Up to this point, 2022 can be summed up by one word: VOLATILITY.
Volatility continued through April as both equity and bond markets experienced large fluctuations. However, the housing market is one area that has been relatively unaffected until now.
With the Federal Reserve intent on aggressively raising interest rates to combat inflation, mortgage rates have surged over the past two months. Questions are mounting about whether the housing market is starting to lose momentum.
When analyzing the real estate market, the key data points are home sales and home prices. Quoting Harold Samuel, real estate values are highly predicated on “location, location, location”! We are still in the midst of a supply/demand imbalance where demand has outstripped supply, which has pushed prices higher. The recent surge in interest rates appears to be slowing demand, which will likely be a headwind moving forward.
Appreciation
The U.S. housing market surged by nearly $10 trillion in value during the pandemic, with Florida, California, and Arizona experiencing some of the largest percentage gains. A combination of low interest rates, limited supply, and pent-up demand sent prices soaring.
The “problem” is the appreciation was so rapid and over such a short period, few homeowners could cash in and “upgrade” since the unrealized profits weren’t enough to buy a nicer or bigger home because those prices shot up even more!
This situation has left many feeling “stuck” with no realistic alternatives and feeling no better off than before, even though their homes appreciated to record levels! This issue isn’t only impacting home prices. It extends to other markets (cars, boats, etc.) and illustrates the danger of inflation. Even with a meteoric rise in values, very few feel any more “wealthy” than before.
The Federal Reserve has acknowledged how far behind the curve they were with inflation and why they are now hell-bent on aggressively raising rates to get things under control. The strategy seems to be working somewhat, as existing home sales dipped in February and March, with March falling below consensus estimates.
Although this dip can seem alarming, much of it has to do with the limited supply on the market.
While home values have remained stable, the recent uptick in mortgage rates is something to keep an eye on.
Mortgage Rates
For the first time in over a decade, the 30-year fixed mortgage rate topped 5%. While we knew interest rates couldn’t remain so low forever, no one expected them to rise this quickly either.
Source: FRED.
On the surface, a 1% increase in mortgage rates may not seem like much, but the impact on the mortgage payment can be massive. Let’s look at a few examples:
A 30-year mortgage at 4% on $1 million = $4,774/m (principal and interest)
A 30-year mortgage at 5% on $1 million = $5,368/m (principal and interest)
A 30-year mortgage at 6% on $1 million = $5,996/m (principal and interest)
The difference between a rate of 4% and 6% is ~$1,200 per month—now multiply that over 30 years!
How realistic is it to assume 6% or higher mortgage rates? Historically, it’s common. From 1971 to 2008, the 30-year fixed mortgage rate never dropped below 5%. That’s right: For nearly 37 years, the rate was 5% or higher, reaching as high as 18.4% in 1981!
Source: FRED.
Home Values
As counterintuitive as this may seem, the solution likely involves a slowing housing market. An extended period of low to no growth will create relative value and help fix the supply/demand imbalance. In my opinion, for sales to pick up, two things must occur:
New home construction (supply) needs to increase.
Prices need to remain steady or slightly decline.
With the worst of the pandemic behind us, fingers crossed, supply should naturally increase. Remember: For the last two years, homebuilders have grappled with supply chain disruptions, labor shortages, and record-high lumber prices! Housing inventory remains near historic lows, but we are starting to see progress. New home construction jumped nearly 7% in February, a 22% increase from the year prior.
Added inventory and rising interest rates should keep a lid on price appreciation as this combination will reduce demand and increase supply. This is the Federal Reserve’s goal since an overheated housing market can have long-term negative side effects.
Of course, risks are here as well. Raising interest rates this aggressively could send the economy into a recession or a prolonged period of low growth.
In the end, it is important to remember that we are dealing with factors never seen before. While anything is possible, a repeat of the 2008 housing crash seems unlikely. That was mainly based on extreme speculation, low lending standards, and excessive leverage, which, thankfully, are not present today. We should have more answers and fewer questions in the coming months.
Discuss your situation with a fee-only financial advisor.
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