Residential Real Estate: Minuses And Pluses

Federal Reserve (Fed) Chairman Jerome Powell has made clear that interest rates will rise further, making the future of the housing market problematic at best. Higher mortgage rates cannot help but make ownership less affordable and depress buying and building even more than they already have. As the year progresses, however, a countertrend will likely develop as potential buyers come to appreciate how real estate offers them at least a partial hedge against the effects of inflation and prompt them to buy despite high financing rates.

So far, the picture has been all on the negative side of the ledger. The Fed’s anti-inflation efforts have driven mortgage rates up from about 3% early in 2022 to over 7% at present.Affordability accordingly has declined nearly 30% over the twelve months through December, the most recent period for which data are available. Home buying has followed, falling almost 20% between January 2022 and this past January, as has new home construction, with starts of new dwellings falling some 23.7% during this same time. Not surprisingly, home prices have weakened as well. The National Association of Realtors (NAR) notes the median price of a home sold in the United States had by last December fallen more than 11% from the highs of last June.

Because Fed Chairman Jerome Powell plans to keep raising interest rates for the foreseeable future, this negative pressure will continue. No one knows how far the Fed will ultimately have to go, but Powell has made clear that the Fed’s current policies will remain in place until he and his advisors are convinced that inflationary forces have abated sufficiently. That means several more rate hikes. To be sure, these future rate hikes will come as less of a shock than last year’s did and may be less extreme, so future downward pressures on housing will develop with less intensity, but they will still weigh heavily. And since the inflation is not likely to go away overnight and the Fed in any case would hold its counter-inflationary stance for a while longer, the adverse pressure of rising rates on housing will likely build until the second half of the year at the earliest.

The longer inflationary concerns last , however, the more they will carry something of a countertrend into the housing market. Homebuyers will come to see real estate as an inflation hedge and buy despite elevated mortgage rates. Even though median prices have edged down, one obvious allure is how home ownership, even if costly, fixes cost of shelter, a major budget item. While all other prices are rising, homeowners, whether they own their property free and clear or have financed it with a fixed mortgage, will enjoy no increase in their cost of shelter. That is no small consideration in an inflationary environment. But there is more. History shows that residential real estate values tend to outperform other investments during inflationary times and rise ahead of inflation. That was certainly true during the last great inflation in the 1970s and 1980s. Even though inflation from 1970 to 1990 averaged a horrible 6.2% a year and occasionally rose above a 10% annual rate, housing values gained 8.7% a year on average for the entire 20-year period.

Buyers then will strive increasingly to avail themselves of the real estate hedge even as buying becomes less affordable. History shows that rather than give up on securing the inflation hedge, they will simply trade down along the price distribution, purchasing a smaller, less lavish house than they otherwise might have or one in a less desirable location. In this way, they secure the hedge against inflation that ownership provides at a price point that their income can support — and do so despite higher financing costs. Commerce Department data shows that such trading down has already started. A smaller percentage of new purchases are occurring at the high end of the price distribution than in say 2020.

It is doubtful that this countertrend can overwhelm the downward pressure that rising interest rates will continue to place on buying and building. But the longer inflation persists, the stronger this countertrend will become and the more it will tend to mitigate the otherwise negative influences on residential real estate.