Most analysts agree that the austerity measures scheduled to take place at the end of the year if Congress and the White House fail to reach a budget agreement for 2013 would plunge the U.S. economy back into recession. Economists predict a drop in gross domestic product (GDP) of up to 5%, while economic growth has been limping along at 2% for the last several years. That is terrible news for a housing sector that has only just begun to see recovery this year.
The fiscal cliff’s measures include tax hikes, automatic spending cuts and the expiration of the Bush-era tax cuts. Among the tax increases is the removal of the mortgage interest deduction, which is the largest real estate-related tax deduction for most taxpayers and one that makes real estate a particularly attractive investment. Even if Washington agrees to a budget and avoids the fiscal cliff, the mortgage interest deduction may remain on the chopping block in a compromise deal, or may be drastically reduced. Among the possibilities being discussed is only allowing it to be taken for primary residences, which would eliminate the deduction for rental properties and skyrocket tax liability for landlords.
Some analysts have looked to the United Kingdom and how their economy has weathered the reduced government spending and tax increases that were implemented in early 2010. Since then, the unemployment rate has risen, lending has slowed, and credit quality has declined. In the U.S., this sounds awfully familiar, after the credit crunch that made borrowing money so difficult in the years following the Great Recession. Regardless of how low interest rates are, if banks are unable or unwilling to lend money then fewer homebuyers and real estate investors will be able to buy, which means lower demand and thus lower values.
And a potential credit crunch is far from the only familiar feature that would re-emerge in a second recession. Higher taxes (including an expiration of the payroll tax break) would mean less money for individuals to pay bills, less money for companies to hire, and a sudden spike in payroll tax liability for employers (a recipe for layoffs). Mass spending cuts would mean $109 billion/year in government employee layoffs and cuts in government contracts to private employers. In other words, thousands of people would lose their jobs, and those that did keep their jobs would take home less money. Higher unemployment and lower take-home income would mean more defaults on rent and mortgages, which means a second foreclosure crisis, which in turn will drive down values and further prevent banks from lending. Higher rent defaults means more evictions, more turnovers and higher vacancy rates, all of which are terrible news for landlords and property managers (not to mention the displaced tenants).
A less obvious effect that high unemployment and lower take-home incomes would have on the housing sector is another round of household “bundling,” in a housing sector that has just begun unbundling from the last recession. The bundling effect occurs when adults who would ordinarily live independently decide to share a household with others, which can be seen when young professionals live with roommates instead of living alone, or when couples move in together sooner than they would otherwise, or when recent graduates move back in with their parents (or fail to move out in the first place). According to National Association of Realtors’ spokesman Walter Molony, "Household formation in the US in the past four years has been half of what it should be," for a population growing at roughly three million people each year. The household formation rate has been growing closer to normal in 2012, a trend that would quickly reverse given higher unemployment and hefty tax hikes. Household bundling is a primary reason that the housing sector lagged so far behind other sectors’ growth over the last few years: with more people sharing one roof, there is far less demand for housing units.
So what are the likely scenarios for how the budget negotiations will play out? A deadlock is one possibility, sending the U.S. over the fiscal cliff, but both Congress and the White House claim they want to avoid this outcome. On the other extreme of the spectrum, Democrats and Republicans could theoretically map out a long-term roadmap to balancing the budget, offering businesses and investors a predictable and stable economic environment in which to make long-term investments. Both of these extremes are considered unlikely by most analysts, leaving the most likely outcome a short-term resolution that will solve few problems other than immediate avoidance of the fiscal cliff. This could take the form of either postponing the budget decision until new members of Congress are inaugurated in early 2013, or a minor set of compromises that will get the federal budget through another year but fail to address the unsustainable growth in public sector spending relative to GDP.
In other words, Washington will likely pass the buck along to next year, and no substantive change will be made to avoid the kind of budget imbalance that landed Europe in its present economic turmoil.