Why Your Kids Can’t Afford a House

Home affordability is a function of two primary things: 1) the ability to save enough for a down payment; and 2) having the income required to service the mortgage each month. With housing costs making up the largest part of family expenses, it would naturally be expected that there would be a close relationship between median household income and median home prices. As shown below, between 1972 and 2000, that relationship was very close. However, at the turn of the century, that relationship began to go haywire with home prices rising much faster than incomes and that divergence has only become wider. From current levels, it would require a 28% decline in the median home value to return to the 1972-2000 trendline, other things being equal.

We can only speculate about what started this distortion in home prices, but it can’t be denied that the late 1990’s was a period of excessive speculation that came crashing down in late 2000/early 2001 (the Internet Bubble). Money flowing out of stocks needs to find a new home and real estate was as good a destination as any and the housing bubble began to inflate.

In addition, the 9/11 attacks had many re-thinking where they wanted to live. Much like the pandemic, it created a migration to the suburbs. Put those things together and the rise of home prices that began at the turn of the century, appears quite logical.

The initial divergence culminated with the Great Financial/Subprime Crisis of 2008-09. That episode is now far in the rearview mirror, but the chart above suggests that we never fully corrected the original housing bubble. Housing prices never returned to the old trendline. In fact, after a brief correction, the divergence between home prices and income began to grow once again.

Anyone that can recall the jarring economic collapse that occurred when the subprime bubble burst knows it was a very difficult and scary time. So why didn’t home prices fully correct? The Federal Reserve is an important part of the answer. By late 2008, the Fed announced a stimulative measure that they had never used before as they acted to shore up financial institutions from the brink of failure and return confidence to financial markets. That technique is called Quantitative Easing (QE).


The Fed ‘Prints Money’

Normally, Fed monetary policy is implemented using only short-term instruments (T-Bills), but that only impacts short term interest rates. The problem was that short-term rates quickly went to near zero in late 2008 and the economy was not responding. The solution at the Fed was to force longer term interest rates down as well and QE is designed to do that. It is implemented by the Fed purchasing longer term securities in the open market from banks and other financial institutions. This has a threefold impact:

      • Buying bonds pushes new money into the banking system and strengthens bank balance sheets.
      • Additional bond demand raises bond prices and lowers long term interest rates (higher bond prices = lower rates).
      • It increased the money supply in the economy as the bonds were purchased with ‘newly minted’ money.

Once this policy was set in motion, it acted as a continuous stimulus for the economy and a continuous flow of money (liquidity) into financial institutions. The idea was that this money would eventually find its way into the real economy, that is, it would move from Wall St. to Main Street, but that transition largely failed to materialize. Money can’t exist in a vacuum; it has to be somewhere and it found a home in financial assets. Stock prices rose, bond prices rose, assets of all kinds rose, including houses.

Markets gradually settled down and all appeared well on the surface, but for many years, the Fed as unable to shut off the QE spigot. Each time the FED attempted to wean us off QE, they were met with higher interest rates and falling markets. With both economic growth and inflation running below target following the GFC, that raised the specter of deflation and the Fed always relented. It wasn’t until 2018 that the Fed had any modest success in slowing down the pace of QE and that was fairly short lived as by early 2019, the FED balance sheet was again rising as QE operations picked up again.

The pandemic further complicated matters and as the economy closed in the face of COVID, the Fed kicked QE into high gear. The Fed’s efforts made the response to the subprime crisis appear modest. At the time QE began, back in 2008, the Fed balance sheet had about $1 trillion of assets. More than 10 years later, immediately before the pandemic, that had risen to a bit more than $4 trillion. By early 2022, after the pandemic, that had risen to $9 trillion. (See chart above.) To put that vast amount into perspective, think of one pile of $1 million, now think of 9 million piles of $1 million. That is $9 trillion.

As if that inflow of new money wasn’t enough to push house prices up, the pandemic created another real estate dislocation as city dwellers once again left for the suburbs/country to escape the close proximity of urban living. For many, that escape became at least semi-permanent as working from home has become more acceptable, but in any case, demand for housing was again rising.

Fast forward to today and the Fed is dealing with an inflation problem and is raising interest rates in response. That sharply increases monthly mortgage payments, even if home prices stay flat, making homes even less affordable than they were. Finally, home prices have now begun to decline, but only very modestly thus far.


There Is No Free Lunch

We concede that there is nothing that requires the old trend line to remain intact, but we are sure that continued growth in home prices that are far exceeds income levels is simply unsustainable. The only questions that remain are where the wall is and how fast do we hit it?

The Fed’s implementation of QE may have ‘saved the world’ in 2008, but the full reverberations from that time have yet to be fully resolved and some additional future pain probably lies ahead. The old saying is still true. There’s no such thing as a free lunch.


If Lunch Isn’t Free, How Much Does It Cost?

Over the long run, economic problems are always about supply and demand. All other things being equal, if demand increases, price go up and if supply increases, prices come down. The problem is that the influence of monetary policy (QE) as well as the pandemic, has pushed housing demand significantly higher. At the same time, supply has been constrained over most of the last 15 years as the recovery from the sub-prime crisis was tepid at best and pandemic supply chain problems slowed construction. The result is that the number of homes completed over the last 10 years is well below normal levels.

The laws of supply and demand can be distorted at times, but eventually a balance is achieved and we appear to be headed in that direction. New housing units under construction are currently higher than at any time since at least 1972. So today we have demand being dampened by affordability issues and record amounts of new supply on the way. That is eventually the recipe for lower prices. It may take some time to catch up with the past shortage, but if the current trend is able to hold, it will happen.

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Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

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By: Adam