The impact of today’s higher interest rates on the housing market

With 30-year mortgage rates topping more than 7%, many existing homeowners appear reluctant to sell only to risk taking on a new, more costly mortgage. While homebuilding activity is picking up, it’s moving forward at an uneven pace. Between lower inventories of homes for sale and higher borrowing costs, home affordability has emerged as a major issue for would-be buyer.

The landscape for the housing market changed significantly after inflation’s resurgence led to the Federal Reserve (Fed) hiking short-term rates from near 0% to more than 5.25%, in an effort to slow the broader economy and lower inflation. The Fed’s policy shift resulted in higher mortgage rates and consequently, increased monthly payments for home buyers. The combination of mortgage rates exceeding levels not seen in years and home prices rebounding to new highs set the tone for a muddled housing market.

Home values recover quickly

Owning a home remains an integral aspect of the “American dream.” Even though the housing market is subject to fluctuations in value, most homebuyers expect appreciation in property values over time.

Home prices, like those for any product or service, are driven in large part by supply and demand. Prior to 2022, supply lagged demand. Home prices skyrocketed through 2020, 2021 and the first half of 2022, particularly in some suburban areas, as homeowners looked for larger houses to accommodate changing lifestyles, including more work-from-home arrangements.

As the Fed’s new monetary policy took effect in early 2022, the average 30-year mortgage rate topped 7% for the first time in more than 20 years.¹ That dampened activity in the housing market, and as a result, average home prices in the U.S. began to decline. According to the S&P CoreLogic Case-Shiller 20-City Composite Home Price Index, home values fell for seven consecutive months beginning in July 2022, the first decline in more than a decade.² Prices began to recover in February 2023 and by July, average home prices nationwide fully recovered to peak levels reached in mid-2022.

Source: S&P Dow Jones Indices.

“Some who track the housing market predicted that average home prices nationally would fall by 10-15%,” says Matt Schoeppner, senior economist at U.S. Bank. Yet at their low point in the current cycle, home prices (based on the Case-Shiller Index) were down only 6.8% before rebounding to previous levels.2 “Even as the Fed tries to slow down housing demand to temper inflation, the result of today’s limited supply of available housing is that we may not see a significant deterioration in home values,” says Schoeppner.

Mortgage applications fell to a 28-year low in February 2023, though mortgage activity levels fluctuated up and down since that point. Mortgage applications for home purchases declined in late September 2023 and stood 27% lower than application activity at the same point a year ago.³

Existing home sales have dropped in five of the last six months, including a 0.7% decline in August 2023. Over the previous year, existing home sales activity declined 15.3%.⁴

New-home sales had declined for a time as interest rates rose, then recovered in recent months. In August, new home sales fell 8.7% compared to sales activity in July. However, home sales volume in August 2023 exceeded activity from a year earlier by 5.8%.⁵ “Homebuilders have adjusted to higher costs,” says Haworth. “Based on the data, it appears they are increasingly confident in finding sufficient labor and supplies to get new homes built.” Haworth also notes that more new homebuyers are finding better opportunities in the new construction market rather than among existing homes.

The average 30-year mortgage rate in the U.S., which was below 3% less than two years prior, rose above 7% in mid-August 2023 and remains above the 7% threshold into September.⁶ It’s the highest mortgage rate since June 2001. The result is more costly borrowing, which can dampen housing market activity.

Source: Federal Home Loan Mortgage Corporation (Freddie Mac).

Rising mortgage rates and home prices make affordability more of an issue for those trying to enter the housing market. According to the National Association of Realtors, the average monthly mortgage (based on average 30-year mortgage rates and home prices) rose 85% in the past 20 months, from $1,212 in January 2022 to $2,243 in September 2023.⁷ “It creates a meaningful headwind for new homebuyers,” says Haworth. “They either need to be able to make a bigger down payment or they must earmark more of their monthly budget for housing costs.”

Impact on the real estate investment market

For those looking to add diversification by including real estate in their portfolios, a commonly used vehicle is a real estate investment trust (REIT). REITs have been in a challenging position given the higher interest rate environment.

“Real estate as an asset class was one of the first to be repriced lower in reaction to higher interest rates,” says Tom Hainlin, national investment strategist at U.S. Bank. “Although REITs are often considered a way to hedge the risk of higher inflation, the unfavorable interest rate environment resulted in REITs underperforming other parts of the equity market,” Hainlin says. “Improved yields on U.S. Treasury securities create cash flows that look much more attractive in today’s market when compared to REITs.” As a result, demand for REITs has fallen, at least in the near term. For the 12-month period ending in August 2023, the S&P Developed REIT Index returned -3.72%, compared to a return of 15.94% for the S&P 500, a benchmark measure of U.S. stock market performance.⁸

Haworth points out that results vary depending on the category of REIT. “Light industrial properties may have the highest demand and have overtaken cell towers and data centers as the largest REIT sector,” says Haworth. “There’s still steady demand for apartments, the market is softer for office properties, and the retail market remains weak, an environment that’s existed since the pandemic began.”

Haworth notes that the environment may remain challenging. “Even though REITs are less expensive today than they were in early 2022, there’s not an all-clear signal yet,” says Haworth. “We may need to see additional repricing to account for existing vacancies in some properties.”

Housing market’s impact on economic growth

Fed policy has clearly placed housing and other real estate markets on the front lines of efforts to slow the economy’s pace and lower inflation. Thus, regardless of the extent of your real estate holdings, it’s important to keep in mind that the housing market can have a significant impact on the broader economy and capital markets generally. “The formation of households is one of the main drivers of economic growth in the U.S.,” says Hainlin. “It has a large spillover effect on the economy, including materials that go into building or remodeling, and furnishings for homes.”

Be sure to consult with your wealth management professional to determine when and how real estate investments might be a good fit for your portfolio.