Exhibit 1 shows the home buying power of a fixed $1,309 payment (the payment required to purchase a median-priced existing single-family home with a conventional 30-year fixed rate mortgage at the end of 2021) at various interest rates.
In this static equilibrium analysis, we observe home prices dropping on average by just over 3% for every .25% increase in mortgage rates, or by minus 11.7% for a 1% (100 basis point) increase in rates. The problem with this type of analysis is it not only holds demand (buyer capacity) constant, but it also holds the supply constant, which begs the question: What if the seller won't accept a lower price?
Some buyers are more sensitive than others to rate changes. Some have more savings or equity to use after a sale. Some sellers anchor off of recent neighborhood sales and want to believe they can secure similar prices. To the extent sellers are stubborn and reluctant to accept the new lower prices offered from identical households, they could stay on the market longer waiting for higher offers. If they have discretion on timing, they may simply take their listing off the market. If half the sellers have such discretion (what we describe as a price elastic supply) then rather than see prices drop as shown in Exhibit 1, buyers may be the ones who have to compromise, lowering their expectations and submitting full-price offers on less-expensive homes. Our point is that if sufficient buyers and sellers have some discretion in their pricing or timing, static equilibrium analysis does not work - at least in the short or intermediate term.
Taking into account that seller as well as buyer behaviors can change also helps explain why prices continue to appreciate now during a period when nominal interest rates are increasing and affordability seems to be decreasing.
Static equilibrium analysis also ignores a host of other important home price factors currently present in the market, including an unusual dearth of inventory and fewer than normal new homes in production.
Why Mortgage Rate Increases Matter
It is not enough to know that mortgage rates are increasing. What matters is why they are increasing. If they increase because real rates have increased based on a scarcity of capital relative to demand, such as when the government must borrow money to cover a deficit, then the impact on asset prices is likely to be strong and negative. If mortgage rates go up simply because of more inflation, without any change in real rates, then the impact on home prices is likely to be less negative.
Before expanding on this point, let's examine the empirical evidence on mortgage rates and home prices.
Mortgage Rates and Housing Market Supply vs. Demand
Our discussion thus far has been focused on movements in mortgage rates and their direct impact on home prices. The reality is that the mortgage rate transmission is primarily through home sales. In particular, lower rates increase the potential pool of households who can afford to purchase a home and higher rates do the opposite.
The past several years have seen an unprecedented decrease in the number of homes available for sale. As mortgage rates declined with the onset of the pandemic, the pool of potential buyers increased significantly as would be expected. However, these lower rates did not lead to a meaningful increase in new home construction, in part because of the pandemic and supply chain constraints on building materials and labor.
At the same time, the new phenomenon of employees working from home led to greater demand for existing homes. As a result, there has been greater demand for a much smaller supply of available new and existing homes for sale. The predictable result has been the sharp increase in home prices which dates back to the summer of 2020. Rising mortgage rates will likely put a cap on the level of homes sales which would be happening anyway with the current limited inventory situation. At the same time, very tight inventory will slow down prices increases but not reverse them.
Recent Inflation Indicators, Mortgage Rates and Demand Versus Supply
In December 2021 the Consumer Price Index (CPI) increased at an annual rate of 7% shocking some observers. In January 2022, the CPI increased at an annual rate of 7.5%. If these trends were expected to be permanent and long term, we would be observing mortgage in the double digits, as we saw in the early 1980s. But most observers expect longer term inflation to be more in line with the government's target of 2.5%, perhaps running 3% to 5% in 2022 and then declining slowly thereafter.
In parallel with higher inflation reports, early 2022 mortgage rates started increasing, exceeding even the longer term expected inflation rates. Normally, this dampens affordability and demand and causes prices to fall. But inventories are not increasing and remain at historically low levels. Rather than wait for lower prices, price-constrained buyers are going to need to settle for smaller, cheaper homes.
Another sign that prices aren't going to be coming down any time soon: When inflation hit 7%-plus, mortgage rates did not move up to 9.0% as one might have expected. Instead, they increased only about 50 basis points. With 30-year FRM rates currently near 4%, it would be reasonable to assume that a long-term inflation rate of no more than 3% has already been baked into current mortgage rates, providing a real return of 1% or so on financed real estate.
Where Prices Might Head Given Higher Inflation Rates and Higher Mortgage Costs?
Durable assets like real estate are a good inflation hedge, so inflation and higher mortgage rates are a double-edged sword. Higher inflation increases interest in holding durable assets like real estate as opposed to bonds, which suffer from unexpected inflation. But the cost of money also increases, and both of those effects impact prices.
Interest rates incorporating inflation rates do not necessarily have a negative impact on assets that are expected to appreciate at that same rate, or more, but the market seldom gets this right. Inflation can be unexpectedly low (as has been the case over the past several years) or unexpectedly high, as might be the case for the next year or two. If mortgage investors (lenders) price in inflation at lower rates, like 2%, and it then ends up at 7%, there will be a wealth transfer from mortgage lenders to borrowers. The more inflation we expect in the future, the more desirable it is to buy a home now and capture this price appreciation.
If rents or prices grow at rates comparable to, or above, those embedded in mortgage rates, then the impact of higher interest rates may not be negative, especially for assets like single family homes.
What is unusual about the present market is that inventories of homes available for sale remain at historically low levels. With that as a backdrop, it is hard to imagine interest rate increases high enough to bring nominal prices down. Further, if the interest rates increase because of inflation expectations increasing, that has a dampening impact on affordability, but also increases the desire to hold durable assets as an inflation hedge.
Current market trends are not following the patterns of some previous periods when mortgage rates have increased. Since the start of the year, Conventional mortgage rates have increased by approximately 60 basis points, and theory suggests that should or could reduce demand. At the time of this writing, 30-year FRMs were approximately 4.1% but longer-term inflation indicators were 3% to 4% for at least the next few years. This suggests prices will be somewhat neutral and not fall, until we observe significantly higher mortgage rates, above inflation expectations and or a significant increase in inventory for sale.
With current inventories so low, the market remains somewhat frozen with existing homeowners hesitant to sell since there are not many choices with regard to other homes to buy. While mortgage rates have climbed, some sellers in this "sellers' market" can simply take their listings off the market, rather than suffer price declines, and this appears to be the likely case in 2022. Prices are more likely to increase then decrease, but not at 2021 rates.