The U.S. housing market looks red hot based on virtually every indicator. Single-family home prices—and price appreciation—have reached new records, the supply of existing homes for sale is the tightest it’s been in several decades and housing affordability is at its lowest point since the financial crisis. The rental market isn’t any better, with occupancy rates at all-time highs and rents on the rise.

But with mortgage interest rates increasing, home buyers and investors are asking what’s next for housing.

The good news: This market has many unique characteristics—including limited supply, significant home equity and healthy owner finances—that suggest it won’t follow the same trajectory as the great housing boom and bust of the early 2000s. Although home price appreciation is likely to slow, these dynamics could keep home prices climbing.

The not so good news: Rising mortgage rates could potentially squeeze supply even further and exacerbate affordability gaps.

“The unifying feature is that there’s simply not enough supply,” says James Egan, co-head of U.S. Securitized Products Research. “With a new Fed hike cycle underway, rental occupancy rates at all-time highs and residential supply at all-time lows, we think this will put continued pressure on rents.”

U.S. housing analysts and strategists with Morgan Stanley Research looked at the relationship between housing prices, interest rates and rental affordability—among other key factors—to outline why this housing market is like no other.

It doesn’t take long for rising interest rates to make their mark on housing markets. Historically, rising interest rates impact home sales volume, or the number of houses sold, but with a slight lag. Volume initially climbs during the first six months of rate increases and then drop in the subsequent 12 months as higher mortgage rates drive up the cost of owning.

Declining sales volume is often a precursor to declining prices—but not always.

Here’s where supply comes in. “Right now, inventories are historically low, and the rapid rise in mortgages rates over the past several months should keep inventory tight as current homeowners have more incentive to stay locked into their low rates,” says Egan.

“So, while home price growth might slow, we think it could still remain positive.”

Egan and his team think that the year-on-year home price growth will slow over the next 12 months from nearly 19% in Dec 2021 to around 5% by the end of 2022, under their base case.

Meanwhile, a significant rise in mortgage rates could initially push the supply of houses for sale even lower. That’s because when rates increase, would-be sellers are more reluctant to “trade up” and in the process let go of their low fixed-rate mortgages.

What’s more—and this is a key difference from the last housing boom—owners today are in better shape financially than previous housing cycles. They have less debt, more home equity and manageable mortgage payments.

“The strength of mortgage underwriting over the past decade has resulted in a backdrop of healthy-credit homeowners who, we think, won’t be will be forced to sell homes into depressed bids,” says Jay Bacow, co-head of U.S. Securitized Products Research. In other words, buyers on the sidelines shouldn’t assume that higher mortgage rates will bring more distressed and foreclosed properties onto the market.

Mortgage credit availability is more conservative than it has been historically.

Following the financial crisis, new home construction virtually came to a halt. While it has steadily improved, it is still a long way from its peak in late 2006 and not nearly enough to meet continued demand from Millennial and, now, Generation Z buyers in their peak nesting years.

Recently, new units under construction and permits have increased significantly, but the housing market is still playing catch up—and COVID-19 lockdowns, labor shortages and supply chain issues have complicated matters.

“While single unit permits and housing starts are up 13.5% from year-ago levels and 24.6% from the beginning of the pandemic, they have not hit the market as completions in the same way that they normally have because supply chain disruptions are elongating build timelines,” Egan adds. Even if the pace picks up, new housing supply may not ameliorate shortages in many markets.

Unfortunately, the rental market offers little reprieve for housing affordability. Effective rents for Class A multifamily apartments—typically more desirable properties with higher rents and lower vacancies—increased 15.3% year over year in the first quarter of 2022.

Those rising rents will erode households' ability to save for a down payment, pushing the prospect of homeownership further into the future and keeping pressure on rents.

For those who can afford it, buying may be a better move in Chicago, Honolulu, New York and San Francisco, according to Morgan Stanley Research. However, it’s still more affordable to rent than buy in nearly all the 390 markets that Morgan Stanley tracks.

All in, says Richard Hill, who leads U.S. REIT Equity and Commercial Real Estate Debt Research, “we are worried that the unique state of the housing market—specifically with respect to rental occupancy rates near all-time highs and residential supply at all-time lows—has us poised to enter a vicious cycle.”