Updated: Jan 25
“It was the best of times; it was the worst of times.” The opening passage of the classic novel, A Tale of Two Cities captures the essence of the U. S. residential housing market’s performance in 2022. Let’s do a quick recap:
First Half - The beginning of the year saw an already exuberant residential market hit a peak with mortgage rates well below 3.5% and homebuilders pumping out new homes at a healthy pace. Much of this resulting from the Federal Reserve’s (“Fed”) monetary easing policy designed to prop up an economy in freefall early on during the Pandemic. Over time the Fed’s directive led to an increase in money supply without increasing the output of goods and services, bringing about an inflationary economy whereby prices for everyday consumer items like food, fuel and entertainment were increasing rapidly on a monthly basis.
In March, Fed Chairman Jerome Powell announced that the Fed was reversing course and implemented an aggressive monetary tightening policy which included raising the fed funds rate in the face of an inflationary economy. The fed funds rate impacts all types of consumer loans (credit cards and auto loans are just a couple of examples) including residential mortgages. By the end of the first half of the year 30-year fixed mortgage rates exceeded 5.00%.
Second Half - By year end, mortgage interest rates traded above 7.0%, more than doubling rates from a year earlier, increasing mortgage payments upwards of 50%. If that wasn’t enough to negatively impact housing affordability, price increases attributable to inflation added an additional $500-$1,000 in monthly household expenses.
The swift increase in mortgage interest rates only exacerbated the ongoing affordability crisis facing prospective homebuyers. Home sales were down 35% from the year before; active homes for sale were sitting on the market for a greater number of days; builders were slashing output as pending purchase contracts were being voided by homebuyers. At year end the overall U.S. housing market had few buyers, few sellers and little change in home prices.
As we embark upon 2023, the real estate market is in a transitory phase as a new reality sets in for real estate investors. The once in a lifetime sub 3.5% 30-year loan is now in the rear-view mirror. The Fed’s fight against inflation has changed the landscape of the residential housing market.
Here’s what investors can expect in 2023...
MORTGAGE INTEREST RATES
Fed Chair Powell has been vocal and transparent about the Fed’s aggressive stance in an effort to slow down the economy and moderate price growth. As residential real estate is the most interest rate sensitive sector of the economy, it has borne the brunt of the Fed’s actions.
The good news is that it appears the Fed is making headway in taming inflation. The Fed strives to maintain what it calls a healthy rate of 2% inflation over the long term. Monthly economic data including the Consumer Price Index (“CPI”) indicate that inflation may be moderating. The CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The percentage change in the CPI over a period of time is referred to as the inflation rate. The annual inflation rate in the U.S. slowed down for a 6th straight month to 6.5% in December, down from a peak of 9.1% in June. While 6.5% is well above the 2.0% target rate, it is moving in the right direction. While monetary easing may not be around the corner, continued aggressive monetary tightening going forward is unlikely so long as the signs of inflationary pressure continue to dissipate.
Anyone expecting mortgage interest rates to revert back to under 4.0% probably also believes in Santa Claus. While traditional 30-year mortgages currently hover in the 6.1% - 6.5% range, we may be lucky enough to eventually see rates dip as low as 5.5%-. This would require more moderate economic growth going forward and that won’t happen overnight. It may take an additional 12 months for inflation to work its way to a more manageable level before the possibility of sub 6.0% interest rate environment becomes a reality.
Most homeowners are electing to stay put in light of the drastic increase in mortgage rates. Millions of homeowners took advantage of the sub 4.0% mortgage rate environment with home purchases and refinancings. As a result of the higher rates, the amount of house they can now afford is substantially less. This affordability crisis makes it doubtful homeowners will willingly make a lateral move let alone a move-up.
Higher interest rates doesn’t mean the housing market will remain at a standstill either. People are getting married, divorced, moving to care for aging family members, relocating for career opportunities and so on, every day. For those people, it’s less about mortgage rates and more about their present situation and whether they can afford a house that fits their needs. And let’s not forget the America’s largest generation, millennials who are busting at the seams as they enter prime homebuying age.
WHAT THIS MEANS FOR INVESTORS: Cash buyers of investment real estate will have a major advantage over investors in need of financing. Expensive financing is cause for many potential investors to remain on the sidelines in anticipation of more favorable rates or a softening of home prices. Because of the elevated rates, a pro forma analysis of a property that last year was considered to have a positive cash flow may now be cash flowing negatively. For the cash buyer however, as prices begin to soften because of the higher rates and less demand, the property’s cash flow may look better today versus last year.
Real estate investors requiring financing shouldn’t be totally discouraged. Instead, they need to sharpen their pencils when analyzing a property’s investment potential and brush up on their negotiating skills in an effort to convince sellers a deal can be struck with price reductions or mortgage buydowns reflecting the new interest rate reality.
Smaller investors have to contend with competition from institutional investors with deep pockets, specializing in Single Family Rentals or SFRs. These institutions continue to actively purchase swaths of residential subdivisions at a discount from homebuilders looking to unload their excess inventory. Cash has always been king and will continue to be so during economic hardships. According to Yardi Matric, theses institutional investors already own 700,000 homes making up 5% of the national stock. Some estimate that they will own 10x that amount in 7 years. That being said, the institutional presence in the SFR space should not deter small investors from looking for investment opportunities in the space as 90% of the SFR investors own fewer than 10 units.
The number of existing homes on the market continues to be small relative to historical averages. This dearth of inventory is a holdover from the frenzied demand for suburban housing that began during the Pandemic. The most recent National Association of Realtors (“NAR”) numbers show a 3.3-month supply of existing homes for sale, which is better than the January 2022 all-time low of 1.6-months. Historically, 6-months of inventory is equilibrium. With fewer new homes under construction and elevated interest rates, it will take some time before the market reaches that healthy 6-month inventory level.
The inventory pool of newly constructed homes has also dwindled. According to the U.S. Census Bureau, housing starts in November 2022 were at a seasonally adjusted rate of 1,427,000, 16.4% below the November 2021 rate of 1,706,000. In December the National Association of Homebuilder housing market index which measures homebuilder confidence hit a fresh 10 year low (excluding the immediate impact of the Pandemic). Homebuilders are scaling back on developing properties as high interest rates leave potential buyers on the sidelines. The lack of supply today is compounded by the fact that experts believe there is a long-term housing shortage notwithstanding the current sparse supply of homes for sale. Freddie Mac estimates that the existing housing stock is short 3.8mm housing units to keep up with household formation, and even with accelerated construction it will take 10 years to reach equilibrium.
WHAT THIS MEANS FOR INVESTORS: The likelihood of housing inventory remaining below the historical 6-month average may well continue until later in the year. Low housing inventory is one of the reasons for the ongoing affordability crisis, leaving many households with little choice but to continue renting. This bodes well for real estate investors interested in acquiring their first rental as well as those experienced landlords who are looking to expand their portfolio.
After home prices hit their peak in June, we saw the first monthly decline in home price growth in a decade, with the lagging Case-Shiller Index showing price increases falling 1.3%. The most recent results confirm a continuing lag in home prices as the October 2022 data marked the fourth consecutive month of declining home prices in the U.S. According to the Mortgage Bankers Association, mortgage applications for the week ending December 30, 2022 declined to the lowest level since 1996, and thus, another contributing factor to home price weakness. None of these data points should come as a surprise to anyone. The pace of appreciation has either slowed down or reversed. Prospective homebuyers who continue to rent, especially first-time homebuyers dealing with affordability issues will peruse the data in the coming months in hopes that moderating prices are around the corner, thus making homeownership a reality. The downside for renters is that they may not see meaningful softening either way because of the tight markets which will only further delay their ability to purchase a home and build wealth via homeowner equity.
According to Zillow, home prices appreciated on average 11% annually over the past 5 years, supercharging homeowners’ equity in their home. This equity cushion gives homeowners more options in case of a mortgage delinquency. They can choose to sell at a gain or rent and move to a smaller home. Having that cushion, along with the sparse number of homes on the market will keep the foreclosure/distressed segment of the market at bay.
It’s a foregone conclusion that we will see home prices decline in 2023. How severe those declines are is anybody’s guess. Homes located in the Pacific, Southwestern and Southeastern regions of the nation (e.g., San Diego, Boise, Phoenix, Austin, and Charlotte) appreciated at a rapid pace in the last few years and, as a result, will likely experience more pronounced declines than areas with generally more consistent markets like the Northeast and Midwest where housing is supply constricted. The limited housing supply should act as a floor against plunging home prices. Unless there is an external black swan event, it’s improbable that the housing market experiences a crash of the magnitude seen in 2007-2009.
WHAT THIS MEANS FOR INVESTORS: The limited decline in home prices bodes well for those looking to invest in rentals in 2023 in two ways; First, while the availability of distressed properties is generally the best option, buying properties at fair market value in a relatively stable housing market is the second-best option, as long as the cash flow and tax benefits from the investment property meets your predetermined Return on Investment (“ROI”) minimums; Secondly, with the expectation of limited home price declines in some markets (e.g. Northeast and Midwest) competition for those properties may not be as fierce as they were in 2021 and early 2022 considering the “affordability” dilemma.
It's not all negative. Mortgage rates in the 6.0% plus range are still below the 7.75% 30-year mortgage rate historical average. Those investors and homeowners who took advantage of the low mortgage rates of the past were given a gift. Good times don’t last forever, but neither do bad times. This is not a bad time. It is simply a new reality that we have to face when making intelligent economic and investment decisions.
It’s critical for real estate investors to keep in mind that real estate markets are distinct and independent from each other. Know your local housing data, it is more critical to your investing success than national averages. Areas that experienced above average appreciation may experience steeper declines than the national average. Focus on the data for the market you are investing in.
At Delarosa Lending Group we are seeing consistent deal flow with borrowers continuing to find high-quality properties with good ROI. Moving forward with cautious optimism through this current cycle and prepared to adapt to quick market changes will serve you well.