Residential Real Estate – The Implications of “Higher for Longer”

$119.8 trillion.

That’s the estimated size of the U.S. real estate market, according to Statista. And it’s expected to grow by 4.5% annually through 2028.

Moreover, residential real estate accounts for $94.4 trillion of this market. That makes it one of the country’s most important sources of wealth.

In fact, using data from the 2017 Federal Reserve Survey of Consumer Finances, as visualized by Equitable Growth, we see that home equity is the single biggest source of wealth for the middle class.

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And using Census Bureau data released in June 2023, we find it’s the second-largest household asset, with a median value of $174,000 (in first place is real estate investment properties).

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It is this enormous and complex market that’s become a contentious battleground in the Fed’s fight against inflation. Consider how March’s month-over-month all-item CPI came in 0.1 percentage points higher than expected…

Housing and gasoline costs contributed more than half of that increase.

In other words, you can blame both for helping the Fed decide yet again not to cut rates.

Going into this 2024, the implied probability of the Fed funds rate being above 5% by year’s end was close to zero. That means that the market believed there was an extremely low chance (almost none) that the Fed wouldn’t cut rates at least once before the end of the year.

But since the latest inflation report, it’s jumped to roughly 50%.

In fact, to quote an April 18 Bloomberg article (emphasis added):

"Housing is the biggest stumbling block,’ says Chicago Fed President Austan Goolsbee. ‘We thought we basically understood the mechanical, short-run model of how much housing inflation should be coming down. And it hasn’t come down as fast as we thought…"

It could get even more complicated still. As we can see, rent inflation in all U.S. regions is well above the Fed’s 2% inflation target.

Since CPI is calculated based on average rents from new and existing leases, any changes in them take time to filter through the larger market. Even worse, the odds are rising that rental inflation is here to stay, along with housing-related inflation in general.

A Deeper Dive Into the Underlying Issue

Because of higher-than-expected inflation in March, mortgage rates are rising again.

Mortgage rates recently surged past 7%, renewing pressure on the housing market. With the 30-year fixed mortgage rate now at 7.1%, that’s roughly 20 basis points above its 52-week average. Unfortunately, that means for regular people, interest rates haven’t come down at all.

As a result, the recent uptrend in existing home sales abruptly ended when March sales were down 4.3% over February. That was the largest percentage decline since November 2022, according to The Wall Street Journal.

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Summed up, affordability is moving in the wrong direction thanks to both higher mortgage rates and higher prices. And Redfin recently reported mid-April that home prices are rising again.

The median increased by 5% on a year-over-year basis in the four weeks ending April 14.

It’s now $380,250, just $3,095 below the all-time high set in June 2022. And, as of April 14, the median payment to service mortgage debt was roughly $2,800.

Compare that to 2021, when average homeowners spent less than $1,750 per month to finance their homes.

None of these facts make the Fed’s job of managing inflation easy. Or, so far, successful.

One could even make the case that, after two years, the Fed hasn’t been able to impact housing inflation at all.

The Real Real Estate Problem

The real problem the Fed is battling here is supply.

Although elevated interest rates can subdue demand in certain areas, it’s also kept a lid on supply. People who locked in cheap rates before 2021 aren’t willing to sell in today’s conditions.

Understandably so.

The New York Times recently showed that the gap between new loans and existing mortgages hasn’t been this high in decades.

It adds that, between 1998 and 2020, there was never a time when more than 40% of American mortgage holders had locked-in rates more than one percentage point below the market rate. So it’s only reasonable that a working paper from the Federal Housing Finance Agency, published in March, found that (emphasis added):

“… for every percentage point that market mortgage rates exceed the origination interest rate, the probability of sale is decreased by 18.1%. This mortgage rate lock-in led to a 57% reduction in home sales with fixed-rate mortgages in 2023-Q4 and prevented 1.33 million sales between 2022-Q2 and 2023-Q4. The supply reduction increased home prices by 5.7%, outweighing the direct impact of elevated rates, which decreased prices by 3.3%.”

The Bad News and Good News Broken Down

The bad news is that inflation is increasingly sticky.

Housing inflation will likely require a significant surge in new supply before it falls to “acceptable” levels. But it’s difficult for homebuilders to cost effectively borrow and construct homes in a high interest rate environment. And equally difficult for homebuyers to afford a mortgage.

The Fed must combat inflation though, so they may have to keep rates higher for longer.

Without a crisis like we all experienced in 2008/2009, it’s tough to see enough new supply hitting the market that home prices would retreat.

This would not be bullish for the economy or the average American.

The good news in all this is that the market remains strong for now. It’s therefore supporting home equity and real estate investment trusts (REITs) and private landlords operating in the residential sector. Most existing homeowners also have significant and growing equity in their homes.

And when there is pain in the markets, there is also opportunity. For instance, the two largest multi-family REITs Mid-America Apartment Communities (MAA) and Camden Properties (CPT), could do well under these conditions. These companies and their peers benefit from the current environment in several ways.

When mortgage rates rise, a lower percentage of people can afford to buy homes all other things equal. That keeps them renting. Higher rates also make constructing new homes and apartments more expensive, which reduces competition. And since apartments generally have staggered 1-year lease terms, landlords are able to increase rents almost in real-time alongside inflation.

We also see relative strength returning to the multifamily sector as it outperformed Vanguard Real Estate Index Fund ETF Shares (VNQ) – a suitable stand-in for the larger publicly traded REIT world – since rates started to increase again.

In general, both REITs have outperformed the market consistently since 2015. That trend may continue if supply remains an industry issue.

In Closing

It cannot be overstated that the residential real estate market is a crucial source of wealth in the U.S. However, with housing inflation proving to be stubborn and mortgage rates soaring past 7%, challenges keep mounting.

This is why the Fed's dilemma in balancing inflation and housing market stability is so challenging… and so difficult to solve.

We can’t predict how long this situation will last. But as long as it does, opportunities do exist for investors in resilient sectors such as multi-family REITs. And if inflation in the housing sector becomes too elevated, that increases the risk of the Fed “overtightening.” That’s when rates increase too fast for the economy to handle, and a sharp recession occurs.

That’s why we believe paying close attention to the U.S. housing market is valuable for all investors.

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Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.

Wide Moat received compensation from FundSomm for publishing articles on topics mutually selected by Wide Moat and FundSomm.

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