapid price appreciation, rising construction costs, higher interest rates, and a persistent housing shortage. This process will take time, and the market may experience price stabilization or corrections along the way. Yet, for the foreseeable future, the risks to the housing market appear manageable, provided that policymakers and industry stakeholders continue to address the underlying structural challenges facing the sector.

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