Rising home prices across the United States have been a main contributor to recent inflation. Blame for these inflated prices can be placed upon a period of record low interest rates and a savings stock-pile built by U.S. consumers coming out of the COVID-19 pandemic. Recently, Inflation has run out-of-hand, and the Fed responded by raising interest rates at an unprecedented scale. According to CPI data for All Urban Consumers, annualized inflation was 5.64% since the start of 2020, and has ballooned to at an annualized rate of 11.78% so far in 2022. During that same period, home prices, measured by the S&P/Case-Shiller Index, grew at an annualized rate of 15.86% since 2020, and have accelerated to an annualized rate of 18.94% so far in 2022.
Source: St. Louis FRED; S&P CoreLogic Case-Shiller Home Price Index
In practice, raising interest rates should put a quick end to a surging housing market, as buying power diminishes when monthly mortgage payments increase. Overall, mortgage rates have responded in-kind to the rise in the Fed Funds rate, with the average 30-yr fixed mortgage rate increasing by 57% from January 2022 to July 2022.
Source: St. Louis FRED
It stands to reason that rate increases and subsequent increases in mortgage payments on this scale would substantially diminish buying power and therefore place huge downward pressures on housing prices. This reasoning, however, would fail to consider all factors baked into housing prices. An important factor is the opportunity cost of renting vs owning. The choice to rent or own is often determined by personal factors, but a relationship exists between renting or owning. Supply and demand indicate that the costs of renting vs the costs of owning should not significantly differ for an extended period, after factoring in a premium to ownership and the consumer’s availability of capital. This relationship must exist, because if rents are sustainably elevated above monthly mortgage rates and the consumer has capital sufficient for down payments, consumers will likely purchase a home and take advantage of the monthly savings. In response, landlords would lower rents to keep their units occupied. The reverse is true for home prices: If prices become elevated to point where mortgage payments exceed rental costs, consumers will likely rent and home sellers must decrease prices until home ownership becomes viable.
Two important caveats exist in the rental cost vs mortgage cost. First is the premium to home ownership, which reflects the benefits to owning equity in a home and is captured in the value of the down payment. Because equity is involved in home ownership, mortgage payments should be lower than the cost of renting that same home, as the owner has already paid a portion of the benefit for housing. This benefit should accrue to owners through a lower monthly payment than renting the same property. The second caveat is the capital available to the consumer. During a recession, the consumer is relatively capital poor due to decreases in asset valuations and declining wages, which diminishes their ability to make a down payment. Therefore, when the consumer is relatively capital poor, the spread between rental rates and mortgage payments grows, as the consumer simply does not have the capital available to make a down payment and is required to rent.
Considering these caveats, monthly mortgage payments should in theory be bound by the rental rates of comparable homes. If mortgage payments raise above rental rates, home prices should decline to a point where rental rates are above the cost of a mortgage by a factor that considers the premium to home ownership and the consumer’s availability of capital. Given home prices tend to take time to adjust after a rise in interest rates, the only instance where mortgage payments should exceed rental rates is shortly after a fed interest rate hike, after which mortgage payments should stabilize back to equilibrium.
Source: St. Louis FRED; Zillow Observed Rent Index
A small compression in housing prices is likely as they adapt to recent rate increases and monthly mortgage payments stabilize below the rental rate, but interest rate increases alone are unlikely to cause a large-scale decline in housing prices when rental rates remain elevated. Instead, the financial health of the consumer would likely need to substantially degrade to a scale where rental rates decline before housing prices begin to descend from their recent highs
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Brant Goodrich, CFA
Assistant Vice President, Acquisitions
Boyd Watterson Asset Management, LLC