August 25, 2023
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If interest rates are so high, why have house prices not declined?
The housing market is out of whack.
he process of buying a home can be painful, and the unpredictable and counterintuitive dynamics of the current real-estate market don’t help.
Painful, in fact, might be an understatement.
“It was a hellish experience,” Odeta Kushi, who bought a home last year in the D.C. metro area with her husband. One of the homes she had bid on ended up receiving 19 other offers. “That was a house that I really loved,” she said.
When Kushi had begun looking for homes two years ago, she had the exact neighborhood she wanted pinned down. It had a semi-suburban vibe, was in D.C., and had a good school district in case she wanted to expand her family.
Kushi, deputy chief economist at First American, has spent a good portion of her career building a model that can estimate the value of homes, so she knew how much to offer and — crucially — when to step out of the bidding process.
At the time, mortgage rates were about half of what they are in 2023, which made homeownership an even more enticing prospect. And yet Kushi knew it would not be easy.
“I lost bidding war after bidding war,” she told MarketWatch, “because I knew exactly what I was going to pay.”
The housing market has slowed down in the last two years, but rising interest rates have not put a big dent in prices.
In 2021, interest rates were relatively low, and competition among buyers and sales prices were high. In 2023, interest rates are high, and yet so are sales prices — and there’s still fierce competition to buy homes.
Bidding wars are back in earnest. In fact, they’ve never really gone away. The housing market has slowed down in the last two years, but rising interest rates have not put a big dent in prices. So what gives?
Buying a house is an emotional experience, so it can be harrowing to pass up on a house you have set your heart on. “I had a lot of heartbreak in the housing search because you get attached to these homes,” Kushi added.
A couple of times, when it looked like it was a done deal, a buyer swept in at the last minute and offered “something absurd above our asking,” Kushi said. “All’s fair in love and housing,” she added.
It’s been more than a year since she’s closed on — and moved into — her new home. Since then, the prospects for buyers have only gotten worse: The 30-year mortgage rate has doubled over the last two years, and is now marching towards 8%.
A stalemate between buyers and sellers
Putting aside homeowners, who either purchased a house with an ultra-low mortgage, or refinanced to secure that low rate, most Americans — from renters to investors to economists — are in equal parts baffled and frustrated with the trajectory of the U.S. housing market.
Home sales are falling, mortgage rates are at the highest level in 22 years, yet the market is still out of reach for many: Home prices are still high, with the median price of a resale home over $400,000.
The biggest problem for the housing market right now, however, is an imbalance between current homeowners and aspiring homeowners: There’s a severe mismatch of incentives and motivations.
Traditionally, the majority of home sales are of homeowners selling their houses to buyers. But homeowners today don’t feel the need to sell, unless they have to for personal reasons, as they probably have low mortgage rates.
Affordability has fallen. If they do move, they will find that — while they may be able to sell their home for a higher price than they bought it — they may only be able to afford a smaller house or a similar-sized house in a less desirable neighborhood.
Compounding that problem, buyers have fewer home listings to choose from. They turn to builders, who offer new homes and even mortgage-rate buydowns to make owning a home a little less expensive. But builders can’t meet all of the demand. They also don’t want to overbuild, having been bit once during the Great Recession.
Some renters have stuck it out, adopting a mentality of “date the rate, buy the house,” choosing to purchase a home that meets their criteria now and to refinance later on in their life.
But the math doesn’t make sense for many other renters. The median rent for a two-bedroom home in the U.S. was nearly $2,000 in July 2023, according to Realtor.com. The same month, the median list price of a home was $440,000 — or over $2,220 in just principal and interest payments.
Even though the real-estate sector has been profoundly impacted — sales are at “rock bottom,” Redfin CEO Glen Kelman told MarketWatch this month — home prices, to the frustration of many, haven’t budged.
Given that rising home values broadly affect how housing costs are calculated in the government’s inflation measures, some economists fear that the resilience in home prices mean that there’s still a long way to go before the U.S. economy cools off.
“We’re in uncharted waters,” Andrew Levin, a former Federal Reserve economist, told MarketWatch. “We’ve never had an increase in mortgage rates that’s been as sharp and sustained as we’ve had in the last year and a half.”
Even home builders, who have seen a sharp increase in demand from home buyers, are worried about high rates killing demand. They’re already seeing traffic of potential buyers drop, and some are building smaller, more affordable homes.
The bottom line: housing inflation will likely “run high for a long time,” Levin added.
Some analysts sound baffled and frustrated. “Housing should be repricing,” Drew Matus, chief market strategist at MetLife said on Bloomberg Surveillance in mid-August. “The fact that it is not, is not a sign of health,” he added. “It is a sign of dysfunction.”
Others have changed their minds about prices correcting, as home buying demand has remained stronger than expected despite higher rates. Goldman Sachs in August said it expects home prices to rise in 2023 by 1.8%, revising a prior prediction of a drop of 2.2%.
One economist described the current situation as a “tale of two housing markets.” Michael Reid, U.S. economist at RBC Capital Markets, wrote in a note that the data shows a divergence between existing home sales, which have stalled and new home sales, which have surged.
The cost of “shelter” or housing is one of the key components the Federal Reserve uses to measure inflation. One of the Fed’s key tasks is to maintain inflation at a low and steady pace — it has a 2% target — so any major increase in the cost of living will provide more incentive to raise rates.
When the Fed raised interest rates last summer, that prompted mortgage rates to shoot up, and dampened home sales. After raising its benchmark rate in 11 of its last 12 policy meetings, most economists say it’s less likely to hike rates at its next policy meeting in September. In fact, financial markets put the odds close to zero.
Still, with inflation running at an annual rate of 3.2%, primarily driven by high housing costs, the Fed may not be done hiking interest rates and, by extension, mortgage rates may have some room to rise. That would be bad news for both the real-estate industry, and home buyers.
What happened after rates hit 18% in 1981?
The fact that the housing market appears to be out of balance isn’t just due to first-time homebuyers — millennials and Generation Z — lamenting higher rates and home prices. Older generations may point to higher rates and shrug it off as something that younger generations just need to accept. A new normal, if you will. After all, mortgage rates peaked at 18% in 1981.
But Kushi said there’s something people need to remember about how the 1980s played out: monetary policy became extremely tight before inflation improved. “From December of 1979 to January of 1980, interest rates were soaring as the Federal Reserve was combating the ‘Great Inflation,’” she said. “As mortgage rates soared to levels unseen before or since, homes were becoming significantly less affordable and home sales and new construction was falling.”
But by October of 1982, inflation had fallen to 5%, she added. The Fed allowed the Fed funds rate to fall, and as a result the 30-year mortgage rate fell too.
Kushi’s analysis of the 1980s, which she considers a period when housing went into recession much like today, indicates that though the current housing market may be in a dark place, it will stay as such until the Fed hits its target inflation rate, or something else triggers the economy to slow even further.
Meanwhile, the typical home buyer may need to finally make peace with higher-than-normal interest rates. Reid, the RBC economist, noted that for a family earning median income, their monthly mortgage payment with current rates would be 28.5% of their total salary. “That is the highest share in the last 30 years,” Reid wrote, “and well above the sub-20% shares we saw in the previous decade.”
The typical home buyer in 2023 may need to finally make peace with higher-than-normal interest rates.
And the imbalance — or the dysfunction — that we’re seeing in the housing market may take a while to iron itself out. Given that the economy and the labor market is strong, it does not seem likely that the Fed will be cutting rates anytime soon, Levin said; the Fed may even need to raise them further.
“It doesn’t seem terribly likely to me that mortgage rates are going to come down very much anytime soon,” he added. “So the housing market we’re seeing now is probably the housing market we’re gonna be seeing for quite a while.”
For those still in the thick of house-hunting, meanwhile, Kushi had one piece of advice: Stick to your gut instinct. Hers was to not overpay for a home.
When Kushi was planning to buy a home, she had been gung-ho about her finances to estimate the couple’s budget.
“I had spreadsheets on spreadsheets and spreadsheets, budgeted everything in, how it would impact this part of my discretionary spending, and what rate I was willing to,” Kushi said.
At certain points during a bidding war, she relied on “escalation clauses” to make sure they weren’t going over what she felt was comfortable. An escalation clause is a term used in real estate to specify how much more the potential home buyer is willing to pay than the highest offer and the amount they ultimately want to spend.
Kushi has since become the first homeowner in her immediate family. Although it was not an easy process, she held onto her nerve, stuck to her financial projections, and it paid off.
“I was not willing to budge on price,” she said.
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