Potential is defined as the latent ability for a thing to develop into something bigger in the future. Currently, the housing market is trying to find a new “post-pandemic norm” amid an environment of rising interest rates, record-high inflation, and home prices that seems to just never stop increasing.
First American Financial Corporation’s [1] newest report, the Potential Home Sales Model [2] covering June 2022, lays out their predictions on what the healthy market level of home sales should be based on economic, demographic, and housing market fundamentals.
According to the report, potential existing-home sales decreased to a 5.47 million seasonally adjusted annualized rate (SAAR), a 2.5% month-over-month decrease. This represents a 59.9% increase from the record potential low recorded in February 1993.
On an annual basis, market potential for existing-home sales decreased 13.1% year-over-year, a loss of 822,786 sales.
Currently, potential existing-home sales is 1,320,000, or 19.4% below the pre-recession peak of market potential, which occurred April 2006.
“The market potential for existing-home sales in June was estimated to be 5.47 million at a seasonally adjusted annualized rate (SAAR), down 2.5% compared to last month, and 13.1% lower than one year ago, which is near the same level as in early 2019,” said Mark Fleming [3], First American’s Chief Economist. “While housing market potential remains strong from a historical perspective, it is down from pandemic highs. To understand why, one must look at how the fundamentals that drive the potential for existing-home sales have changed since June of last year. We can also examine what those changes mean for housing market potential in the near future.
“Compared with June 2021, the market potential for existing-home sales has decreased by approximately 823,000 sales,” Fleming continued. “Based on a dynamic simulation using our Potential Home Sales Model, we can identify the fundamentals influencing potential existing-home sales today relative to a year ago and segment them by the fundamentals that are reducing or boosting housing market potential.”
Fleming also gave brief insights some market conditions that are affecting potential home sales numbers in negative and positive ways:
Fundamentals Reducing Housing Market Potential
Declining House-Buying Power: “House-buying power is how much home one can afford to buy given household income and the prevailing 30-year, fixed mortgage rate. Mortgage rates in June were 2.5 percentage points higher than they were a year ago. Holding household income constant at its June 2021 level, the increase in mortgage rates reduced house-buying power by $123,500,” said Fleming. “A 4.4% annual increase in household income helped to mitigate some of the impact of rising rates on affordability. Once accounting for the rise in household income, house-buying power fell by $108,000 since June 2021. The overall decline in house-buying power reduced housing market potential by 522,000 potential home sales.”
Tighter Credit Standards: “When lending standards are tight, it becomes more difficult to qualify for a mortgage to buy a home. Likewise, when standards are loose, it’s easier to get a mortgage and buy a home. When home buyers are less likely to receive mortgages for a new home, they are also less likely to purchase a home,” said Fleming. “Credit standards tightened in recent months due to increasing economic uncertainty and monetary policy tightening. Compared with a year ago, credit tightening reduced housing market potential by 458,000 potential home sales.”
Increasing Tenure: “According to the most recent data from June 2022, tenure length has increased from 10.4 years to 10.6 years compared with a year ago. The main reason? Low mortgage rates discourage existing homeowners from selling because there is no increased house-buying power other than that which comes from household income growth,” said Fleming. “Homeowners staying put reduced market potential by 80,000 potential home sales compared with one year ago.”
Fundamentals Boosting Housing Market Potential
Rising House Prices: “As a homeowner gains equity in their home, they are more likely to consider using the equity to purchase a larger or more attractive home. However, if equity is low, homeowners are likely to remain ‘equity locked-in’ to their home,” said Fleming. “Compared with one year ago, house price appreciation increased housing market potential by nearly 193,000 potential home sales. This may be particularly important in an environment where house price growth is beginning to moderate, as sellers may be tempted to jump into the market to capture the higher sale price, yet these potential sellers must also contend with a rising interest rate environment.”
Rising Household Formation: “The more households formed, the higher the demand for homes. The growth in household formation contributed to 43,000 potential home sales in June compared with one year ago,” said Fleming.
More New-Home Supply: “The lack of supply and the fear of not being able to find something to buy keeps many existing homeowners from selling. As homebuilders bring more new homes to the market, the risk of not being able to find something to buy lessens and homeowners’ confidence in the decision to sell their existing home grows,” said Fleming. “Compared with last year, more new-home supply is entering the market, increasing housing market potential by 1,400 potential home sales.”
Finally, Fleming posed and answered the question on how the housing market has fared over the last year, stating that most of the recent highs recorded for potential sales and other metrics were probably the exception, and not the norm.
“Relative to last year, the reduction in demand stemming from falling house-buying power, tighter credit, and homeowners staying put resulted in a significant decline in the market potential for existing-home sales. Yet, despite these headwinds, market potential is currently near early 2019 levels,” Fleming concluded. “Households are continually forming and increasing demand for shelter, existing homeowners have record levels of home equity, and the fear of not being able to find something to buy is easing. As the housing market adjusts to a post-pandemic norm with higher mortgage rates, housing market potential will subside from recent highs, but those highs were the exception and not the norm.”