Is the American Dream of Homeownership Still Within Reach?

Having a home has been essential to achieving the American Dream, yet various factors are hindering that aspiration for many. The main culprits: persistently elevated housing costs; high mortgage rates that increase with interest rates but don’t decrease similarly; a mortgage lock-in effect limiting the number of homes for sale and thereby elevating home prices; strict zoning regulations; and increased construction expenses. Attempts are underway to alleviate the supply limitations, but the most significant advantages will arise from controlling inflation.

Experts from the University of Pennsylvania Wharton School explored these topics at an event called “Real Estate, Interest Rates, and the Shifting American Dream” on December 4, 2024. The panel featured Joseph Gyourko, a Wharton professor specializing in real estate, finance, and business economics and public policy, alongside Susan M. Wachter, a Wharton professor in real estate and finance, as well as co-director of the Penn Institute for Urban Research. The event was moderated by Wharton real estate professor Maisy Wong. It was the third event in an innovative Wharton series titled “Policies That Work.”

Mortgage rates indicate the premiums that lenders and investors seek to offset the risks they encounter, including the inflation rate and anticipated inflation, fluctuations in interest rates, and a surge in prepayments if rates fall. In August 2024, the Federal Reserve initiated a reduction in the short-term Fed funds rate, with the most recent decrease placing it between 4.5% and 4.75%, yet the 30-year mortgage rate has remained around 7%. The Fed funds rate indicates the overnight interest rate banks charge one another to comply with reserve requirements. “Regardless of whether the Fed lowers short-term rates … you can anticipate mortgage rates around 6% to 7% for some time,” Gyourko stated.

Mortgage rates do not fluctuate in sync with the Fed funds rate as they are influenced by a different calculation. Investors providing funds for mortgages refer to the 10-year Treasury bond rate, currently at 4.28%, which already incorporates risks related to inflation and productivity growth.  However, they need to be paid for the extra risks introduced by the extended duration of a 30-year mortgage. These risks can move both ways: One is the danger of increased inflation, where borrowers retain lower mortgage rates and choose not to refinance, known as the mortgage lock-in effect.

“That’s precisely what we’ve observed in the current crisis,” stated Wachter. “Everyone retains their 4%, 5%, 3% mortgage, with supply diminishing, but the anticipated drop in rates that would alleviate supply heightens the risk for investors because of prepayments, which keeps the mortgage rate premia over the 10-year [Treasury] elevated.” If interest rates decrease, it is unfavorable for those investors, as it introduces a prepayment risk: Borrowers will refinance their homes at the newly lowered rates and pay off their previous, higher-cost mortgages.

“According to Wachter, in this unstable environment, we are currently facing mortgage rates between 6% and 7% for the time being, even though the Fed has lowered the funds rate by 25 basis points.”  Wachter observed that elevated mortgage rates are leading to a shortage of housing. Due to the mortgage lock-in effect, individuals are remaining in their residences. This has decreased the availability of homes on the market, consequently driving up home prices.

The decline in mobility due to the lock-in effect is significant, with Gyourko estimating that decrease to be around twenty-five to thirty-three percent. Gyourko observed that 80% to 90% of all home sales annually come from the existing inventory, so a 30% decrease in the proportion of current owners who relocate each year suggests that more than a quarter of the homes for sale are currently unavailable.

According to Wachter, newly constructed homes have quickly filled that void, and their proportion of overall sales has significantly risen to a record high. However, this new building alone is not enough to substantially alleviate the housing supply shortage. What exacerbates this issue in some supply-limited coastal cities like Boston, San Francisco, and Los Angeles is an almost complete halt on new housing development, due to stringent zoning and permitting regulations. In housing markets where permitting is less restrictive, new construction is boosting densification, and these homes — potentially including multi-story apartments and townhouses — are more expensive to construct.

The demand for housing is currently elevated, while the supply is limited. “Wachter noted, ‘Our demographics are giving us a boost; millennials are in their prime years for homeownership, and they are purchasing.'” However, she anticipated that this trend would shift in the coming ten years as the pent-up demand was satisfied. In initial indications of the upcoming shift, “we’re observing a decrease in demand for higher education currently … and looking ahead, we will witness this reflecting in a reduced demand for entry-level homes, but that pertains to the future and is not applicable to this cohort of new homebuyers,” she forecasted.

Gyourko referenced estimates from an engineering consulting company named RSMeans, indicating that a newly built, 1,800-square-foot house in the Atlanta suburbs had a construction cost of $250,000 in 2020, encompassing land and the developer’s profit; by 2023, the same house was priced at $302,000 — a rise of 21%, not accounting for inflation. According to him, the primary reason for that rise was due to “labor costs soaring,” rather than significantly due to land and material expenses.

Wachter noted that although the RSMeans estimate reflects the average cost, developers currently are optimizing production and charging at the marginal cost level, which exceeds the average cost. “She mentioned that the cost of a similar new home today is 50% higher than it was in 2019.”

To address the market demand, developers are creating more cost-effective housing by decreasing the home sizes and simplifying the finishes. Wachter stated, “For the first time, new home prices are not higher than those of existing homes, indicating that construction companies are aligning with market demand.” Homebuilders are reducing the size of houses and opting for smaller plots. Moreover, lately, margins have been decreasing, as builders encounter resistance from buyers regarding prices. “We are experiencing a 40-year low in affordability metrics, which is the reason the younger generation struggles to become homeowners.”

“Wong stated, ‘We continually believe that supply is a method that can assist us in enhancing affordability.'” Although stringent zoning regulations, mortgage lock-ins, and increased density restrict housing availability, several alternatives are beginning to appear. One trend involves prominent developers providing single-family rentals as an alternative to homeownership; it is significant that institutional owners like Invitation Homes and American Homes 4 Rent have ventured into a market segment historically dominated by small-scale operators, according to Gyourko.

Single-family rentals present a practical choice for young families with children seeking a home in a good school district but lacking the financial resources to purchase one. “Homeownership is traditionally linked to what we perceive as the American Dream,” stated Wong. “Yet individuals might prefer to reside where possibilities exist.” That is also an element of the American Dream. “Additionally, leasing can provide you with chances.”

Numerous states are trying out various approaches to boost housing availability. One option is to allow homeowners to construct what are known as “accessory dwelling units” in their backyards. California, New York, and Washington are some of the states that permit such building. “As Wachter mentioned, this is yet another method to own a home and earn money through rentals.” Gyourko noted that in an effort to alleviate supply issues, some states have started limiting local governments’ power to enforce strict zoning regulations. However, he emphasized that addressing the housing supply issue requires active government involvement backed by political support; market forces by themselves will not resolve the problem. “In the United States, there is no informal housing sector.” “Thus, permits are the point where this all begins,” he mentioned.

Construction technology is also contributing: Firms like Greystar are entering the modular construction of apartment complexes, providing advantages like enhanced productivity, minimized waste, and quicker time-to-market.