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

As homebuyers adjust to a higher mortgage rate environment, the U.S. housing market still appears to be in transition. Home affordability has emerged as a major issue due to low inventory and increased borrowing costs. Although average home prices nationwide are off their peak, prices have recovered in recent months. After an initial slowdown, new home construction has picked up as well, which could ultimately help alleviate inventory constraints.

The landscape for the housing market changed significantly after inflation’s resurgence led the Federal Reserve (Fed) to take dramatic steps. The Fed’s actions, including hiking short-term rates from near 0% to more than 5.25%, are designed 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. That often means housing is less affordable for those new to the market. Another consequence of elevated mortgage rates is an unwillingness among existing homeowners to sell. Such a transaction may lead to trading a relatively inexpensive mortgage for a potentially pricier one needed to finance the purchase of another home.

Home values on the rise again

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. Recently supply has lagged demand, particularly in certain markets across the country. Prior to 2022, this supply-demand imbalance, supported by low interest rates on home mortgages, pushed home prices higher.

“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, 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.

The environment quickly changed 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. According to the S&P CoreLogic Case-Shiller 20-City Composite Home Price Index, home values started to fall in July 2022 for the first time in more than a decade.² Following seven consecutive months of declines in home values, as reflected in the index, prices began to recover in February 2023 and continued their upward trend through June 2023.

Source: S&P Dow Jones Indices.

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 predicted that average home prices nationally could 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%. As of June, the average home price is off just 1.2% from its June 2022 peak. “Homeowners still have significant home equity given the rebound in values this year,” says Schoeppner. Of course, price changes vary depending on location.

The housing market slowdown was also reflected in mortgage applications to finance new home purchases, which fell to a 28-year low in February 2023, though mortgage activity levels fluctuated up and down since that point. Mortgage applications declined in late August 2023 and stood 30% lower than application activity at the same point a year ago.³ Despite uneven demand, single-family homes have managed to hold value, due in part to their limited inventory. “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.

According to a recently released study, 14 million homeowners refinanced their mortgages between the second quarter of 2020 and the end of 2021, before mortgage rates began to climb in 2022. With significantly higher mortgage rates persisting today, the report states that this “leaves homeowners somewhat disincentivized to sell or change properties.” The report notes that owners looking to sell their existing home and purchase another property “will face increased borrowing costs and higher (home) prices.”⁴

Existing home sales experienced a brief resurgence, rising 14.5% in February 2023 compared to the previous month.⁵ However, existing home sales dropped again in four of the last five months, including a 2.2% decline in July 2023. Over the previous year, existing home sales activity declined 16.6%.⁶

Mortgage rates have risen to their highest levels in more than two decades. The average 30-year mortgage rate in the U.S., which was below 3% less than two years prior, rose to 7.23% as of August 24, 2023.⁷ 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 19 months, from $1,212 in January 2022 to $2,246 in August 2023.⁸ “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.”

New home construction rebounds

For a time, higher financing costs created barriers for builders, potentially dampening the supply of new construction. Housing starts declined significantly in late 2022 and early 2023, but this market, too, seems to be adjusting to the new interest rate environment. In July 2023, new privately-owned housing starts held at a seasonally adjusted annual rate of 1.442 million, comparable to the previous month, when a major uptick in homebuilding activity occurred.⁹ “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.

Even with the home prices stabilizing and mortgage rates remaining elevated, Haworth says market demand remains strong. “There’s ample evidence that, armed with wage increases and a solid job market, home buyers are coming back into this market, reflecting their persistently strong desire for home ownership.” Haworth says the recent emergence of more favorable homebuilding data could be a signal of what’s to come in the housing market. “Even with higher mortgage rates, it appears we’ve found a new and acceptable equilibrium for housing market transactions to occur.”

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). As interest rates rose beginning in early 2022, however, REITs faced a challenge.

“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 July 2023, the S&P Developed REIT Index returned -6.71%, compared to a return of 13.02% for the S&P 500, a benchmark measure of U.S. stock market performance.¹⁰

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 softer for office properties, and the retail market remains weak, 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. “REIT prices have already corrected much more quickly than is the case in the direct real estate market,” says Haworth. “But that doesn’t mean the REIT market is ready to recover. If interest rates remain high, this dynamic will continue to create headwinds for REITS.”

Housing market’s impact on economic growth

Fed policy has clearly landed 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.