The rapidly rising interest rates have made headlines for most of this year. Before the pandemic, the housing market was experiencing a supply shortage, resulting in inflated prices. Over the past two years, the housing market experienced extreme demand by the surge of remote workers looking to relocate to less expensive areas. Supply remained limited, driving prices up in stiff bidding wars. Meanwhile, the economic impact of the pandemic has resulted in ballooning inflation worldwide. 

The Feds have been raising interest rates since March 2022 to curb inflation and restore the balance of demand and supply. This uncertainty in the market has left buyers and investors alike questioning whether they should wait for interest rates and housing prices to “cool.” The anticipated consequence of the Fed’s efforts will ultimately be a transference of wealth to housing.

We’ve been here before - The Volcker Recession

When Paul Volker stepped into his role as Chair of the Fed Reserve on August 6th, 1979, he inherited an economy attempting to recover from multiple inflation surges stemming from an embargo that quadrupled energy and, subsequently, food prices. Before Volker took office, the Feds raised interest rates modestly in hopes of taming prices but to no avail. On October 6th, 1979, Volker called a surprise meeting that would ultimately alter the course of monetary policy, allowing interest rates to go higher than before and send the economy into two successive recessions. Higher interest rates generally reduce inflation by reducing spending, slowing the economy, and can lead to mass unemployment. The result is less spending, and thus less inflation, but also slower growth.

All is not lost - Housing affordability remains high

Source: NY Times

In the 16 months between July 1981 and November 1982 - the only comparable time in history with high inflation and high interest and contracting GDP - housing affordability was crushed under the weight of 15%+ interest rates. The housing affordability index was 62 - meaning people with a median income looking to buy a home had only 62% of the income necessary to afford the median home. A home is ‘affordable’ if the mortgage payment (principal and interest) amounts to 25% or less of the family’s income. In 2022, almost every area of the country will have a housing affordability index of over 100, meaning that while consumer prices are rising for durable goods, the ability of households to buy homes at recently accelerated prices is still excellent. 

Source: Federal Reserve Bank of St. Louis

The current federal funds rate is 3.75% to 4.00% as of November 2nd, 2022. This is the fourth consecutive rate hike of 0.75% and the sixth rate hike this year. During the pandemic, inflation hit close to 0%. Inflation quickly rose, hitting 5.4% one year ago and peaking at 9.1% in June 2022. Even with the interest rate hikes, inflation only dropped to 8.3% in August. According to its recent statement, the Fed is committed to bringing inflation down to 2%. "We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2%," stated Jerome Powell, the Fed Reserve Chairman. Powell is running the same playbook Paul Volcker did in the 1980s to tame inflation; however, we cannot use the same approach due to the extreme difference in debt to GDP ratio in the 1980s vs. today. 

In 1981 the debt to GDP ratio was 31%, while today, it is over 100% more - sitting at a whopping 134.24%! The Federal Reserve doesn't have the luxury of keeping interest rates high for a protracted period as it could have in 1980. The government simply doesn't have enough money to keep interest rates where they are heading and still make interest payments on its debt. If the government runs out of money, it will need to make more of it which will again push inflation up, or cut services which it seldom does. Quantitative easing during the pandemic got us into this inflation problem, and we cannot use it as a solution. The wisest course of action is to bring interest rates back down by the second half of next year. 

The current trajectory signals that interest rates aren't likely to stay high for long; in fact, they are projected to decline to 3.9% in 2024 and 2.9% by 2025, which sets up a very similar situation around housing in 1981 - 1991, post the 'Volcker recession.' With mid-range interest rates and a high affordability index, consumers will likely continue to purchase homes and drive prices up after we leave this period of uncertainty.

What happens next?

Why will consumers flock to homeownership rather than stocks or other investments? In most cases, higher interest rates mean a stock market that declines in value because companies will borrow less money when interest rates rise. The result is their earnings will grow at a slower rate than investors anticipate. From 1960-1990, new construction or housing starts in the US were cyclical but constant, keeping pace with steady linear US population growth. That linear population growth has continued chiefly, but housing starts weren't consistent and cyclical. In 2006 housing starts began to fall; in 2010, the Great Recession brought housing starts to their lowest levels ever recorded. Despite increasing over the past decade, housing starts have never since reached the peaks of past decades, setting the stage for a larger-than-ever deficiency in housing inventory. As a more stable asset and projected demand-driven price increases, consumers will gravitate more heavily toward real estate to capitalize on equity over the next decade. 

Source: FRED

As previously mentioned, from 1981 to 1991, home prices surged 73.4% after interest rates began to decline. However, during this time, there wasn't a drastic undersupply within the housing market, and shopping for a home had much lower price transparency. You couldn't exactly jump on the internet in the 1980s to get on-demand home pricing and sales history. The first MLS began in 1985 and was a printed book. The other drastic difference catalyzing home prices is the rise of homes as an asset class. Institutional investors are flocking to real estate ownership as a durable long-term income diversification and appreciation tactic. Consumers are now competing with a larger pool of buyers than ever for a smaller pool of homes-to-population than ever before.

Source: FRED

With higher affordability, lower inventory levels, stability and interest on the consumers' side, and increased competition from institutional investors, we can expect a surge in real estate pricing equal to or greater than that of the 1981-1991 period. That means the median home price could reach as high as $760k by 2032.

Why is now still the right time to invest in real estate?

The real estate market can be positively affected by rising interest rates. In short - equity and increased rental income. If you buy now, you can start building equity immediately. That's true no matter which way the real estate market is leaning at the time. With the systematic low inventory levels and new construction already lagging, the increased demand will drive home prices upward as interest rates decline. As mentioned, prices rose 73% between 1981 - 1991 following the Fed's tough-love tactic that cooled inflation, benefiting homeowners greatly. With Welcome, buyers receive a locked-in asset price upfront, so demand-driven prices or continuous bidding wars do not heavily impact homeowners and investors. 

As mortgage rates reach their highest since the 2008 market crash, the market for rental properties will expand because fewer people can qualify for mortgages. When interest rates are high, the declining demand for mortgages lowers prices, so it can sometimes be better to buy during a rising interest rate environment. As home buyers are being pushed to less expensive homes, and some are pushed out of the home purchase market altogether, the rental market becomes clogged, and prices surge. Because the housing supply is not highly elastic, and housing starts are facing record lows, investors benefit from the demand-driven rental income increases. When there is urgency on the market, renters are willing to pay more because they don't know how much longer a space will be available. As the economy cools and interest rates decline, as is predicted over the next two years, home values will increase due to more activity in the housing purchase market. It's a win, win. 

The Bottom Line 

Buying a home or investing in a property as mortgage interest rates rise is nothing to fear. From a historical standpoint, our interest rates are still relatively low, which bodes well for buyers. 

When you work with Welcome, our team will guide you through the home building process from financing to construction, connecting you to our preferred lenders for the best rates and a thorough breakdown so you can feel secure with your financial decisions. If you're ready to build your home or invest in a rental property, our Welcome advisors are here to help you achieve your financial goals. Get started

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