What Needs to Happen for Home Price Growth to Slow

The big question homebuyers are wondering in 2022 is when will home prices stop rising?

Unfortunately, the answer to that is not anytime soon.

Home price forecasts are all over the map, but the one thing forecasters agree on is that prices will keep rising in 2022, even after a year of record growth in 2021. So the question becomes what needs to happen to slow price growth?

Real estate prices are set by supply and demand in the housing market, which have been way out of balance for the last few years. Here are the forces pushing on either side of the scale.

Inventory needs to increase

Perhaps the most crucial piece of the puzzle: the number of homes for sale. We’re beginning the year with record low inventory which, based on basic supply and demand, is fueling price growth.

One source of supply is new homes. After a decade-plus of underbuilding, homebuilders were picking up pace in the late 2010’s before the pandemic crippled the industry. Homebuilders are still struggling to find labor, lots, and material which is driving up the time and cost to build homes.

In December 2021, it cost on average $48,000 more to build a home than it did the year before – a cost that is absorbed by homebuyers.

Another major source of inventory that we’re not seeing is existing homes. Sellers have been tentative in the previous two years because of the pandemic, leading to low supply. Perhaps they’ll be more comfortable after a year of vaccinations, omicron wave fading, and soaring home values.

However, the new challenge is that homeowners may put off selling so they don’t have to become buyers in this market. This is concerning because it could cause a feedback loop that keeps supply scarce and prices rising.

A third source of homes could be distressed sales from folks who fell behind on their mortgage during the pandemic. We really didn’t get the foreclosure wave that was predicted last year. If folks were in trouble, they simply sold their homes for top dollar. This is a great outcome for distressed homeowners, but it didn’t provide any bargains for buyers. Still, we may continue to see people choose to sell as they come out of mortgage forbearance, adding some inventory.

Mortgage rates need to stay high

Rising mortgage rates are a double-edged sword. They have the potential to slow demand and home price growth, but do so by making homebuying less affordable.

Mortgage rates are rising faster than forecasters predicted and are currently flirting with 4%. Before the pandemic spoiled borrowers with rates in the 2’s and 3’s, a rate in the low 4’s were considered quite favorable (and should be today with inflation running at 7.5%).

So far, rising rates have done little to deter homebuying. In fact, existing-home sales increased 6.7% from December to January despite rates climbing from the low- to mid-3’s in a matter of weeks. National Association of Realtors Chief Economist Lawrence Yun suggested rising rates increased demand as homebuyers raced to lock in a lower interest rate.

But will mortgage rates climb enough in 2022 to slow price growth? That depends on who you ask.

CoreLogic Chief Economist Frank Nothaft said in a report that rising rates will slow demand and price growth to 3.5% annually by December.

“As we move further into 2022, economic factors – such as new home building and a rise in mortgage rates – are in motion to help relieve some of this pressure and steadily temper the rapid home price acceleration seen in 2021.”

At Fannie Mae, Chief Economist Doug Duncan seems to think demand will persist regardless of mortgage rates, leading to a more gradual deceleration of home prices.

“For homebuyers, we believe that borrowing costs will likely rise with the increase in mortgage rates, further eroding affordability. At the same time, we expect demographic factors and a shortage of housing supply to be supportive of housing activity.”

Fannie Mae is forecasting annual home price growth to decelerate from 15.5% in Q1 to 7.6% in Q4, which is still well above the historical average of 4-5% per year.

Demographics need to change (they won’t)

In the statement above, Duncan mentions “demographic factors” as a supportive force for housing activity. To translate from mortgage-ese to English: there’s a giant wave of millennials – the largest age cohorts alive – aging into peak homebuying age and they’re all but guaranteeing homebuying demand for the next handful of years.

That means that for every buyer who is sidelined by rising prices and rates, there may be two or three ready to take their place. And that’s not to mention the army of cash-laden baby boomers (the second largest generation) looking to downsize.

At least that’s what the replacement buyer theory suggests.

And there’s another force corralling these buyers into the purchase market: rising rents. According to Redfin, rents increased 15% nationwide in the last year, and more than 30% in the hottest markets.

If renting were cheaper, it would be easier for outpriced first-time homebuyers to rent while they save up or boomers to find a low-priced rental to retire to. But the difficult rental market provides an extra incentive for homebuyers to secure fixed mortgage payments.

Remote work opportunities need to fade away

Fingers crossed omicron was the last substantial COVID wave and the pandemic will see itself out in 2022. Here’s how that could affect home prices.

One driver of demand during the pandemic was the ability to work from anywhere and the desire for more space to do it. This led many high-earning city workers to purchase homes in more affordable suburban and rural areas – and drove up home prices. Think San Francisco tech workers buying homes in Ogden, Utah.

This trend should fade with the pandemic, especially as companies call workers back into the office. In fact, housing demand increased in urban areas increased last year after falling off the map in 2020.

Bottom line

The bottom line is that all signs point to home prices to continue rising at least through 2022 and probably longer, although it's difficult to predict by how much. Although ultra-low mortgage rates and ample work from home opportunities are fading with the pandemic, long-standing imbalances in supply and demand will take more time to cure.

Understanding the forces at play may help homebuyers come into the market with more reasonable expectations.