“We think we are poised for an improvement in affordability that we have only seen a handful of times over the past ~35 years,” the strategists, led by Jay Bacow and James Egan, wrote in the note. 

This requires a big “to be sure,” since the investment bank is still forecasting only a 3% drop in nationwide home prices through next year. The combination of other factors is crucial, though. 

Morgan Stanley’s strategists see relief primarily coming from inventory, which has been tight in recent months, to say the least, and from mortgage rates. They see mortgage rates coming down throughout next year, and with that, they “expect affordability to improve and for-sale inventory to increase.”

In other words, as mortgage rates drop, new-home sales and existing-home sales should increase, and single-unit starts should trend higher. Also, home prices should fall slightly next year as the “growth in inventory offsets the increased demand.” But home prices will fall even more in real terms as mortgage rates come down.

It’s important to note that while they expect new-home sales to continue to outperform existing-home sales, the general increase in sales will drive housing starts. Their forecast is that single-unit housing starts will climb by roughly 10% next year. 

In terms of home prices, that’s not a sizable correction, in their words, so homeowners will continue to hold the power in the market, but it could provide some relief. It’s clearly better for would-be buyers than if home prices were to rise, but also indicative of a larger push-and-pull between homeowners (who may or may not have bought at the perfect time) and priced-out buyers. 

“Herculean or devastating”

“As we sit atop our year-ahead outlook perch, the evolution of the U.S. housing market has been Herculean or devastating depending on where you look,” the strategists wrote. For one, home prices are yet again at a record high, up 6% since the end of last year, they said. At the same time, sales volume has fallen tremendously: Existing-home sales are down 21% in the first nine months of this year versus last year; new-home sales are up 5%, but total transaction volumes are at their lowest level in more than a decade, as of the first three quarters of this year, according to the note. Until then, affordability largely depends on mortgage rates.

“With the volatility in mortgage rates, affordability has recently threatened to resume deteriorating at a record pace…or start to show improvement from historically pressured levels depending on the week,” they wrote. 

After reaching slightly above 8%, mortgage rates have been falling for weeks as inflation cools, signaling a potential end to the Federal Reserve’s interest rate hikes (some even expect to cut rates in the coming months). But Morgan Stanley strategists said “that under any realistic mortgage rate regime in the near term, affordability in absolute terms is going to remain very stretched.” And if mortgage rates hit 8% again, then the rate of deterioration in affordability would be around the worst seen in three decades, they added.

Interestingly enough, the immediate response to the volatility in mortgage rates has been a decrease in supply. But if mortgage rates continue to trend lower, which analysts expect, then the likelihood of homeowners putting up their homes for sale (as the lock-in effect fades) will increase. That’s why they don’t expect to see substantial declines in inventory next year. 

“We think the path of least resistance is a slight increase in the number of homes available for sale,” they wrote. As mentioned above, strategists expect a roughly 10% increase in single-unit starts next year—particularly as new-home sales increase. All of this, in their view, equates to a modest decline in home prices next year. 

Lastly, without giving an exact forecast, the Morgan Stanley strategists said they expect 2025 home prices to “outperform” their 2024 projection. 

But here’s where they say they could go wrong in their forecast for next year: For one, someone who’s seen mortgage rates above 8% might eagerly lock in a 7% or so rate “in far greater numbers” than Morgan Stanley’s strategists expected. That demand on top of constrained supply could push home prices up 5% next year, which would be another record high, they said.  

Then again, if mortgage rates stay high and the economic climate becomes more dire in the case of a recession, demand could soften, they wrote. Increased supply coupled with weakened demand could drive home prices down. “Our bear case for a decline in home prices in 2024 is -8%,” the strategists wrote.