The housing market has been hit more by rising interest rates than any other sector. Both the decrease in housing activity and the decrease in property prices have far-reaching implications on households, the economy, and the financial markets. The property market, like many others, saw a boom during the pandemic, and is now suffering the aftereffects. The 2008 housing boom and subsequent global financial catastrophe is still fresh in the minds of some investors, and they may fear a repeat. What long-term effects could the current housing market slowdown have on investment portfolios?
The housing market has made strong gains since 2012 but is slowing
The housing market has substantial implications for the overall economy and the financial system. Mortgage payments are the highest monthly expense for most people because their primary residence is the most valuable asset on their personal balance sheets. It's important for diverse investors to keep an eye on the housing market because it can be both a source of income and a barometer of the economy at large. The "wealth effect" refers to the positive feedback loop between rising housing prices and increased consumer spending and investor optimism.
Housing prices accelerated during and after the pandemic as many sought to purchase new homes because they left cities, needed more space, or were working from home. In addition, robust consumer balance sheets and limited spending on other goods and services meant that consumers had the excess savings to consider major purchases. The chart above shows an index of housing prices across 20 major U.S. metropolitan areas and highlights the steep rise since 2020. This added to the gains since the housing market bottomed in 2012. Over this full period, the average home price in these areas rose 127%.
One measure of the economic impact of housing is what's referred to as "residential fixed investment" in the quarterly GDP report. According to the Bureau of Economic Analysis, residential fixed investment increased by 7.2% and 10.7% on an annual basis in 2020 and 2021, respectively, contributing 0.28 and 0.47 percentage points to annual growth in those years. This has also added to inflationary pressures. In October, the shelter component of the Consumer Price Index, which has a weight of 42% within core CPI, rose 6.9% compared to the previous year. A red hot housing market added to economic growth but also to the price pressures felt by many households.
Mortgage rates are at their highest since the mid-2000s housing bubble
More recently, the Case-Shiller index experienced its largest deceleration in its history. This is due to rapidly rising mortgage rates, the slowing economy, and the general reversal of pandemic trends that has impacted many economic and stock market sectors. The average rate on a 30-year fixed mortgage currently sits at 6.6% after briefly rising above 7% for the first time since 2002. This exceeds the 30-year average of 6% and is well above the average of 4.1% since 2008. Homebuyers and investors alike are experiencing sticker shock as rising rates make housing less affordable by pushing up mortgage payments, even as home prices decline. Many measures of housing activity have slowed as a result, from building permits and housing starts to existing home sales and mortgage refinancing.
Similarly, the S&P 500 real estate sector has fallen 25% this year, worse than the overall index decline of 16%. While privately held real estate may be holding up in value on paper, this is likely due to delayed mark-to-market adjustments. For those holding private real estate, this may not matter if there is steady rental income, especially if it can offset rising costs in this inflationary environment.
Existing home sales have slowed
Where does the dramatic rise and now decline in the housing market leave us? While the future is uncertain, market expectations are for rates to remain elevated alongside inflation. Even if the Fed does slow its pace of rate hikes, fed funds futures suggest that policy rates will hit 5% by mid-2023. Of course, it's also unlikely that rates will surge as much as they have already. So, unless there is another surge in housing demand, the short-term path of home prices is likely to be sideways at best. Regardless, these factors could continue to affect the entire housing sector and detract from residential real estate activity.
The good news for investors is that a repeat of 2008 is also unlikely. Household balance sheets strengthened during the pandemic and many focused on paying off debts and shoring up savings. Additionally, the housing bubble was not just due to sky-high home prices - it was due to historic levels of financial leverage that led to systemic risks within and across banks. Fortunately, there are few signs that this is the case today. Collapses in areas such as cryptocurrencies, and declines in tech stocks, appear to be having few spillover effects into the real economy so far.
The bottom line? While the housing market may face headwinds, many other parts of the economy are steady. Investors ought to remain diversified across sectors and construct their portfolios and financial plans with a broad view of their assets, including their real estate holdings.
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