Home prices are dropping. That doesn’t mean buyers can afford them.

In recent months, Ja’Marquis Perkins has watched house prices come down to earth. As a real estate agent in Tuscaloosa, Alabama, he’s begun advising buyers to look for deals where they might once have faced bidding wars. He recently helped a first-time buyer close on a two-bedroom house for $185,000, which was below the listing price. “It’s definitely starting to slow down. Homes are going for less than what owners had asked,” he says. 

As goes Tuscaloosa, so goes the nation. 

A red-hot U.S. property market juiced by rock-bottom mortgage rates is finally cooling as the Fed raises interest rates to curb inflation. Most cities are seeing fewer sales and flat or falling house prices as higher borrowing costs bite. In July, month-on-month average sales prices fell for the first time since January 2019, according to a national home-price index.

The sharpest falls are in cities like Seattle, Boise, and Los Angeles that had seen some of the biggest run-ups in prices, says Skylar Olsen, chief economist at Zillow, an online real estate platform. Not all markets are swooning; buying has been strong in Florida, hurricane damage notwithstanding. But the overall trend is clear: House prices have peaked. 

“This is a cooldown. Sales are pulling back. Prices are pulling back. But supply is also pulling back,” says Ms. Olsen. 

What would it take to make homes affordable?

For middle-class Americans trying to buy their first home, or move up the property ladder, this pullback offers little comfort. House prices are going down but mortgage rates are way up, putting ownership, or a move, out of reach for many. By the yardstick of how much it costs households monthly to own an average house, housing remains unaffordable in most cities. And that puts a chill on the aspirations of younger Americans in particular to own homes and build wealth as their parents did. 

Take Greater Boston. In April, the median house cost around $660,000. To afford such a house would require a household income of over $180,000, according to calculations by the Joint Center for Housing Studies at Harvard University. That house might fetch less today, but higher borrowing costs would more than erase any nominal savings. Similarly, the average homebuyer in Los Angeles would need to earn $262,000 to buy the median house there.  

Even Sun Belt cities, where land is cheaper and new houses more plentiful, aren’t immune to price inflation. In the Atlanta region, the average house costs $376,000, calling for a minimum income of $103,000. In 2020, the median household income in Atlanta was $64,179. 

How far would house prices need to fall to put them within reach of more Americans? Much depends, say analysts, on the strength of the overall economy, employment, and wage growth, as well as the trajectory of interest rates. If nominal house prices keep declining and inflation-adjusted wages go up, housing eventually becomes more affordable.

Edward Pinto, a former executive at Fannie Mae, estimates that U.S. house prices could fall by 10% on average through the end of 2023. That’s still far less than the nearly 40% rise since the start of the pandemic in early 2020.

Such a modest correction in prices doesn’t bode well for aspiring homeowners, says Mr. Pinto, who directs the AEI House Center at the American Enterprise Institute, a right-leaning think tank in Washington. “The problem with affordability for first-time buyers is still going to be with us,” he says. 

Housing is considered affordable if total costs – rent or mortgage, plus taxes, insurance and utilities – are no more than 30% of gross income. While rents fell in many cities in 2020 amid pandemic shutdowns, they have since risen on the back of the buoyant real estate market and are likely to remain elevated, underpinned by demand from younger renters who have been unable to afford their first home. High rents relative to incomes are another dampener on homeownership, since it makes it harder for renters to save for a down payment. 

In Colorado, where house prices rose rapidly during the pandemic, driven in part by work-from-home movers, the Colorado Futures Center applied a benchmark of 2015 to calculate how far average home prices would need to fall to become affordable. The study found that to restore the income-to-housing ratio of 2015, before the run-up in prices, it would take a statewide decline of 32%, which it noted would cause “considerable pain” to homeowners. 

Of course, a rapid fall in house prices brings its own risks. The bursting of a debt-fueled real estate bubble in 2007 ended in a global financial crisis that wiped out billions of dollars in household wealth. Few expect a repeat this time because of tighter mortgage standards and less-leveraged lenders. Another big difference, say analysts, is no supply overhang of new and half-built houses in speculative real estate markets in states like Florida and Nevada.  

A dearth of starter homes

In fact, the opposite is true: New-home construction has failed to keep up with rising demand, particularly for modest-size homes for first-time buyers. In 2021, the financing agency Freddie Mac estimated the overall shortfall at 3.8 million units, based on a population of 126 million households. It noted that completions of starter homes of 1,400 square feet or less had fallen to 65,000 a year, compared with over 200,000 in the 1990s. 

This shift has been driven by land-use regulations, including zoning for single-family homes, along with growing neighborhood resistance to greater density. As land costs rise, developers are less likely to build entry-level houses, so demand for those that already exist pushes prices higher.

This squeeze is particularly acute in California, which struggles to house low-income workers. Some are living instead in cars or recreational vehicles, which has caused friction in wealthy communities. Mountain View, the Bay Area city where Google is headquartered, has banned RVs from parking on most residential streets. 

Even for affluent Californians, the price of housing is eye-watering, says Mr. Pinto. In cities like Santa Clara, where the median income is $130,000, modest houses cost over $1 million. 

It all comes back to supply and land-use restrictions. “They build very little, and they made land extraordinarily expensive and scarce and that drove the price up,” he says.  

The thorny politics of NIMBYism mostly play out locally, though state and federal policy can arm-twist localities to allow more moderately priced housing to be built. President Joe Biden has proposed giving greater incentives to communities that relax zoning laws. Some states have begun easing rules on adding extra units to existing single-family homes. 

Homebuilding has been squeezed for other reasons, too. Fed tightening weighs on homebuilders, since it pushes up borrowing costs on projects. Developers also face shortages of skilled labor and higher prices for materials like lumber and concrete. Permits for single-family home construction are down this year, a sign that developers are pulling back, says Ms. Olsen. “That’s what worries me over the long term,” she says. 

Rising rates could also crimp the supply of entry-level homes in another way, says Laurie Goodman, a fellow at the left-leaning Urban Institute and founder of its Housing Finance Policy Center. During the easy-money boom, owners of modest houses could take advantage of low mortgage rates to trade up to a larger house that had extra bedrooms for their kids. 

For a similar homeowner today who wants more space, the math doesn’t add up, since borrowing costs are so much higher on the new loan than the old one. “You may not like that [starter] house – but you love that mortgage,” says Ms. Goodman. 

Younger households that want to own

The pressure to add housing of all sizes isn’t going away. Millennials, the country’s largest demographic group, are becoming homeowners, with rates of ownership among 25-to-34-year-olds rising in recent years. Some Millennials bought their first home during the pandemic helped by record-low interest rates, while those who were college graduates also benefited from a freeze on federal student-debt repayments. 

Then there are the millions of young Americans who pay no rent or mortgage because they live with their parents. Around one in five 25-to-34-year-olds report living at home; in California, the share is nearly double, according to Mr. Pinto. 

Building more starter homes would help middle-income households to get on the property ladder. Relaxing zoning rules to allow the construction of more rental units, such as multifamily apartment blocks, would also help ease the upward pressure on rents and allow households to save for a down payment, says Alex Schwartz, a professor of public and urban policy at The New School in New York. 

But that doesn’t address a segment of the housing market that isn’t on a path to homeownership, namely those earning low wages that don’t get public housing assistance. A pandemic moratorium on evictions, and federal and state aid for rent payments was a balm for many, but those programs largely have ended. For these households, market rents for basic apartments are simply too high, even in Midwest cities like Cleveland that aren’t typically seen as unaffordable. 

“There’s a fundamental mismatch between what a renter can afford and the actual cost of operating a housing unit,” says Professor Schwartz.