Tax Reform and Housing

January 17, 2018

Economics Group Special Commentary

Mark Vitner, Senior Economist mark.vitner@wellsfargo.com â—? (704) 410-3277

Tax Reform and Housing New limitations on housing-related deductions raise several questions Home sales and new home construction strengthened over the past few months, with nearly every housing indicator ending 2017 on a positive note. In addition to widespread optimism within the industry, new and existing home sales and median home values ended the year well above their average levels for 2017, which means housing has strong momentum going into the New Year. The recently enacted Tax Cuts and Jobs Act should support continued improvement in the broader economy and will benefit the housing market. On net, we have slightly raised our 2018 forecast.

While the new tax is likely to be a net positive for 2018 economic growth, there are several provisions within the new law that may create some challenges for housing. New limitations on several housing-related deductions will remove or reduce some of the tax incentives for homeownership. This should reduce demand for owner-occupied housing from what it otherwise would be, which in turn would slow the improvement in home sales and price appreciation.

Stronger economic growth will more than offset these effects, however, leaving housing better off than was earlier projected.

The new tax is likely to be a net positive for 2018 economic growth.

The provisions of the new tax law impacting housing the most include the lowering of the mortgage interest deduction to $750,000 from $1 million, capping the deduction for state and local taxes, including property taxes, at $10,000, and doubling the standard deduction for joint-filers to $24,000 from $12,000 and to $12,700 from $6,325 for single filers. The new tax law also eliminates the deduction of interest on home equity loans, which was previously capped at $100,000. One significant potential offset is the lower corporate tax rate, which fell from 35 percent to 21 percent. The lower tax rate will benefit large homebuilders most. The boost to profit margins should increase construction of mid-priced and lower-priced homes, both of which remain exceptionally scarce.

Figure 2

Figure 1

Existing Home Sales

New Home Sales vs. NAHB Wells Fargo Index Thousands of Units, SAAR, Index

1,650

110

New Home Sales: Nov @ 733K (Left Axis) NAHB Wells Fargo Index: Jan @ 72.0 (Right Axis)

Seasonally Adjusted Annual Rate, In Millions

7.5

7.5

Existing Home Sales: Nov @ 5.81M

100

7.0

7.0

1,350

90

6.5

6.5

1,200

80

6.0

6.0

1,050

70

5.5

5.5

900

60

750

50

5.0

5.0

600

40

4.5

4.5

450

30

4.0

4.0

300

20

3.5

3.5

150

10

1,500

0

0

90

92

94

96

98

00

02

04

06

08

10

12

14

16

18

3.0

3.0 04

05

06

07

08

09

10

11

12

Source: U.S. Department of Commerce, NAHB, and National Association of Realtors

This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

13

14

15

16

17

With a lower tax rate these firms will be betterabled to build lower-priced homes.

Tax Reform and Housing January 17, 2018

WELLS FARGO SECURITIES ECONOMICS GROUP

Rethinking Homeownership?

We have long contended that people do not buy a home for a tax deduction, but tax considerations do influence when they buy a home, where they buy it and how much home they buy. Of all the changes to the tax code that directly affect housing, the reduction in the cap on the mortgage interest deduction is the most prominent. The previous law had allowed interest on up to $1 million of mortgage debt to be deductible. The new law lowers that cap to $750,000, although homes purchased before Dec. 15, 2017 are grandfathered in and the prior $1 million cap still applies. The new law also applies to total mortgage debt, meaning only the combined interest from primary and secondary homes can be deducted. Homes priced in the $750,000-$1.5 million range will be most affected by these changes. Interest on mortgages priced below that level would still be deductible, while many homeowners with homes priced above that range previously saw the benefit of the mortgage interest deduction reduced or eliminated by the Alternative Minimum Tax. The reduction in the cap on the mortgage interest deduction has received the most attention.

The new law also removes the ability of homeowners to deduct interest on home equity debt. Home equity loans are typically used for major repair and remodel projects and the previous tax law allowed a deduction for interest on up to $100,000 on these lines of credit. The effect of this change will likely be minimal, since homeowners undergo these projects either out of necessity, life cycle changes, or because they believe their home values have appreciated enough to justify investing more into their home. The ability to deduct the interest on these home equity loans was not likely the deciding factor to spend on renovations, but might have encouraged homeowners to spend more on home improvements. The more critical factor for home improvement spending is home price appreciation and anticipated future appreciation, which remains buoyant at this time.

The state and local tax deduction, which includes property taxes, will now be capped at $10,000. The new limitation will affect homeowners in many high priced regions that have relatively high income and property taxes and may spur homeowners to relocate to lower tax areas.

In some cases, this may simply involve a move from higher-priced urban areas to lower-priced suburban areas. In other cases, this may trigger a relocation to a lower cost state. This had been the norm for much of the post-war period but not so much in the current cycle. Several high-tax states and metro areas will likely be disproportionately affected, particularly in the Northeast and California. Residents of these regions not only tend to have higher home values, but also typically face higher-than-average tax rates. We believe these changes alone will not prompt businesses and individuals to relocate to lower-tax states, but they may prod folks already contemplating relocating to go ahead and make such a move. The results may be substantial but will not happen at all once.

The effects of tax reform will also be felt at the local level, as homeownership near higher-valued and higher-taxed center city areas will now be relatively more expensive compared to lower-priced suburban areas. The trade-off between access to the amenities of urban areas and their higher costs will need to be reassessed. This may induce those that had previously been using the local tax deduction to offset these higher costs to relocate to lower-priced housing in suburban areas. This shift was already underway, however, as higher home prices and rising rents in most of the nation’s fastest growing large cities had already set off an affordability migration to the suburbs. Changes in the tax law will likely intensify this shift but urban areas are still likely to hold onto a larger proportion of residents than in past decades due to shifts in technology and demographics.

This will remove some of the imperative for younger households to switch from renting to purchasing their first home.

2

With standard deduction for married couples doubled to $24,000, many potential home buyers will receive no additional tax benefit from buying a home. While the interest would still be tax deductible they would be better off taking the standard deduction. As a result many younger households will see homeownership as less essential from a financial standpoint. Homeownership among younger cohorts had already been lagging, however, as younger persons have taken much longer to form households than prior generations. Millennials came of age shortly after the Great Recession and many were saddled with student loan debt and entered a relatively weak labor market, with wages and salaries rising only modestly. With the leading edge of the Millennials now in their late thirties, household formation and homeownership have been increasing however, and there was an expectation that this would continue. We doubt the doubling of the standard deduction alone will reverse this trend but a larger proportion of Millennials may now rent for even longer than they would have otherwise, particularly given the rise in rental options.

Tax Reform and Housing January 17, 2018

WELLS FARGO SECURITIES ECONOMICS GROUP

With the corporate tax rate being lowered to 21 percent from 35 percent, the large national homebuilders should be more profitable. The boost to profit margins is a timely offset to builders that have been dealing with rising material, labor, and land costs. The prior squeeze on margins had encouraged builders to focus more on higher-end homes and in-fill projects, which also typically did not face large entitlement mandates. Tract development largely fell out of favor, as the profit margin on entry level homes were too small to compensate builders for higher building costs and greater difficulty bringing new lots into production. Moreover, lengthening commute times boosted demand for homes closer in to major cities or close to key employment centers.

Homebuilders changed their models to fit this new paradigm, focusing more on teardowns, where there are little or no entitlement costs, or smaller in-fill projects rather than new tract development.

The focus on higher priced single-family housing was accompanied by a surge in urban apartment development, most of which was high-end luxury product. Demand for entry level homes has been slow to materialize. Household formations have also been lagging, as Millennials have generally delayed marriage and having children. In addition, fewer younger households have been in a financial position to buy a home. These circumstances have been changing more recently, however.

Millennials now comprise the largest cohort of first-time buyers. Still, the supply of homes available to first-time buyers has been severely limited, with inventories of both new and existing homes remaining near historic lows. Inventories of homes priced at or below the median are practically nonexistent in many metro areas. The new tax law should shift the paradigm back to where it was previously. Lower corporate tax rates will make homebuilding more profitable, particularly at lower and middle price points dominated by the large national homebuilders. Many of the more active markets should be in the South, including Dallas, Houston, Atlanta, and Orlando, where the large builders have lots of land available for tract development. The West should also see more development, particularly California, Arizona, Nevada and Utah.

The supply of homes available to first-time buyers has been severely limited.

The new tax law should help change this.

We have slightly boosted our 2018 outlook. We now see real GDP rising 2.8 percent, up from 2.2 percent in 2017. Business fixed investment will be the notable standout this year, with equipment purchases rising much more solidly. The strength in business investment should broaden economic gains and lift many areas of the country that had seen only modest gains since the last recession.

We are now looking for a 10.6 percent increase in new home sales this year. While a double-digit percentage rise is unusual this late into a business cycle, the gain comes off still-depressed levels and reflects increased construction this past year. That momentum should carry over into 2018.

Single-family starts are expected to rise 11.2 percent in 2018 to 940,000 units. Existing home sales should rise 2.4 percent, with the bulk of that gain coming in the South and West. Prices will continue to outpace incomes, which will pull affordability lower. We have also raised our estimate for multi-family construction. The doubling of the standard deduction will likely reduce some of the imperative for renters to become homeowners, bolstering demand for apartments.

Figure 3

Figure 4 Home Prices 25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%

-5%

-5%

-10%

-10%

-15%

-15%

-30% 97

99

01

03

05

07

09

11

2.1

2.4

Multifamily Starts Multifamily Forecast Single-Family Starts Single-Family Forecast

2.1

1.8

1.8 Forecast

1.5

1.5

1.2

1.2

0.9

0.9

0.6

0.6

0.3

0.3

-20%

Median Sale Price: Nov @ $248,800 Median Sale Price, 3-M Mov Avg: Nov @ 5.2% FHFA Purchase Only Index: Oct @ 6.6% S&P/Case-Shiller Composite-10: Oct @ 6.0%

-25%

Millions of Units

2.4

Thousands

Housing Starts

Year-over-Year Percentage Change

25%

-20%

We have slightly boosted our 2018 outlook for the economy and the housing market.

-25% -30% 13

15

17

0.0

0.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20

Source: National Association of Realtors, Case-Shiller and Wells Fargo Securities

3

4 608.8 430.5 178.3

1.6 0.5 174 8.9 780.6 535.3 245.3

2.2 13.5 179 8.1

2012 2.6 3.5 250 6.2

2014

924.9 1,003.3 617.7 647.9 307.2 355.4

1.7 11.9 192 7.4

2013

0.25 3.25 3.22 4.69

221.8 2.4 172.9 0.2 -3.0 2.1 0.25 3.25 2.78 4.46

227.2 2.4 166.1 -3.9 -4.1 -3.5 0.25 3.25 1.80 3.66

245.2 7.9 176.8 6.4 3.0 0.3

0.25 3.25 2.35 3.98

268.9 9.7 197.1 11.5 7.2 11.7

0.25 3.25 2.54 4.17

288.5 7.3 208.3 5.7 5.2 7.9

322.0 305.0 369.0 429.0 437.0 4,190.0 4,260.0 4,660.0 5,090.0 4,940.0 3,708.0 3,787.0 4,128.0 4,484.0 4,344.0 474.0 477.0 528.0 603.0 591.0

586.9 471.1 115.8

2.5 -2.5 88 9.6

2011

0.27 3.27 2.14 3.85

294.2 2.0 222.4 6.8 5.5 4.6

501.0 5,250.0 4,646.0 608.0

1,111.8 714.5 397.3

2.9 10.2 226 5.3

2015

Source: U.S. Dept. of C ommerce, U.S. Dept. of Labor, FRB, FHFA, FHLMC , National Association of Realtors, S&P, Wells Fargo Securities

Forecast as of: January 16, 2018

Interest Rates - Annual Averages Federal Funds Target Rate Prime Rate 10-Year Treasury Note Conventional 30-Year Fixed Rate, Commitment Rate

Home Prices Median New Home, $ Thousands Percent Change Median Existing Home, $ Thousands Percent Change FHFA Purchase Only Index, Percent Change S&P Case-Shiller C-10 Home Price Index, Percent Change

Home Sales New Home Sales, Single-Family, in Thousands Total Existing Home Sales, in Thousands Existing Single-Family Home Sales, in Thousands Existing Condominium & Co-op, in Thousands

Home Construction Total Housing Starts, in Thousands Single-Family Starts, in Thousands Multifamily Starts, in Thousands

Real GDP, Percent Change Residential Investment, Percent Change Nonfarm Payroll Change (Avg. Monthly) Unemployment Rate

2010

National Housing Outlook

0.52 3.52 1.84 3.65

307.8 4.6 233.8 5.1 6.1 4.5

561.0 5,450.0 4,838.0 614.0

1,173.7 781.5 392.2

1.5 5.5 187 4.9

2016

1.25 4.25 2.33 3.99

319.0 3.6 247.8 6.0 6.6 5.5

615.0 5,535.0 4,910.0 625.0

1210.0 845.0 365.0

2.2 1.6 171 4.4

2017

2.06 5.06 2.74 4.15

330.5 3.6 261.7 5.6 6.1 5.2

680.0 5,670.0 5,030.0 640.0

1,310.0 940.0 370.0

2.8 5.5 163 4.0

Forecast 2018

2.63 5.63 3.16 4.56

342.0 3.5 275.3 5.2 5.9 5.1

740.0 5,860.0 5,210.0 650.0

1,370.0 1025.0 375.0

2.7 7.3 148 3.8

2019

Tax Reform and Housing January 17, 2018 WELLS FARGO SECURITIES ECONOMICS GROUP

Wells Fargo Securities Economics Group Diane Schumaker-Krieg

Global Head of Research, Economics & Strategy

(704) 410-1801 (212) 214-5070

diane.schumaker@wellsfargo.com

John E. Silvia, Ph.D.

Chief Economist

(704) 410-3275

john.silvia@wellsfargo.com

Mark Vitner

Senior Economist

(704) 410-3277

mark.vitner@wellsfargo.com

Jay H. Bryson, Ph.D.

Global Economist

(704) 410-3274

jay.bryson@wellsfargo.com

Sam Bullard

Senior Economist

(704) 410-3280

sam.bullard@wellsfargo.com

Nick Bennenbroek

Currency Strategist

(212) 214-5636

nicholas.bennenbroek@wellsfargo.com

Eugenio J. Alemán, Ph.D.

Senior Economist

(704) 410-3273

eugenio.j.aleman@wellsfargo.com

Azhar Iqbal

Econometrician

(704) 410-3270

azhar.iqbal@wellsfargo.com

Tim Quinlan

Senior Economist

(704) 410-3283

tim.quinlan@wellsfargo.com

Eric Viloria, CFA

Currency Strategist

(212) 214-5637

eric.viloria@wellsfargo.com

Sarah House

Economist

(704) 410-3282

sarah.house@wellsfargo.com

Michael A. Brown

Economist

(704) 410-3278

michael.a.brown@wellsfargo.com

Jamie Feik

Economist

(704) 410-3291

jamie.feik@wellsfargo.com

Erik Nelson

Currency Strategist

(212) 214-5652

erik.f.nelson@wellsfargo.com

Michael Pugliese

Economic Analyst

(704) 410-3156

michael.d.pugliese@wellsfargo.com

Harry Pershing

Economic Analyst

(704) 410-3034

harry.pershing@wellsfargo.com

Hank Carmichael

Economic Analyst

(704) 410-3059

john.h.carmichael@wellsfargo.com

Ariana Vaisey

Economic Analyst

(704) 410-1309

ariana.b.vaisey@wellsfargo.com

Abigail Kinnaman

Economic Analyst

(704) 410-1570

abigail.kinnaman@wellsfargo.com

Shannon Seery

Economic Analyst

(704) 410-1681

shannon.seery@wellsfargo.com

Donna LaFleur

Executive Assistant

(704) 410-3279

donna.lafleur@wellsfargo.com

Dawne Howes

Administrative Assistant

(704) 410-3272

dawne.howes@wellsfargo.com

Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Clearing Services, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication.

Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC’s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company © 2018 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority’s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only.

SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE