Refinance Incentives and the 5.5% Affordability Target

Our Co-Head of Securitized Products Research James Egan joins our Chief Economic Strategist Ellen Zentner to discuss the recent challenges facing the U.S. housing market, and the path forward for home buyers and investors. 

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James Egan: Welcome to Thoughts on the Market. I'm James Egan, U.S. Housing Strategist and Co-Head of Securitized Products Research for Morgan Stanley. 

Ellen Zentner: And I'm Ellen Zentner, Chief Economic Strategist and Global Head of Thematic and Macro Investing at Morgan Stanley Wealth Management. 

James Egan: And today we dive into a topic that touches nearly every American household, quite literally. The future of the U.S. housing market. 

It's Thursday, September 25th at 10am in New York. 

So, Ellen, this conversation couldn't be timelier. Last week, the Fed cut interest rates by 25 basis points, and our chief U.S. Economist, Mike Gapen expects three more consecutive 25 basis point cuts through January of next year. And that's going to be followed by two more 25 basis point cuts in April and July. 

But mortgage rates, they're not tied to fed funds. So even if we do get 6.25 bps cuts by the end of 2026, that in and of itself we don't think is going to be sufficient to bring down mortgage rates, though other factors could get us there.

Taking all that into account, the U.S. housing market appears to be a little stuck. The big question on investors' minds is – what's next for housing and what does that mean for the broader economy? 

Ellen Zentner: Well, I don't like the word stuck. There's no churn in the housing market. We want to see things moving and shaking. We want to see sellers out there. We want to see buyers out there. And we've got a lot of buyers – or would be buyers, right? But not a lot of sellers.  And, you know, the economy does well when things are moving and shaking because there's a lot of home related spending that goes on when we're selling and buying homes. And so that helps boost consumer spending. 

Housing is also a really interest rate sensitive sector, so you know, I like to say as goes housing, so goes the business cycle. And so, you don't want to think that housing is sort of on the downhill slide or  heading toward a downturn [be]cause it would mean that the entire economy is headed toward a downturn. 

So, we want to see housing improve here. We want to see it thaw out. I don't like, again, the word stuck, you know. I want to see some more churn. 

James Egan: As do we, and one of the reasons that I wanted to talk to you today is that you are observing all of these pressures on the U.S. housing market from your perspective in wealth management. And that means your job is to advise retail clients who sometimes can have a longer investment time horizon. 

So, Ellen, when you look at the next decade, how do you estimate the need for new housing units in the United States and what happens if we fall short of these estimated targets? 

Ellen Zentner: Yeah, so we always like to say demographics makes the world go round and especially it makes the housing market go round. And we know that if you just look at demographic drivers in the U.S. Of those young millennials and Gen Z that are aging into their first time home buying years – whether they're able to immediately or at some point purchase a home – they will want to buy homes. And if they can't afford the homes, then they will want to maybe rent those single-family homes. 

But either way, if you're just looking at the sheer need for housing in any way, shape, or form that it comes, we're going to need about 18 million units to meet all of that demand through 2030. And so, when I'm talking with our clients on the wealth management side, it's – Okay, short term here or over the next couple of years, there is a housing cycle. And affordability is creating pressures there. 

But if we look out beyond that, there are opportunities because of the demographic drivers – single family rentals, multi-family. We think modular housing can be something big here, as well. All of those solutions that can help everyone get into a home that wants to be. 

James Egan: Now, you hit on something there that I think is really important, kind of the implications of affordability challenges. One of the things that we've been seeing is it's been driving a shift toward rentership over ownership. How does that specific trend affect economic multipliers and long-term wealth creation? 

Ellen Zentner: In terms of whether you're going to buy a single-family home or you're going to rent a single-family home, it tends to be more square footage and there's more spending that goes on with it. But, of course, then relatively speaking, if you're buying that single family home versus renting, you're also going to probably spend a lot more time and care on that home while you're there, which means more money into the economy. 

In terms of wealth creation, we'd love to get the single-family home ownership rate as high as possible. It's the key way that households build intergenerational wealth. And the average American, or the average household has four times the wealth in their home than they do in the stock market. And so that's why it's very important that we've always created wealth that way through housing; and we want people to own, and they want to own. And that's good news. 

James Egan: These affordability challenges. Another thing that you've been highlighting is that they've led to an internal migration trend. People moving from high cost to lower cost metro areas. How is this playing out and what are the economic consequences of this migration? 

Ellen Zentner: Well, I think, first of all, I think to the wonderful work that Mark Schmidt does on the Munis team at MS and Co. It matters a great deal, ownership rates in various regions because it can tell you something about the health of the metropolitan area where they are. 

Buying those homes and paying those property taxes. It can create imbalances across the U.S. where you've got excess supply maybe in some areas, but very tight housing supply in others. And eventually to balance that out, you might even have some people that, say, post-COVID or during COVID moved to some parts of the country that have now become very expensive. And so, they leave those places and then go back to either try another locale or back to the locale they had moved from. 

So, understanding those flows within the U.S. can help communities understand the needs of their community, the costs associated with filling those needs, and also associated revenues that might be coming in. 

So, Jim, I mentioned a couple of times here about single family renting, and so from your perch, given that growing number of single-family rentals, how is that going to influence housing strategy and pricing? 

James Egan: It is certainly another piece of the puzzle when we look at like single family home ownership, multi-unit rentership, multi-unit home ownership, and then single family rentership. Over the past 15 years, this has been the fastest growing way in which kind of U.S. households exist. And when we take a step back looking at the housing market more holistically – something you hit on earlier – supply has been low, and that's played a key role in keeping prices high and affordability under pressure. 

On top of that, credit availability has been constrained. It's one of the pillars that we use when evaluating home prices and housing activity that we do think gets overlooked. And so even if you can find a home to buy in these tight inventory environments, it's pretty difficult to qualify for a mortgage. Those lending standards have been tight, that's pushed the home ownership rate down to 65 percent. 

Now, it was a little bit lower than this, after the Great Financial Crisis, but prior to that point, this is the lowest that home ownership rates have been since 1995. And so, we do think that single family rentership, it becomes another outlet and will continue to be an important pillar for the U.S. housing market on a go forward basis. 

So, the economic implications of that, that you highlighted earlier, we think that's going to continue to be something that we're living with – pun only half intended – in the U.S. housing market. 

Ellen Zentner: Only half intended. But let me take you back to something that you said at the beginning of the podcast. And you talked about Gapen’s expectation for rate cuts and that that's going to bring fed funds rate down. Those are interest rates, though that don't impact mortgage rates. 

So how do mortgage rates price? And then, how do you see those persistently higher mortgage rates continuing to weigh on affordability. Or, I guess, really, what we all want to know is – when are mortgage rates going to get to a point where housing does become affordable again? 

James Egan: In our prior podcast, my Co-Head of Securitized Products Research, Jay Bacow and myself talked about how cutting fed funds wasn't necessarily sufficient to bring down mortgage rates. But the other piece of this is going to be how much lower do mortgage rates need to go? 

And one of the things we highlighted there, a data point that we do think is important. Mortgage rates have come down recently, right? Like we're at our lowest point of the year, but the effective rate on the outstanding market is still below 4.25 percent. Mortgage rates are still above 6.25 percent, so the market's 200 basis points out of the money. 

One of the things that we've been trying to do, looking at changes to affordability historically. What we think you really need to see a sustainable growth in housing activity is about a 10 percent improvement in affordability. How do we get there? It's about a 5.5 percent mortgage rate as opposed to the 6 1/8th to 6.25 where we were when we walked into this recording studio today.  We think there will be a little bit response to the move in mortgage rates we've already seen. Again, it's the lowest that rates have been this year, and there have been some… 

Ellen Zentner: Are those fence sitters; what we call fence sitters? People that say, ‘Oh gosh, it's coming down. Let me go ahead and jump in here.’ 

James Egan: Absolutely. We'll see some of that. And then from just other parts of the housing infrastructure, we'll see refinance rates pick up, right? 

Like there are borrowers who've seen originations over the course of the past couple years whose rates are higher than this. Morgan Stanley actually publishes a truly refinanceable index that measures what percentage of the housing market has at least a 25 basis point incentive to refinance. Housing market holistically after this move? 17 percent? Mortgages originated in the last two years, 61 percent of them have that incentive. So, I think you'll see a little bit more purchase activity. Again, we need to get to 5.5 percent for us to believe that will be sustainable. But you'll also see some refinance activity as well, right? 

Ellen Zentner: Right, it doesn't mean you get absolutely nothing and then all of a sudden the spigot opens when you get to 5.5 percent. 

Anecdotal evidence, I have a 2.7 percent 30-year mortgage and I've told my husband, I'm going to die in this apartment. I'm not moving anywhere. So, I'm part of the problem, Jim. 

James Egan: Well, congratulations to you on the mortgage… 

Ellen Zentner: Thank you. I wasn't trying to brag, But yes, it feels like, you know, your point on perspective folks that are younger buyers, you know, are looking at the prevailing mortgage rate right now and saying, ‘My gosh, that's really high.’ But some of us that have been around for a lot longer are saying, ‘Really, this is fine.’ But it's all relative speaking. 

James Egan: When you have over 60 percent of the mortgage market that has a rate below 4.5 percent, below 4 percent, yes, on a long-term basis, mortgage rates don't look particularly high. They're very high relative to the past 15 years, and to your point on a 2.7 percent mortgage rate, there's no incentive for you... Or there's limited incentive for you to sell that home, pay off that 2.7 percent mortgage rate, buy a new home at higher prices, at a much higher mortgage rate. That has – I know you don't like the word stuck – but it has been what's gotten this housing market kind of mired in its current situation. 

Price is very protective. Activity pretty low. 

Ellen Zentner: Jim, we've been talking about all the affordability issues and so let's set mortgage rates aside and talk about policy proposals. Are there specific policies that could also help on the affordability front? 

James Egan: So, there's a number of things that we get questions about on a pretty regular basis. Things like GSE reform, first time home buyer tax credits, things that could potentially spur supply. And look, the devil is in the details here. My colleague, Jay Bacow, has done a lot of work on GSE reform and what we're really focusing on there is the nature of the guarantee as well as the future of regulation and capital charges. 

For instance, U.S. banks own approximately one-third of the agency mortgage-backed securities market. Any changes to regulatory capital as a result of GSE reform, that could have implications for their demand, and that's going to have implications on mortgage rates, right? First time home buyer tax credits. We have seen those before – the spring of 2008 to 2010, and if we use that as a case study, we did see a temporary rise in home sales and a pause in the pace with which home prices were falling. 

But the effects there were temporary. Sales and prices wouldn't hit their post housing crisis lows until after those programs expired. 

Ellen Zentner: Right. So, you were incentivized to buy the house. You get the credit; you buy the house. But then unbeknownst to any economist out there, housing valuations continued to fall. 

James Egan: You could argue that it maybe pulled some demand forward. And so, you saw a lot of it concentrated and then the absence of that demand afterwards. And then on the supply side, there are a number of different programs we have touched on, some of them in these podcasts in the past. And then some of those questions become what needs to go through Congress, what is more kind of local municipality versus federal government. 

But look, the devil's in the details. It's an incredibly interesting housing market. Probably one that's going to be the source of many podcasts to come. 

So, Ellen, given all these challenges facing the U.S. housing market. Where do you see the biggest opportunities for retail investors? 

Ellen Zentner: So, in our recent note  Housing in the Next Decade, we took a look at single family renting; you and I have talked about how that's likely to still be in favor for some time. 

REITs with exposure to select U.S. rental markets; what about senior housing? That is something that you've done deep research on, as well. Senior and affordable housing providers, home construction and materials companies. 

What about building more sustainable homes with a good deal of the climate change that we're seeing. And financial technology firms that offer flexible financing solutions. 

So, these are some of the things that we think could be in play as we think about housing over the long term. 

James Egan: Ellen, thank you for all your insights. It's been a pleasure to have you on the podcast. And I guess there's a key takeaway for investors here. Housing isn't just about where we live, it's about where the economy is headed. 

Ellen Zentner: Exactly. Always a pleasure to be on the show. Thanks, Jim. 

James Egan: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.