Are you ready for a (deeper) housing market downturn?
It’s rough in the real estate space right now. Price growth is non-existent or negative in many markets, rates are sky-high, and home builders are seeing the world seemingly collapse around them.
Lenders are not immune, with volume way down and default rates likely to grow as long as housing continues on a downward trajectory. All of this with the ever-present specter of sustained high inflation hanging over the American economy like an executioner’s axe.
According to research compiled by the Federal Reserve Bank of Dallas, American home prices could fall as much as 20%, largely as a result of rising mortgage rates, which are dramatically increasing homeownership costs and thinning the pool of prospective home buyers.
Pantheon Macroeconomics Chief Economist Ian Shepherdson also anticipates a slump in home prices, adding his voice to a chorus of real estate insiders that predict dark days for the industry in 2023. The contagion is not limited to the residential space; commercial real estate is also taking hits right now, with the poor performance of office buildings dominating real estate headlines in the past few months.
So why is everyone so worried about real estate markets in 2023?
Inflation is at the core of our current economic woes. While it’s hard to assign blame to a single factor, it’s likely that a decade of easy money Fed policies, followed by global supply chain constraints, COVID-19, the War in Ukraine, and pandemic-related governmental responses (like PPP loans and expanded unemployment) got us to where we are now.
In mid-November, James Bullard, president of the Federal Bank of St. Louis, suggested that the Federal funds rate will need to hit 5-7% in order to beat inflation, which is close to a four-decade high rate. Bullard’s comments should be taken seriously. As a member of the Fed’s rate-setting committee, he is one of the deciders when it comes to how high rates go, and what downstream effects we might see from a substantial rise — like pain in the real estate space.
After more than a decade of easy credit and low interest rates, the Fed has made clear that the party is over. As of the writing of this article, the average 30-year fixed-rate sits at 6.52% — almost three times as much as the average rate in December 2020, which sat at a comparatively paltry 2.68%.
Right now, the benchmark federal funds rate ranges from 3.75% to 4%, with rates expected to peak at 4.5% to 4.75% in 2023. Despite seeing several positive reports showing inflation may be on the decline, Fed Chair Powell has signaled that they do not plan to ease up on rate hikes anytime soon, which also dashes hopes for those real estate investors, lenders, and real estate professionals hoping for a return to the old days of easy money policy.
We’re also likely going to see fewer property sales and reduced loan volume over the next year or so. Higher rates are causing sellers to remain in place, as they’re unable to secure financing at similarly favorable rates, reducing liquidity in the entire real estate market. It makes sense — if you’ve got a 3% interest rate on your current mortgage, are you really going to move to a new house and more than double your rate?
This phenomenon is already playing out in cities across the country, from Miami to Seattle, with stubborn sellers and buyers refusing to budge. Lower inventory volume means pain for real estate agents, brokers, loan officers, and lenders, as many generate revenue based on churn or getting a high volume of deals done.
As borrowing gets more expensive, you’ll also see investors start to sit out. Why participate in the real estate market for lower returns when 20yr T-Bills are paying 4.63%, with essentially no risk? As investors pull their money, prices will likely continue to drop, potentially prompting a destructive spiral that could result in that 20% drop in property values we mentioned earlier.
While some lenders have seen a spike in demand after some positive signs on the inflation front, many loan officers and executives believe it’s still too early to say whether or not this drop is sustainable. Still, there has been some progress, with this week’s 30-year fixed rate down to 6.61%, compared with last week’s 7.08%. But when you step back and see that the same rates averaged less than half of that (3.10%) a year ago, you might guess that we’re not out of the woods yet.
As a lender or a loan portfolio manager, you’re at the mercy of the market. The real estate market is cyclical, meaning lenders and investors will mostly rise or fall with the tide. However, the difference between sinking and swimming is all about how you prepare for the eventual downturn. Do you have a lifeboat? At least a raft?
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horizon. You can’t control the market, but you can take precautions to ensure you don’t sink when you hit rough water.