"Why Sky-High Interest Rates Can't Tame the U.S. Real Estate Market: The Surprising Truth Revealed"

summary

Real estate prices in the United States have remained resilient despite the recent surge in interest rates, a phenomenon that has puzzled many observers and stakeholders in the housing market. Traditionally, high interest rates tend to suppress property values as borrowing becomes more expensive, but the current situation reveals a more complex interplay of factors that are sustaining elevated real estate prices. This trend is influenced by a combination of historical, economic, and policy-driven elements, each contributing to the market's unexpected stability. Several key factors are at play in maintaining high real estate prices. The dynamics of supply and demand are particularly influential, with limited housing supply, driven by high construction costs and regulatory constraints, juxtaposed against strong and persistent demand. Additionally, real estate's role as a hedge against inflation makes it a preferred investment during inflationary periods, further bolstering property values. Government policies and fiscal measures, including pandemic-era relief programs and ongoing housing initiatives, have also provided significant support to the market, preventing steep declines in asset values. Economic and fiscal policies, including those implemented by the U.S. Federal Reserve, aim to control inflation through interest rate hikes. However, other economic factors, such as strong wage growth and low unemployment, continue to underpin housing demand. Mortgage rates, which have reached their highest levels in over two decades, typically would dampen affordability and slow down the housing market. Nevertheless, essential life events and market expectations of future price increases maintain a baseline level of demand, ensuring that prices do not drop significantly. The COVID-19 pandemic has had a profound impact on the real estate market, driving changes in housing preferences and increasing demand in suburban and rural areas as remote work became more prevalent. Government stimulus programs and financial support measures have played crucial roles in stabilizing the market, providing landlords and homeowners with necessary financial relief and maintaining continuity of income and occupancy rates. Overall, the interplay of limited supply, strong demand, inflationary pressures, and effective government interventions explains why real estate prices in the United States have not decreased significantly, even as interest rates remain high. Understanding these factors provides insight into the current market dynamics and the challenges faced by potential homebuyers and investors in navigating this complex landscape.

Historical Context

Historically, the relationship between interest rates and real estate prices has been complex and multifaceted. For instance, although there is no straightforward correlation between federal funds rate changes or 10-year Treasury rate changes and property cap rates, the context of these interest rate changes plays a crucial role in determining their impact on real estate prices[1]. This nuanced relationship has often resulted in scenarios where real estate prices do not follow the expected downward trend even when interest rates are high. During periods of high inflation, real estate has traditionally been considered a robust investment. A review of the NCREIF Property Index over a span of 43 years revealed that private real estate total returns were strong during inflationary years. For example, in the 12 months ending in Q3 2021, despite annual real GDP growth and inflation rates being 4.9% and 5.4% respectively, the NCREIF Property Index posted a healthy annual rate of 12.1%[2]. This indicates that real estate values can keep pace with inflation, making property a preferred investment choice during such periods. Moreover, the COVID-19 pandemic induced significant distortions in the real estate market. Governmental financial support programs played a pivotal role in stabilizing asset values. Federal, state, provincial, and municipal levels of government implemented various support measures ranging from indirect support, such as deferrals of rent, to direct financial assistance to landlords[3]. These measures helped maintain continuity of income and occupancy, preventing a more severe decline in real estate asset values. Consequently, unlike other parts of the economy that experienced a strong rebound by the end of 2020, the real estate market witnessed only a modest recovery, with asset values generally remaining below pre-COVID-19 levels[3]. Additionally, the rise in mortgage rates has also influenced the real estate market. The average 30-year mortgage rate in the U.S., which was below 3% until late 2021, peaked at 7.79% in late October 2023, the highest since November 2000[4]. Although rates later declined slightly, they have remained elevated, leading to more costly borrowing and potentially dampening housing market activity[4]. However, despite these higher mortgage rates, real estate prices have not decreased significantly, indicating the complex interplay between various market factors and interest rates. Understanding these historical nuances helps elucidate why real estate prices in the United States have not decreased significantly even though interest rates are high.

Factors Influencing Real Estate Prices

Real estate prices in the United States have remained resilient despite high interest rates due to a variety of influencing factors. Understanding these factors can shed light on the complexities behind the market's resistance to price declines.

Supply and Demand Dynamics

One of the primary drivers of real estate prices is the balance between supply and demand. When the supply of homes is limited and demand remains strong, prices tend to rise. New construction, a significant contributor to housing supply, has been hampered by rising labor and material costs, as well as higher interest rates that discourage new building projects[5]. This limited supply, combined with consistent demand, helps sustain higher home prices even when borrowing costs increase.

Inflation and Purchasing Power

Inflation also plays a crucial role in real estate prices. Inflation is a general increase in the price of goods and services, which results in the decreased purchasing power of money[2]. Real estate often acts as a hedge against inflation, as property values tend to appreciate in line with or even outpace inflation rates. This makes real estate a particularly attractive investment during inflationary periods, leading to increased demand and sustained prices. For instance, during periods of high inflation, private real estate total returns have been robust[2].

Mortgage Rates and Affordability

While high mortgage rates typically reduce affordability and can slow down the housing market, other factors can mitigate this impact. Mortgage rates surged to their highest levels in two decades, slowing the market significantly[6]. However, essential life events that prompt home purchases, such as marriage, childbirth, or job changes, do not always align with mortgage rate cycles, maintaining a baseline level of demand[6]. Furthermore, if mortgage rates decrease, it could spur a surge of new buyers, exacerbating the already low inventory and keeping prices elevated[6].

Economic and Fiscal Policies

Government and monetary policies also significantly influence real estate prices. The U.S. Federal Reserve's approach to controlling inflation through interest rate hikes aims to curb spending and cool the economy[7]. However, these policies also impact the housing market by increasing borrowing costs. Despite these interventions, other economic factors like strong wage growth and low unemployment continue to support housing demand and prices[7].

Tax Implications

Property taxes can have a notable impact on real estate investment decisions. High property tax rates can reduce the potential return on investment, particularly for rental properties where taxes are often passed on to tenants[8]. Investors may seek regions with lower property tax rates to maximize net returns, indirectly influencing market dynamics and maintaining higher property prices in more favorable tax environments.

Role of Government Policies

Government policies have played a significant role in maintaining real estate prices in the United States, even in the context of high interest rates. Various stimulus plans and housing programs have been implemented to stabilize the market and ensure affordability for different segments of the population.

Stimulus Plans and Relief Programs

During the COVID-19 pandemic, governments around the world, including the United States, introduced stimulus plans to maintain stability in the real estate market. These plans aimed to support tenants, landlords, and the overall property market by providing financial relief and maintaining property values[3]. For instance, rent relief programs and property tax relief initiatives were implemented in various states like South Australia, Western Australia, and New South Wales[3]. These measures have contributed to sustaining property values despite economic challenges.

Federal Subsidies and Housing Programs

The U.S. government has also expanded access to federal subsidies to construct or rehabilitate affordable rental homes, especially for low and extremely low-income households[9]. Programs like the Housing Trust Fund, the HOME Program, Housing Choice Vouchers, and the Project-Based Rental Assistance program have been bolstered to create more affordable housing units[9]. These initiatives have helped to maintain housing supply and support demand, thereby stabilizing real estate prices.

Zoning Laws and Development Incentives

Zoning laws significantly influence property values and development potential. By dictating land use, zoning regulations can either increase or decrease property values based on the permitted types of development[8]. For example, rezoning an area from residential to commercial can enhance property values due to more lucrative development opportunities[8]. On the other hand, restrictive zoning that limits apartment construction in favor of single-family homes drives up housing costs, which can indirectly sustain higher property prices[10].

Expanding the Low-Income Housing Tax Credit (LIHTC)

The Low-Income Housing Tax Credit (LIHTC) is a crucial federal incentive for affordable housing construction and rehabilitation. The recent budget includes a $37 billion investment to expand this tax credit, aimed at increasing the supply of affordable rental housing[11]. By permanently increasing the allocation of tax credits to states and reducing the private activity bond financing requirement, the government aims to leverage more private capital and build more affordable housing units[11]. This effort is expected to build or preserve 1.2 million affordable rental units, contributing to housing market stability.

Monetary and Fiscal Policies

Monetary and fiscal policies also play roles in the real estate market. Expansionary monetary policies, such as lowering interest rates to stimulate economic activity, have been employed by the Federal Reserve to support the economy[12]. Although higher interest rates are generally expected to dampen real estate demand, targeted fiscal policies, including subsidies and tax incentives, have helped to counteract these effects and maintain property values[13][14]. Through a combination of stimulus plans, federal housing programs, zoning laws, and fiscal policies, the U.S. government has managed to sustain real estate prices despite high interest rates, ensuring market stability and affordability for various segments of the population.

Impact of High Interest Rates

Despite the rise in interest rates, real estate prices in the United States have not decreased significantly. This phenomenon can be attributed to several factors, each contributing to the current market dynamics.

Mortgage Rates and Housing Affordability

Historically, high mortgage rates have not necessarily deterred homebuyers. For example, in the 1980s, mortgage rates soared as high as 18%, yet Americans continued to purchase homes. Even during the housing bubble of 2004 to 2007, high mortgage rates did not prevent home prices from rising [6]. However, the recent combination of elevated mortgage rates and substantial home-price growth has significantly reduced housing affordability. Borrowing $320,000 at a mid-March rate of 6.84% results in a monthly payment of $2,094, whereas borrowing the same amount at an 8% rate translates to a $2,348 monthly payment, a difference of over $250 per month [6].

Market Shifts

The shift from a seller’s market to a buyer’s market due to rising interest rates affects supply and demand dynamics in the commercial property market. Higher interest rates tend to reduce demand, as businesses may be less inclined or able to invest in real estate, and developers may be hesitant to finance new projects because of increased borrowing costs. This shift can lead to higher vacancy rates and potentially reduced property values [15].

Investor Behavior and Expectations

Investor expectations play a crucial role in sustaining high real estate prices. When property prices increase over a significant period, many investors anticipate continued growth. This expectation can drive purchases despite high prices, as investors seek to benefit from future price increases [16].

Remote Work and Housing Demand

The COVID-19 pandemic has also reshaped housing demand. Remote work has allowed many renters, particularly millennials, to purchase homes outside of expensive metro areas, as they no longer need to commute. This shift has increased demand in suburban and rural areas, thereby sustaining high prices in these markets [17].

Credit Conditions and Loan Rates

The cost of borrowing has been rising across various loan types. For example, average interest rates for new auto loans have remained steady at around 7%, reflecting buyer demand more than Federal Reserve rate decisions. Meanwhile, credit card APRs have risen significantly, with new credit card rates likely to surpass 24% this month, up from 23.98% in May. Existing credit card APRs are nearly 21%, the highest since 1994, imposing greater financial burdens on consumers [18].

Pandemic Effects on Real Estate

The COVID-19 pandemic has significantly impacted the real estate market in the United States, contributing to an extraordinary growth in home values. The pandemic-induced disruptions led to increased demand for housing and rising building costs, both of which have contributed to record increases in prices[19]. Over the last 12 months, the Case-Shiller U.S. National Home Price Index rose by 18.6 percent, marking the strongest year-long growth in the history of the series[19]. Several factors have driven these changes. For instance, the pandemic caused supply issues, driving the prices of key commodities like lumber, iron, and steel to record highs, which in turn increased the cost of home construction[19]. Lumber prices, for example, increased by 114 percent over the 12 months ending in May 2021, although they did decline by over 20 percent between June and July, indicating some easing of price pressures[19]. The rental market also experienced significant fluctuations. Initially, rental prices, as measured by the Zillow Observed Rental Index (ZORI), fell during the pandemic but have since recovered and now exceed their pre-pandemic trend[19]. However, due to the way shelter costs enter into the Consumer Price Index (CPI), these increases in both owned home and rental costs have not yet contributed much to overall inflation[19]. In addition to these direct impacts, government incentives played a role in magnifying the effects on the housing market. These incentives encouraged landlords to buy single-family houses, further increasing demand and driving up prices. This phenomenon is particularly evident when considering the already inelastic nature of both supply and demand for single-family houses, which makes house prices highly sensitive to unexpected increases in demand[16][20]. Moreover, fiscal policies and stimulus programs have had mixed impacts on the market. Rent support programs have helped stabilize income and occupancy rates, which in turn have shored up asset values. Despite this, the real estate market has seen only a modest rebound compared to other parts of the economy, with asset values generally remaining below pre-COVID-19 levels[3].

Biden Administration's Housing Supply Action Plan

The Biden Administration has launched the Housing Supply Action Plan, which includes 19 immediate steps aimed at addressing the housing crisis in the United States[16]. A key priority of this plan is to reform local zoning laws to facilitate the construction of new housing units. By focusing on new funding for construction rather than purchasing existing houses, the plan aims to avoid inflating house prices further and to increase housing affordability[16].

Key Components of the Plan

Financing for New Construction

One of the significant measures in the plan is to expand forward commitments and increase liquidity for Construction to Permanent financing[9]. This aims to provide a stable and low-cost source of capital for the construction of affordable multifamily units. For instance, the Federal Housing Finance Agency (FHFA) raised the maximum amount of multifamily loans that Fannie Mae and Freddie Mac can purchase by 11% to a total of $78 billion in 2022. This move is expected to enhance liquidity in the multifamily market, making it easier to finance new developments[9].

Addressing Market Gaps

The plan also aims to fill market gaps in financing for various housing types, including single-family homes, 2-4-unit properties, accessory dwelling units (ADUs), manufactured and modular housing, and smaller multifamily properties[9]. These types of housing have the potential to increase supply in constrained markets and create modest density, which can improve labor market outcomes and reduce greenhouse gas emissions when paired with state and local policies that remove barriers to development[9].

Legislative and Strategic Actions

President Biden is urging Congress to pass legislation to further address the housing supply gap, including providing a $10,000 tax credit for first-time homebuyers and those who sell their starter homes, building and renovating over 2 million homes, and lowering rental costs[21]. Additionally, the administration has announced new steps to reduce homebuying and refinancing closing costs and to crack down on corporate practices that exploit renters[21].

Reducing Homelessness

A complementary goal of the Biden Administration is to reduce homelessness by 25% by 2025, as outlined in the "All In: The Federal Strategic Plan to Prevent and End Homelessness"[22]. This plan emphasizes not only providing housing but also ensuring access to necessary support services. The budget for this initiative includes increased funding for multifamily housing programs and mandates energy and water efficiency improvements in housing construction[22].

Zoning Reforms

Zoning laws have been identified as a significant factor driving up housing costs, particularly those that restrict the development of apartments and enforce other limiting regulations such as building height caps and minimum lot sizes[10]. The administration is considering the use of financial incentives to encourage local governments to reform these restrictive zoning laws. Potential strategies include tying federal transportation funds to zoning reform efforts, which could be more effective in prompting changes in wealthier suburbs that currently receive minimal direct funding from the Department of Housing and Urban Development (HUD)[10].

Challenges and Criticisms

Despite the comprehensive approach, the plan has faced criticism for not addressing government incentives that boost investor demand, which could have a quicker and more substantial impact on stabilizing house prices and increasing home ownership[16]. Additionally, while federal policies have aimed to provide relief through direct support and stimulus checks, more targeted measures such as tax credits for landlords might be necessary to effectively address rental market challenges[3].

Case Studies

The Zillow and Census Bureau Partnership

Zillow has been at the forefront of housing research, often collaborating with the U.S. Census Bureau to provide comprehensive data and analysis on housing trends. For instance, a recent webinar by the Census Bureau featured insights from Zillow economists on various housing metrics. However, it's essential to note that this analysis has not undergone rigorous statistical review and may not meet the Census Bureau’s quality standards[17].

The Impact of Interest Rates on Commercial Real Estate

Interest rates and their relationship with commercial real estate (CRE) have historically been complex. Recent analyses show that there is essentially no direct correlation between changes in the federal funds rate and property cap rates. However, narrower spreads when rates change increase the likelihood of rising cap rates. This phenomenon is further complicated by the rising risk aversion observed in tandem with increasing interest rates, as reflected in widening spreads in corporate bond markets and declining price-to-earnings ratios in global equity markets. These dynamics suggest that CRE debt and equity pricing are likely to experience uneven pressure across sectors and geographies, largely dependent on investors' willingness to accept smaller risk premia[1].

Credit Card and Auto Loan Rates

Consumers have also faced the highest annual percentage rates (APRs) on credit cards since 1994, with the current rate nearly 21% for revolving balances. This translates to significant additional annual interest charges for consumers carrying average balances. Meanwhile, auto loan rates have remained steady at about 7% for new vehicles, reflecting more on buyer demand than Federal Reserve rate decisions[18].

Inflation and Its Effects on Real Estate

Inflation has positively impacted commercial real estate by driving up asset values and performance. Despite rising interest rates, real estate remains a robust long-term investment. Investors are advised to focus on properties that generate consistent cash flow to navigate the challenges posed by higher borrowing costs and diminished growth rates. The Federal Reserve’s seven rate hikes have significantly increased the cost of debt, making financing for new real estate developments more challenging[15].

Local Factors Influencing Housing Prices

Local factors such as employment opportunities, quality of school districts, and amenities play a crucial role in housing demand and prices. For instance, the closure of a major employer can reduce demand and cause housing prices to fall, while high demand driven by desirable local features can push prices upward. Additionally, local supply and demand dynamics influence negotiation power between buyers and sellers[5].

Government Initiatives

The American Rescue Plan has introduced several place-based programs aimed at revitalizing regional economies and addressing housing crises in rural areas. For example, the Build Back Better Regional Challenge and the Good Jobs Challenge have awarded substantial funding to regional coalitions and workforce training systems, respectively. These initiatives are designed to leverage regional assets and improve economic conditions, which can indirectly impact housing demand and prices[23]. These case studies illustrate the multifaceted nature of the U.S. real estate market and how various factors, including interest rates, inflation, local conditions, and government policies, influence housing prices.

Market Expectations

A key factor in the sustained high real estate prices in the United States, despite elevated interest rates, is market expectations regarding future house prices. When the price of an asset, such as housing, experiences a significant and prolonged increase, investors and buyers may come to expect that prices will continue to rise. This expectation can create a feedback loop, where the anticipation of higher future prices justifies purchasing at currently high prices, further driving up the market[16]. Moreover, broader economic expectations play a crucial role. Long-term inflation expectations have remained relatively stable, anchored in part by confidence in the Federal Open Market Committee (FOMC) to manage inflation effectively. This stability is reflected in market pricing, which as of late 2022, projected a high probability of the federal funds rate reaching the 1.75% to 2% range. The expectation is that higher interest rates will eventually curb demand and bring inflation under control, thereby stabilizing the housing market[1]. Additionally, the immediate reaction of house prices to monetary policy surprises suggests a dynamic interplay between market expectations and real estate valuations. When the Federal Reserve enacts unexpected changes in the federal funds rate, forward guidance, or large-scale asset purchases, house prices adjust rapidly. Sellers tend to lower their list prices to attract buyers who face higher mortgage costs due to increased interest rates. This rapid adjustment, occurring within weeks rather than years, indicates that market expectations are swiftly incorporated into housing prices[24]. Thus, despite high interest rates, the interplay of investor expectations and broader economic forecasts has maintained elevated real estate prices in the United States. The confidence in future price stability and rapid market adjustments to monetary policy contribute to the persistence of high prices in the housing sector.