A Rational Look at Rate Cuts and Home Prices
By now, you have probably seen headlines like this, “The Federal Reserve will cut interest rates six times in 2024” Then, as you scroll through Instagram or TikTok, you are flooded with real estate marketing posts saying, “BUY NOW before prices surge as low rates unleash a wave of buyers.”
Should you believe the hype? There are two critical parts to this conversation worth analyzing. Will property values react with a rapid push higher if rates drop, and can you even trust these rate predictions? After all, that was the mantra of 2022. Guess what happened? Rates went much higher than anyone expected (including me) in 2023! This dramatic shift underscores the need for careful examination before making significant decisions based on current market forecasts.
Understanding Rate Forecasting
Home Loan Rates closely follow the US 10-year Treasury, reflecting factors like inflation and investor confidence in the economy. Predicting future rates is complex, requiring understanding Fed policy and its economic effects. Though forecasts anticipate these effects, they struggle with the "lag effect," where policy changes take time to impact different sectors fully. Forecasters attempt to interpret these effects and predict market direction.
Two prominent forecasters are Fannie Mae and The Mortgage Banker Association. If you follow these forecasts enough, you’ll see how often they change and how wrong they can be! For example, in February 2023, Fannie Mae believed the Q4 average rate would be 5.7%. One month later, in March 2023, they increased their projection to 6.4%. Then, another increase came in September 2023, jumping to 7.1%! Even experts like Fannie Mae can struggle to predict future rates accurately!
If a forecast is a prediction or estimate of future events, shouldn’t those forecasts change as the future events unfold differently than one expected? Of course. That is exactly what happens every month as new data is released and companies report their earnings.
The Fed Battles Inflation: Housing Market Laughs
The Federal Reserve has been very persistent in its battle to tame inflation. Since early 2022, they raised the Federal Funds Rate by 5.25%. As a result, consumer rates, such as Auto Loans, Credit Cards, and Mortgages, rose in tandem. In past economic cycles, high-interest rates squashed economic activity, leading to a pullback in consumer and business spending. These behaviors would ultimately lead to a recession. If you are curious why this cycle has performed differently so far, be sure to check out my video, “Why The Fed Hasn’t Crushed The Economy.”
Softness appeared early in the housing sector as mortgage rates jumped from 3.25% to over 7.0%! With mortgage payments increasing by as much as 60%, many buyers were priced out of the market. Current homeowners who had the desire to move also felt stuck. As a result, the housing inventory freeze would kick into overdrive.
Probably the most shocking outcome in this Fed tightening cycle was the fact that home values remained firm and, in many markets, increased! Who would have thought sky-high mortgage payments wouldn’t have a negative impact on home prices? The market was reminded of the old law of “Supply-Demand.” High rates pushed out many buyers, but at the same time, they also suppressed inventory due to current homeowners staying put. The result was a market where buyers outweighed sellers, thus propping up home values.
What Really Drives Home Values?
If higher mortgage rates these past two years hurt affordability and softened demand, it’s natural to assume the opposite would be true if rates drop. Low rates would improve mortgage payments, which should improve demand. If demand increases and supply remains constrained, prices will surely rise. But is it really that simple?
If housing is driven mostly by the composition of supply and demand, we need to think about the implications of each to form an opinion. Demand is a product of confidence, income, the wealth effect of asset values (stocks, mutual funds, housing), and general affordability. Supply is derived by building more homes or having more sellers list homes for sale. The specific reason why rates drop will impact each of these greatly.
Soft-Landing
A ”soft landing” is where the economy slows just enough to bring inflation down to the Federal Reserve’s 2% target without pushing the economy into a deep recession. The Fed believes this will be the most likely outcome. In fact, just last week Janet Yellen, the Secretary of the Treasury said that soft-landing skeptics are now “eating their words.” Recent data suggests there is a chance she may be right. Inflation readings have been consistently falling, and the unemployment rate remains near historic lows, all while Q3 GDP just came in at 4.9%!
Let’s think about supply and demand with housing in this environment. Demand would certainly increase. There is no doubt about that. In the Goldilocks scenario of falling inflation, stable to rising incomes, a thriving job market, and the cost of goods dropping, the suppressed buyer demand would surge. Without more inventory, prices would have nowhere to go but up, and probably up a lot!
What could make supply increase under this soft-landing scenario?
Some say we could see increased construction of new homes. In my region, the Baltimore-DC Metro area, building new single-family homes or condos represents a challenge due to long-term planning and, in many cases, a lack of land. Even if that is a cure, it is one that takes many months, if not years, to feel the impact.
One possible shock to supply that could come in 2024 is investors selling their investment properties. In 2021, I was quite surprised by the number of new move-up purchasers who decided to retain their departing residence as a rental. I have spoken to many of them this past year, and some loathe being a landlord and cannot wait to sell when the lease expires!
Others are nearing the three-year mark to sell and avoid paying income tax on their property value gains. The IRS provides an income tax waiver for $500,000 of gains for a married couple and $250,000 for a single tax filer if they have occupied that home as their primary residence for three of the last five years.
It is also possible that inventory worsens much more in this lower interest rate environment. Over the past two years, high rates have locked many buyers in their homes. Their ultra-low interest rate made moving up too expensive. If rates fell, their household balance sheets could more easily afford to move finally. If they listed their home for sale and bought another, the net impact on inventory is zero. But if they decide to maximize their wealth by keeping their departing residence due to the low mortgage payment and rental cash flow, the impact is negative for supply!
In summary, if the Fed engineers a soft landing, Real Estate should perform very well and see steady or significant home appreciation.
Hard-Landing
In the hard landing scenario, there are many possible outcomes, and one that probably varies greatly depending on which market and sub-market we are discussing. While the consequence of a severe recession is low rates, the negative impacts of consumer confidence and job loss may crush demand while at the same time bringing forward an increase in supply.
Demand can be impacted in many ways during a recession. Job loss is the main ingredient in triggering a loss in housing demand. If you lose your job, you can’t buy a house or get a mortgage. If your friend or a family member loses their job, that could shatter your confidence. As the economy weakens, stocks tend to fall. As one sees their net worth dropping, confidence erodes further and causes a state of paralysis in spending behaviors, especially big-ticket items like houses!
Supply is easily impacted as well. Builders and Developers pull back their investments and take a wait-and-see approach. While there is a lag in larger planned communities, it is immediately felt in the Fix & Flip sector.
Individual homeowners begin listing properties for a variety of reasons. Job loss could force someone to sell to capture the equity to get to the other side of their new financial struggle. I’ve seen countless dual-income families forced to sell and downsize when one significant income was lost over the years. That is certainly a possibility this time, especially in this work-from-home era.
Investors may be forced to liquidate their rental portfolio if it performs poorly. If tenants lose their jobs, they could default on their lease agreement, bringing hardship for the seller. This is magnified when the seller has multiple investment properties.
There is also no shortage of short-term rental (STR) properties, which require a strong economy and a traveling consumer for the numbers to work. These STR operators may see rental income evaporate overnight, leading to quick sales and, in some cases, default with their lender.
Fewer buyers reduce demand at a time when inventory could explode higher, with many sellers in distressed situations. If values begin to drop, confidence would be shattered further, causing more buyers to hold off. We also have those who purchased at the peak with 7%-8% interest rates and low down payments. They could be compelled to toss the keys back to the lender as their payments are sky-high, and they find themselves in upside-down mortgages, unable to refinance. This issue is compounded when job loss is experienced, just as in the Great Financial Crisis.
Needless to say, this hard-landing approach, which likely brings us much lower interest rates, might not be the savior many are looking for in real estate. A hard landing in the economy would likely bring depreciation to many housing markets, especially those with high investor concentration or work-from-home migrations.
What do I expect in 2024?
I think it’s a little too early to make a decisive call on how this economy shakes out. I continue to be amazed at the resiliency of the consumer. My clients are still vacationing, frequenting restaurants, buying vehicles, and spending freely. This makes me consider a “No-Landing” scenario where we continue to see a year play out exactly like 2023, with stubbornly high rates and disgustingly low housing inventory.
However, when I get outside my local bubble, I hear stories of financial instability. Credit Card and Auto Loan Delinquencies are now higher than pre-pandemic levels. Credit continues to tighten as many banks are experiencing stress in their deposit base and commercial loan portfolios. The JOLTs (Job Openings) and US Jobs reports also show a consistent downward trend. These factors could push the US Economy into a hard landing.
If I were forced to make a prediction right now, I’d say 2024 will play out somewhat similarly to 2019, which I would define as a soft landing coming off the Fed's last hiking cycle. This time is very different, as the pandemic stimulus response was powerful. But we are now almost two years into this aggressive rate-hiking cycle. The rate of change has been so significant that I believe we will see employment and consumer spending soften. In my view, the Fed will begin to adjust its policy in early 2024, including some rate cuts and a possible change to its quantitative tightening policy. Mortgage rates could surprise many on the low side as we approach a 5-handle.
In 2019, mortgage rates dropped from 5% to 3.5%. The early part of the year was still slow, as many buyers remained cautious on the sidelines. It wasn’t until the summer and fall markets that year that we experienced a meaningful increase in home values and the number of transactions.
Fortunately, I believe the Baltimore-DC region is somewhat insulated from any downturn that comes our way. Our local economy is quite diverse in the types of industries it serves. From a housing perspective, inventory is still obnoxiously low, and the investor animal spirits were quite tame compared to other regions over the past few years. As a result, I believe an improvement in rates will be met with a surge of buyer demand and stable to increasing home prices moving forward.
The housing market is a journey, not a destination. Embrace the unexpected twists and turns, and remember that the most important factor in achieving your real estate goals is having a clear vision and a trusted advisor by your side. If owning real estate is on your wish list for 2024, please contact me directly. I welcome the opportunity to be your trusted advisor!