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

The housing market – perhaps the area of the economy hardest hit by recent interest rate hikes – is showing signs of stabilizing. Recent data indicates home values nationwide are no longer in decline, and homebuilding activity is on the rise. This is a marked change from trends in 2022 and early 2023, which saw a modest slide in home values and a slowdown of activity by homebuilders.

A resurgence of inflation led the Federal Reserve (Fed) to dramatically raise interest rates. The Fed’s actions, including hiking short-term rates from near 0% to a range of 5.00% to 5.25%, were designed to slow the broader economy in an effort to temper the impact of inflation. The Fed’s policy shift was reflected in higher mortgage rates, which generally translate into larger monthly payments for home buyers.

The changing interest rate environment appeared to have multiple effects on the housing market. With affordability an issue, demand dampened and as a result, home prices dropped modestly from their peak in mid-2022. This price drop occurred even as the availability of new and existing homes appeared to fall short of demand. New home construction slowed as well.

Home values start to stabilize

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 property values over time.

Home prices, like those for any product or service, are driven in large part by supply and demand. A recent dynamic 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, 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 showed more improvement in March and April.

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 6.8%. As of April, the average home price is off just 3.5% from its June 2022 peak. “This would rank as a modest correction after a more than 40% runup in home values over the prior two years,” says Schoeppner. “Homeowners still have significant home equity given the dramatic appreciation in values that occurred up until mid-2022.” 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 rose over three consecutive weeks in June 2023 but remained more than 20% lower than application activity at the same point a year ago.³ Despite uneven demand, home values may not face a precipitous loss of value, because of the limited inventory of homes on the market. Some existing homeowners appear reluctant to sell their current house, buy a different property and then borrow at today’s higher mortgage rates. “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 March and April by 2.4% and 3.4% respectively, before coming in relatively flat (+0.2%) in May. Over the previous year, existing home sales activity declined 20.4%.⁶

Mortgage rates remain high. After peaking in November 2022 at 7.08%, the average 30-year mortgage rate in the U.S. dropped to 6.09% in early February 2023, but has been up and down since, standing at 6.67% as of late June 2023.⁷ Higher mortgage rates make borrowing more costly, which can dampen housing market activity.

Source: Federal Home Loan Mortgage Corporation (Freddie Mac)

Haworth notes another impact of rising interest rates – that higher financing costs create potential barriers to builders, potentially dampening the supply of new construction. Housing starts declined significantly in later 2022 and early 2023, but this market, too, seems to be adjusting to the new interest rate environment. In May 2023, new privately-owned housing starts surged to a seasonally adjusted annual rate of 1.631 million.⁸ “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.”

Even with the home price slide subsiding 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 beginning to come back into this market, reflecting their persistently strong desire for home ownership.” Haworth says the recent emergence of more favorable sales and 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 place for housing market transactions to occur.”

Yet market improvement could be gradual. “Some potential new homebuyers may 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.”

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 portfolios, commonly used vehicles are real estate investment trusts (REITs). As interest rates rose beginning in early 2022, REITs faced significant challenges.

“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. 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 May, the S&P Developed REIT Index returned -13.11%, compared to a return of 2.92% for the S&P 500, a benchmark measure of U.S. stock market performance.⁹

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, 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.”

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, this is a market that can have a significant impact on the broader economy and capital markets. “The formation of households 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 might be a good fit for your portfolio.