Wharton's Susan Wachter and Mark Zandi from Moody's discuss the impact of the 2017 Tax Cuts and Jobs Act on homeowners.

By this year end, U.S. home prices are likely to be 4% lower than what they could have been without the tax changes that took effect in 2018, according to Moody’s Analytics chief economist Mark Zandi. The 2017 Tax Cuts and Jobs Act placed a cap of $10,000 on federal deductions for state and local real estate and income taxes, and eliminated some mortgage interest deductions.

Those two tax changes and higher mortgage interest rates caused by higher federal budget deficits are responsible for lower home valuations, Zandi recently told ProPublica. The report calculated the “setback” in U.S. home values at $1.04 trillion on a base of $26.1 trillion, which was the total value of U.S. homes as of March 31, 2019.

Other factors that make it worse for the housing markets are slowing sales, slowing new construction and rising prices, especially for affordable homes. All of those could signal the next recession, according to Zandi and Susan M. Wachter, Wharton professor of real estate and finance. They discussed those trends and the outlook for the U.S. housing markets during a recent podcast with Knowledge at Wharton. (Listen to the podcast at the top of this page.)

Blow by Blow

The growth in house prices nationwide has fallen to about 3% from levels of 6%-7% before the tax bill’s provisions took effect, said Zandi. The impacts will be most significant in places where home prices and real estate taxes have been high, such as the Northeast Corridor, particularly around New York, the Philadelphia area, Washington, D.C., the Chicago area and California, he said. In fact, house price growth has slowed the most in those areas compared to the rest of the country where the effects of the tax law would be less significant, he added.

However, his estimates on what home prices would have been without the tax changes are based on assumptions that other factors stay constant. “We don’t know what the counterfactual is,” he said. “We don’t know what the world would have been without the tax cut [bill].” According to latest data, prices for luxury homes are down 1.6%, while those for non-luxury homes ($300,000 or under) are up about 2.6%, said Wachter, who is also co-director of the Penn Institute for Urban Research.

Of the estimated home-price damage to about 3,000 counties throughout the country, the biggest estimated value loss was in Essex County, NJ (11.3%), followed by Westchester County, NY, suburban New York City (11.1%); and Union County, NJ (11%), according to the ProPublica report. Zandi’s county-by-county list can be found in ProPublica’s Data Store.

Hugh Lamle, former president of M.D. Sass, a Wall Street investment management company, explained the math behind those estimate losses in valuation in the ProPublica report. Homebuyers would have typically figured out how much house they can afford by calculating how much they can spend on a down payment and monthly mortgage payment, adjusting the latter by the amount they’d save via the tax deduction for mortgage interest and real estate taxes, the report said. Lamle’s model figures out how much prices would have to drop for the same monthly payment to cover a given house now that this notional buyer can’t take advantage of the real estate tax deduction and might not be able to take full advantage of the mortgage interest deduction.

“For middle-income Americans who don’t own a lot of stock, and their house is the key asset that they own, the tax law was a negative.” –Mark Zandi

According to Zandi, “the most direct impact is through the scaling back of the deductions in the tax code that are intended to promote owning a home.” That, along with the lower mortgage interest deduction, made it relatively less attractive for many people to buy homes, thereby hurting overall demand for housing.

Prior to the Tax Cuts and Jobs Act, homeowners could deduct interest on up to $1 million of home acquisition debt or $500,000 for those with the tax status of “married filing separate,” a MarketWatch report explained. The tax bill lowered those eligible deductions to up to $750,000 of mortgage debt for individuals, and to $375,000 for those using the “married filing separate” status.

“When demand for housing weakens, that comes at a price,” said Zandi. The casualties were not just on home values, but “on the economy, jobs, interest rates, and everything else,” he added.

Wachter noted that “home ownership is declining a bit after it increased slightly.” She broke it down to specifics, and pointed to “continued pressure on prices” in the non-luxury segment, particularly the starter home bracket. Also, “millennials are still not buying,” she said. “First-time homebuyers now make up less than one-third — an all-time low, and down from more than half in earlier years. Even as mortgage rates are at historic lows, prices for affordable homes continue to rise faster than overall prices, and faster than wages and incomes, except for those at the top end of the market,” she added.

Affordability Concerns

“So, affordability is not easing up where it matters,” said Wachter. “This is a concern obviously for homeownership in the future. For the economy and for affordability it is a concern, [as it is] for families to get on that ladder of home ownership so that they can save and protect themselves against future rent rises, because rents are rising even faster.” Also looming on the horizon are fears of when the next recession might arrive. “Housing is clearly a bellwether for that,” she said. “If sales are slowing, that’s one more factor that may push us over to a recession.”

Zandi noted that during most of the economic expansion since the last recession a decade ago, the large, publicly traded builders had focused on the high end of the market, both in single-family homes and the apartment markets. However, as market conditions changed because of the tax law, they have had to switch gears and are now focused on the more affordable parts of the market, he said.

Builders have hitherto largely ignored the affordable rental market, but are now attracted to that segment, where rents and prices have risen on the back of severe shortages, he added. He noted that the market needs new construction of both affordable single-family homes and affordable rental units.

Even as builders are stepping up their activity in affordable segments, most of the demand for such housing is in urban areas, where they face difficulties in building because of stringent zoning and permitting issues, Zandi noted. “It’s a Catch 22 situation because rents are rising where the job market is — that’s where exactly people want to go to,” said Wachter. But high rents means that that aspiring first-time homeowners cannot save enough to meet their down payments, which further fuels demand for rental housing, and rent increases, in a cascading effect, she explained. “Historically, we haven’t seen rents increase so much for so long — and it’s likely to continue.”

Different Strokes

Zandi explained why the tax code changes hurt home values more in some markets such as in New York, New Jersey, Chicago and California than in others. Homeowners in some of those communities pay comparatively more in property taxes than elsewhere. “It’s one of the key ways those local governments fund themselves and provide the government services that they do to their residents,” he said. “[The tax act] goes beyond just the direct effect in terms of the deductions for housing. It goes to the impact on the finances of those state and local governments, and to the location decisions of businesses.”

“Historically, we haven’t seen rents increase so much for so long — and it’s likely to continue.” –Susan Wachter

The tax act also had the effect of increasing the federal budget deficit to cross the $1 trillion mark and put it on an upward trajectory as a share of the GDP. That caused interest rates to rise, although they have since declined, but one unexpected setback came with the trade war, which did “a lot of damage,” said Zandi.

The regions that are taking a bigger hit than others are those that are export-intensive, said Wachter. “For the first time, we’re seeing population declines in large markets like the New York City Metro area, Washington, D.C., and Los Angeles, which are also hit by trade declines, especially in service industries,” she added. “We see movement toward the more affordable Southern and Midwest markets. We’ll have to wait and see whether this is a long-term trend. But it’s a pretty stunning development.”

“The tax law effects have knocked the wind out of the Bay Area housing market, which is the poster child,” said Zandi. “House prices over the last year or two since the tax law change have weakened considerably, and have been declining more recently.” Added Wachter: “Prices are coming down, and in New York City and San Francisco, for some, they are for the first time affordable.”

The recently lower interest rates have helped lift housing activity, and home sales and new construction are starting to improve, Zandi said. However, it isn’t entirely clear if those trends will make way for home prices to increase.

A Slow Adjustment

According to Zandi, the housing markets will absorb the impact of the tax changes, and settle into a new normal. The tax changes are “like a one-time hit; it will mean a one-time adjustment,” he said. “The market will adjust to the new tax law. It may have a bit more to go, but we’re pretty close to the end of the process. And then, all the other things that matter to housing demand and supply, and house prices, will kind of kick into gear and will move forward.”

Not everybody lost out with the tax changes. The cut in corporate taxes benefitted investors, who saw their stock values rise as a result, Zandi noted. “The very wealthy who have large stock portfolios may say, ‘OK, I lost a little bit on my house, but I gained a lot from my stocks,’” he said. “But for middle-income Americans who don’t own a lot of stock, and their house is the key asset that they own, the tax law was a negative because they lost a lot more from the reduction in their housing value compared to what they gained in terms of rising stock values.”

Both Wachter and Zandi expected housing prices, affordable housing and demand for rental units to be issues in the presidential election campaigns. Zandi noted that Democratic candidate Elizabeth Warren’s proposal includes funding to help development of affordable homes in underserved areas, adding that other candidates, too, have “pretty good plans.”