Hate To Burst Your Bubble, But No One Really Knows What 5% Mortgage Rates Will Mean For Real Estate

In mid-April, average mortgage rates surpassed 5% for the first time in about a decade — and they are expected to increase further as the Federal Reserve increases interest rates this year in an effort to put a lid on inflation.

Higher rates will cut into demand for housing, experts agree, but there is less agreement on whether that means a hard landing for the housing market — a 2008-style bubble pop, that is — or merely some cooling of the market's recent fever pitch.

"Interest rates are going to pull back some of the essentially unserved demand that builders were turning away because of their own supply chain issues," National Association of Home Builders Chief Economist Robert Dietz said. 

If that were the case, a drop in demand might represent a relatively soft landing, since homebuilders haven't been able to keep up with demand anyway.

That isn't for want of trying. The residential industry, both for sale and rent, is in overdrive. 

Despite the onset of the pandemic, single-family starts were over a million in all of 2020 for the first time since 2007, and continued at that pace in 2021, with 1.1 million starts. Multifamily starts were over 389,000 units in 2020, approaching a level not seen in about 30 years, and in 2021, the number of starts was more than 460,000.

The trend has continued into this year. Housing starts in March 2022 were at an annualized rate of nearly 1.8 million units, up 0.3% from February and 3.9% compared with the same month a year ago, according to the Census Bureau.

The total number of all residential units currently under construction is 1.62 million, the highest level since February 1973, just before the energy crisis of that decade took the bloom off homebuilding.

Currently, there are 811,000 multifamily units underway, the most since May 1974, and roughly the same number of single-family houses under construction, the most since November 2006, not long before the onset of the housing bust at the end of the 2000s.

Even so, Dietz said, there will be flat levels of single-family construction for the entirety of 2022 because offsetting factors are just beginning to kick in. 

"The big surge in interest rates is going to have an effect, on top of the gain in home prices," he said.

As of Tuesday, the average 30-year fixed mortgage interest rate stood at 5.27%, an increase of 13 basis points compared to only a week earlier.

The next Federal Reserve meeting is on May 4, and the central bank has already indicated it may raise rates by 50 basis points at that time. New York Fed President John Williams called such an increase a "reasonable option" and it would be the first half-point hike in more than 20 years.

U.S. consumer prices rose 8.5% in March, the biggest annual rise since late 1981, putting further pressure on the Fed to raise the cost of money to try to contain inflation. Although the Fed doesn’t set mortgage rates, they are certain to move significantly higher when the Fed Fund rate does.

Homebuilders are aware of the trend toward higher interest rates, as are would-be buyers, which has given demand a temporary shot in the arm.

"The ability to get into a house, lock down your homeownership or your housing cost for the next 20 years is a significant driving force in what's going on, as overall cost inflation [and] interest rates continue to move up," D.R. Horton CEO David Auld said during the company's most recent earnings call in February.

So far homebuilders have been able to raise prices, according to data compiled by RBC Capital provided to Bisnow. Prices for "same house" floor plans were up an average of 2.6% in March compared with the month before, almost as much as the increase in February (2.8%) compared with January.

On average, new homes are selling for $216 per SF in March 2022, compared with $180 per SF during the same month a year earlier. The strongest markets for price growth tend to be in the warmer parts of the country, with some exceptions, such as Salt Lake City, where average selling prices were up 11.4% in March month-over-month.

The buying binge isn't going to last, since historically such large movements of interest rates have ended with a housing slowdown, Doug Duncan, Fannie Mae senior vice president and chief economist said. 

In particular, the GSE expects house price growth to decelerate to a pace more consistent with income growth and interest rates, Duncan said. For one reason, households with a 3%, 30-year, fixed-rate mortgage are unlikely to give that up in favor of a mortgage closer to 5%, and that so-called ‘lock-in’ effect will also weigh on home sales. 

"Moreover, if mortgage rates remain relatively elevated, we expect the added affordability constraint to price out some would-be first-time homebuyers and contribute to the slowing of demand,” Duncan said.

“We will see a normalization of the market, but I don’t anticipate that housing prices will come down — they just won’t continue to grow exponentially as they have in the past year," mortgage lender Beeline Chief Operating Officer Jess Kennedy told Mortgage Reports. 

Not everyone is so sanguine about the prospect of a slowdown. Any housing slowdown likely will be hard, which is what usually happens when a bubble pops, according to a recent report by the Dallas Federal Reserve that argues that since 2021, house prices appear increasingly out of step with fundamentals and that a correction is entirely possible.

"While historically low-interest rates are a factor, they do not fully explain housing market developments," the report notes. 

Other drivers have included pandemic-related U.S. fiscal stimulus programs and coronavirus-related supply chain disruptions, the report says. As these factors pushed house prices higher, they also might have fueled a fear-of-missing-out wave of exuberance not only among ordinary buyers but involving new large investors and more aggressive speculation among existing large investors. When that wave stops, it might stop cold.

Another line of thinking on the housing market has it that there might be short-term disruption, but it won't change the long-term trajectory of the market, which is characterized by strong demand. When Americans can buy houses, they do.

"We're already beginning to see the impact of interest rates on demand for housing," Broadmark Realty Capital CEO Brian Ward said. Broadmark is a real estate lender.

In the short run, Ward expects demand will drop as interest rates rise — the major disrupter of the for-sale market. On the other hand, he argues, the short-term dynamic doesn't change the fact that in the long run there will still be a fundamental imbalance between a chronic short supply of housing and demand driven by a growing population and household formation.

A 2021 report by the Urban Institute says that there were 7.3 million new U.S. households formed from 2010 to 2020, and it projects that 8.5 million will be from 2020 to 2030, and 7.6 million from 2030 to 2040.

"In the long term, there's going to continue to be demand for housing that exceeds the supply," Ward said. "That will be true for single-family and multifamily. It's a permanent feature of the market."