The impact of rising interest rates on the housing market

The housing market was one of the first segments of the economy to feel the effects of the Federal Reserve’s (Fed’s) recent aggressive monetary policy moves, which began in March 2022. At that time, to help tame stubbornly persistent inflation, the Fed initiated a new policy stance. Rather than maintain near-zero interest rates on its target federal funds rate, they raised rates rapidly. By November 2022, the rate was set to a range of 3.75% to 4.00%. 

While the Fed’s interest rate hikes are designed to slow the economy, few segments of the U.S. economy felt the impact of this policy as rapidly as the housing market. So what does this mean for the broader economy, and how should investors respond to recent developments?

A surge in home values is halted

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

Home prices, like those for any product or service, are driven in large part by supply and demand. A reality of recent times is that supply lagged demand, particularly in certain markets across the country. Prior to 2022, this supply-demand imbalance, supported by low interest rates on home mortgages, supported higher home prices.  

“Consumers were in a strong position to buy or upgrade their homes,” says Rob Haworth, senior investment strategy director at U.S. Bank. “That raised the demand for houses. As COVID-19 first hit, we ran into supply shortages for materials such as lumber and concrete, and even labor shortages for construction workers and building inspectors.” Home prices skyrocketed through 2020 and 2021, particularly in some suburban areas, as homeowners looked for larger houses to accommodate changing lifestyles, including more work-from-home arrangements.

The environment began to change with the onset of the Fed’s new monetary policy in early 2022. By November 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, albeit modestly. According to the S&P CoreLogic Case-Shiller 20-City Composite Home Price Index, home values declined in July and August for the first time in more than a decade.²

                                Case-Shiller Home Price Index

Notably, from the beginning of 2020 until peaking in June of 2022, home values (as reflected by the Case-Shiller Index) rose 45%. “Some who track the housing market forecast that average home prices nationally could fall by 10-15% in the current environment,” says Matt Schoeppner, senior economist at U.S. Bank. “We’re watching to see if the collapse in demand for housing becomes overextended and dramatically impacts home values.” Schoeppner notes that even if values decline by 10% or more, in the coming months, it should not be considered a major setback. “This would rank as a modest correction after a more than 40% runup in home values over the prior two years.”

Higher borrowing costs may affect both sides of the supply-demand balance. For example, potential buyers may be priced out of the market by rising mortgage rates, which in turn could temper demand. But Haworth notes there’s another impact of today’s mortgage environment. “It’s not just a question of an individual’s ability to buy a house, but how higher financing costs will affect builders in the development of new homes.” Haworth believes that if financing proves to be too expensive, it could be a barrier to builders and may dampen the supply of new construction. 

The weakness in the housing market is reflected in data on existing home sales and new construction of single-family homes. Sales of existing homes peaked at an annualized rate of 6.49 million in January 2022. Since that time, sales numbers have declined month-after-month, dropping to an annualized level of 4.43 million in October.³ Recently released data on new residential home construction shows a 4.2% decline in activity on an annualized basis in October. The levels of new construction of single-family homes have declined in every month since February.

The future of the housing market

Prior to the pandemic, housing demand was considered strong as millennials (born between 1981 and 1996) began purchasing homes. “They were supposed to provide the tailwind for the housing market,” says Schoeppner. However, the pandemic moved the market in a different direction. 

As home prices soared in 2020 and 2021, affordability became an issue, particularly for first-time homebuyers. Now, even with home prices leveling off, higher mortgage rates create a different affordability issue. “You may see potential new homebuyers delay home purchasing plans for a year or two and decide to rent instead,” says Schoeppner. “The tailwind of millennial-driven demand will likely return once we get past this ‘temporary’ blip, but it’s hard to define how long ‘temporary’ may last.”

Haworth says that millennials may represent the last sizable generational cohort to move into the home ownership market. “We’re not expecting large waves of new homebuyers beyond that, based on current demographic trends,” says Haworth. “Given expectations for future generations, the prospects are that housing demand will ultimately stabilize, with immigration trends determining whether demand swings higher or remains steadier.”

Impact on the real estate investment market

For those looking to add diversification by including real estate in their portfolio, commonly used vehicles are real estate investment trusts (REITs). In 2022, REITs faced challenges due to the changing 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 this year. Improved yields on U.S. Treasury securities create cash flows that look much more attractive in today’s market.” As a result, demand for REITs has fallen, at least in the near term.

Haworth points out that results vary depending on the category of REIT. “Underlying demand in specific segments of the market influence REIT performance,” says Haworth. “There’s still steady demand for apartments, the market is a little softer for office properties, but the retail market remains very soft, an environment that’s existed since the pandemic began.” Haworth also notes that, as is often the case with real estate, location affects property values. “For example, demand for apartments is strongest in suburban areas, a clear pandemic-driven trend, whereas urban properties face lower demand.” 

A silver lining for REIT investors, according to Haworth, is that a significant price correction has already occurred. “There are still challenges ahead, but REIT prices have already corrected much more quickly than is the case in the direct real estate market, so better values can be found there, but it’s not without risk.”

Real estate within your financial strategy

The Fed’s inflation-fighting stance has clearly landed housing and other real estate markets on the front lines of efforts to slow the economy’s pace and temper inflation’s threat. Thus, regardless of the extent of your real estate holdings, this is a market that can have a significant impact on the broader economy and other capital markets. “Household formation is the main driver of economic growth,” 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 can be appropriate for your portfolio.