House prices should be rising twice as fast as they are now

House prices are getting out of control, but it could be a lot worse.

While that may be of little comfort to prospective homebuyers in bidding wars for their dream home, Capital Economics’ Matthew Pointon laid out the facts in a note Thursday.

To recap what we’ve called the ‘next housing crisis‘: housing inventory is tight, especially in the more affordable end of the market. Meanwhile, buyer demand is strong.

And this combination is ramping up prices.

“Given low inventory levels, experience suggests that house prices should be rising at double their current rate of around 5% y/y,” Pointon wrote.

The balance between housing demand and supply is a good indicator of future prices, and it leads price inflation by about four months. And right now, the indicator shows that there’s less than five months of supply on the market, a measure usually associated with about 10% year-on-year price growth, Pointon said.

So why is this happening?

Examining the new homes market provides clues, as opposed to looking at the overall market that includes more-plentiful existing home sales.

Pointon wrote:

We suspect that builders play a greater role in influencing prices at times when the supply of existing homes is constrained. That is because builders need to generate cash flow. Sitting on an empty home is a cost, so they are more willing to make a deal with buyers than existing home owners. That limits the extent to which sellers of existing homes can up their asking prices even with their product in short supply.

In any event, if new home sales are the better indicator, house price growth is only likely to accelerate to around 6% y/y, in line with our forecast.

In other words, new-home builders have a greater urgency to sell and more leeway to stop negotiating at a lower price point.

Conversely, existing-home owners are focused on getting the best deal, sometimes to gather funds for a better house. And sitting on their existing homes is an asset, not a cost.

But as long as builders have more influence on price, housing inflation — as high as it is — can be tamed.

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