A homebuyer with a monthly budget of $3,000 has gained nearly $40,000 in purchasing power since rates hit their recent Zenith, the Seattle-based real estate brokerage reported. In October, when 30-year mortgage interest rates averaged 7.8%, a $3,000 monthly budget would have bought a $416,000 property. With the current rate hovering around 6.7%, the same budget will buy a $453,000 home.

Put another way, assuming the current 6.7% rate, the monthly mortgage payment on a typical home, valued at approximately $363,000, is $2,545. With an interest rate of 7.8%, the monthly payment swells to $2,713. That’s nearly $200 of relief in just three months.

Even with mortgage rates around three points higher than the lows they slid to during the height of the pandemic housing boom, homebuyers are definitely noting the rate cut and coming to terms with the new norm.

“Bidding wars are picking up as mortgage rates decline and inventory stays low,” said Shoshana Godwin, a Redfin agent in Seattle. “I’ve seen a few homes get 15-plus offers recently, and one got more than 30.”

“Late last year, many listings sat on the market as buyers sat on the sidelines, hoping for rates to drop,” she continued. “Now, buyers are snapping up homes because even though rates haven’t plummeted, people are realizing that the longer they wait to buy a home, the more competition they’re likely to face.”

“Trying to time the market around mortgage rates is probably a waste of energy, as affordability is unlikely to change meaningfully in the next several months,” echoed Daryl Fairweather, chief economist at Redfin. “Instead, buyers should consider their own personal and financial circumstances: What matters most is whether the home meets your needs long term and whether you can afford it. Timing the market mattered in 2021, when we were in a golden window of record-low rates — but that window is closed.”

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Some 88.5% of mortgage-carrying homeowners have an interest rate below 6%, per Redfin’s figures. That means that more than 88.5% of homeowners have a mortgage rate below the current 30-year rate of 6.66%, according to Freddie Mac. In fact, 78.7% have a rate below 5%, while 59.4% have a rate below 4%. A fortunate (or shrewd) 22.6% have a rate below 3%.

That imbalance is causing a disproportionate number of homeowners to forgo putting their houses on the market, creating the aforementioned lock-in effect and resulting in a dearth of listings for homebuyers.

But as Redfin quips in its report, it’s not realistic to stay put forever. The current share of homeowners with a mortgage rate under 6% is down from the all-time high of 92.8% set in mid-2022. The percentage is falling, in part, because some homeowners are simply having to give up their low rates to move. Some are selling due to circumstances like a divorce or a return to an onsite work schedule, while others simply want to move to a different location.

“I’m also working with homeowners who are bursting at the seams and selling because they’ve outgrown their current home,” said David Palmer, a Redfin agent in Seattle.

Listings are also on the uptick because rates have dropped enough recently to convince some homeowners to dive into the market, even with their low rates. The current mortgage rate has fallen substantially from the recent peak of around 8% in October.

“Sellers have started coming out of the woodwork because that’s typical for January and because mortgage rates have dropped,” Palmer said. “They’re also coming to terms with the fact that rates aren’t going back down to 3% any time soon, which makes it easier to pull the trigger on selling. But a lot of sellers are worried about finding their next house because even though listings are rising, there’s still a housing shortage. That’s part of the reason so many sellers remain on the sidelines.”

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The typical monthly P&I payment rose $144 to cross that threshold. It now takes 40.6% of the median household income to cover monthly P&I, a vast leap from the average of less than 25% over the past 35 years.

With the exception of a single day in October, interest rates spent all of last month above 7.5%. They topped out at 7.8% on Oct. 25, according to ICE’s index for conforming, 30-year fixed-rate mortgages.

“Mortgage rates haven’t been that high in 23 years, which continues to hammer affordability,” said Andy Walden, ICE vice president of enterprise research. “The situation was already dire, but recent weeks have seen rates climb to where it now takes nearly 41% of the median monthly income just to make the P&I payment needed to purchase the median-priced home.”

Sky-high rates have obliterated the refi market, according to Walden.

“The rate-and-term refinance market is essentially nonexistent today,” he said. “In fact, the refinance market in general is but a shadow of what it once was. There are pockets of cash-out lending occurring among a particular set of borrowers, but even that has been a niche market. Given that homeowner equity has risen alongside home prices and is now within 2% of the peaks we saw in 2022, it makes sense that cash-outs would still appeal to some borrowers.”

The one-two punch of elevated rates and ballooning home prices is making for difficult borrowing conditions.

“Historically tight inventory levels have been further bolstering prices, which hit yet another all-time high in September, with the annual growth rate accelerating to 4.3% from effectively flat just four months before,” Walden said. “That said, the pace of monthly gains slowed to 0.39% in September, marking the smallest seasonally adjusted gain since January.”

The last time affordability was comparably out of reach was during the 1980s, when interest rates were in the double digits and the average home cost about 3 1/2 times as much as the median income. Today’s ratio of home prices to median income, in comparison, stands at almost 6 to 1.

Walden was swift to note that the record-high monthly payment doesn’t even factor in taxes, insurance or homeowners association fees.

Rates have risen another 75 basis points since September’s closed sales, a shift that has slashed another 8% from consumer buying power, according to ICE. With rates expected to stay higher for longer, Walden said that it’s “fair” to expect some softening of home prices later in the year.

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The agency’s HPSI fell by 2.4 points in September to hit a reading of 64.5, with five of six component indices declining on a monthly basis. Most notably, the component that measures perceived homebuying conditions decreased, with only 16% of survey respondents saying that it’s a good time to buy a home. That’s down from 18% in August to match the all-time low set last year. Meanwhile, the share of consumers who say it’s a bad time to buy grew from 82% to 84%, a new survey high. In turn, that brought the net share of those who say it’s a good time to buy down by 4 percentage points compared to August.

Additionally, for the first time in the history of the survey, high mortgage rates surpassed high home prices as the No. 1 reason why respondents think it’s a bad time to buy a house.

“Mortgage rates persistently over 7% appear to be deepening the malaise consumers feel about the home purchase market,” said Doug Duncan, Fannie Mae senior vice president and chief economist.

Unfortunately, buyers don’t see much semblance of relief on the horizon, as they also continue to project further home price increases in the next year. The net share of respondents who say home prices will go up in the next 12 months grew by 4 percentage points from August to September. Consumers are also pessimistic about mortgage rates, with the net share of those who say mortgage rates will go down in the next 12 months falling by 1 percentage point month over month.

Optimism among home sellers is also on the wane, with 63% of respondents saying it’s a good time to sell, down from 66% in August. Meanwhile, the share who believe it’s a bad time to sell grew from 34% to 37%, bringing the net share of those who say it’s a good time to sell down by 7 percentage points month over month.

“On the sell side, respondents also listed unfavorable mortgage rates as the top reason why they believe it’s a bad time to sell a home,” Duncan said. “This indicates to us that many homeowners are probably not eager to give up their ‘locked-in’ lower mortgage rates anytime soon, but it also may reflect the worry of some homeowners that sale values might be suppressed slightly if the pool of qualified homebuyers is constrained by elevated mortgage rates.

“They also indicated that their personal economic situations are showing signs of strain, including lower year-over-year household incomes and a reduced sense of job security,” Duncan added. “In our view, all of this points to home purchase affordability remaining a problem for the foreseeable future, which we forecast will keep home sales sluggish into next year.”

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Before a clear path forward emerges, commercial mortgage brokers and their clients must be patient as the pieces begin to reassemble in the capital markets and in the larger marketplace. They must also weigh the past and future actions of the Federal Reserve. All of these factors add up to a time of uncertainty for the economy as well as the structured finance sector.

“Initially, there was a move by many bank depositors to shift their money from smaller banks to larger ones, specifically those that are considered ‘too big to fail.’”

Currently, market participants are seeing expectations being reset and bond yields declining due to a changing outlook in the Fed’s rate-hike trajectory, as well as a flight to safety. Should banks pull back further on their lending activities and the economy suffers, the Fed may pause or reverse hikes in the near future.

A commonly held view early in 2023 was that the Fed would continue hiking rates until something broke. Clearly, something did break in the banking sector.

Crisis takes shape

The beginning of the crisis occurred this past March when Silvergate Bank became the first institution forced to liquidate, largely due to the collapse of its cryptocurrency banking operations. A few days later, Silicon Valley Bank (SVB) became the largest bank to fail since the 2008 financial crisis. Two days after that, Signature Bank collapsed.

More recently, JPMorgan Chase acquired most of the assets and assumed the deposits of First Republic Bank, which had been taken over by the Federal Deposit Insurance Corp. (FDIC). These failures sent shockwaves through the ranks of the country’s local and regional banks, which hold about two-thirds of all U.S. commercial mortgages. At many banks, real estate loans remain the largest component of the balance sheet.

According to Fitch Ratings, commercial mortgages account for 33% of the loans held on the books of banks with total assets of $1 billion to $10 billion. The exposure is even greater when looking beyond the 25 largest domestically chartered banks, as the Federal Reserve estimates that commercial real estate loans comprise 43% of the assets at these institutions.

With the recent news of declining values across commercial real estate, it is yet unclear how these smaller banks will be impacted. But compared to the financial crisis of 2007 to 2009, banks today are lending a smaller percentage of their capital, so there’s less concentration in real estate. Thus, there’s less exposure and potential opportunity for growth.

Fueling the fire

While various factors played into the failures of these banks, one factor that they all had in common was increased pressure from the Fed’s interest rate hikes that began in 2022. The higher rates weighed heavily on digital assets. When deposit bases are drained, banks get squeezed.

The lack of depositor diversification can push banks past the limits of solvency. Pressure is placed on banks since depositors have other options, such as money market accounts or government bonds, to hold their cash.

SVB is a telling example. With a focus on venture capital-funded firms and startups, the bank got in trouble when these companies spent down their cash balances, draining the bank of deposits. Because SVB was poorly diversified, it had to sell government bonds to raise cash, and it did so at a loss of $1.8 billion. Ultimately, trust in the bank was lost and its shares declined. Companies panicked and pulled cash out in what amounted to the fastest bank run since the Great Depression. This forced regulators and the FDIC to take control of the bank.

The Fed likely realized the implications of rate hikes on banks due to the securities they held but believed there was liquidity elsewhere in the system due to high levels of cash and the ability to borrow from the Federal Home Loan Banks. While this is true, the fundamental problem was the volume of securities, the size of the unrealized mark-to-market assets and the implications of holding them until maturity.

When large depositors acted at the same time, the runs created big problems for banks. The result was a modern-day electronic bank run that had not been seen before but has been revealed as something to keep a closer eye on in the future.

Now the spate of interest rate hikes may be nearing a pause. The Fed has expanded its balance sheet to provide additional support to banks. But the crisis makes a soft economic landing even more unlikely and many experts believe a recession is unavoidable.

Impact on lending

Initially, there was a move by many bank depositors to shift their money from smaller banks to larger ones, specifically those that are considered “too big to fail.” But there’s also a shift by the government to protect smaller banks. Depositors must believe the money they deposit in banks is safe. With the current banking crisis, the FDIC acted to shore up medium- and small-sized banks by quickly making an exception at SVB and Signature Bank to insure deposits above the usual $250,000 limit.

A common view is that economic conditions will deteriorate for the next few quarters and commercial real estate will most likely suffer too. The consumer housing market is in the midst of a major correction and average mortgage rates have increased from 3.22% at the start of 2022 to 6.57% as of May 25, 2023, Freddie Mac reported. The Fed is trying to backstop liquidity risk, but there is underlying credit stress that also can be found in the commercial real estate capital markets.

Banks are currently looking to boost liquidity by asking for greater depositor relationships. Because the largest banks saw a major inflow of deposits following the regional bank failures, many lenders are willing to give better rates to borrowers who provide meaningful deposits. There are also numerous lenders that are shifting their resources from originations to asset management. In some cases, banks are sharply reducing their lending levels.

The largest area of concern in the second half of this year is in extension of credit. The expectation is that commercial real estate borrowers will be hard-pressed to secure loans, unless they are willing to accept low leverage, higher rates and more stringent underwriting standards. Banks are unlikely to fully retreat from real estate, although they are expected to be even more careful about the loans they do make going forward.

Opportunity will knock

As the crisis progresses, developers and value-add investors are being forced to ask for extensions from lenders. Some sponsors are having to make capital calls to cover cost overruns because construction lenders won’t provide more capital or interest reserves have been expended. Lenders will not be able to provide extensions indefinitely because they need to be repaid to make new loans.

Large national and regional banks have a much lower concentration of real estate today. There is opportunity for them to expand, even if it is only a 5% increase from what they have been doing. Industry experts believe the transactions that can be executed today will be among the safest loans possible given the low levels of leverage. The balance of this year could be a prime opportunity for banks that remain active during turbulent times to build relationships with brokers and borrowers.

As the year progresses, expect to see more distressed deals. These are transactions in which the borrower cannot meet the project’s financial obligations. These deals typically involve partially built developments but they occasionally happen with projects that have entered the lease-up phase. If materials and labor costs turn out to be higher than anticipated, the developer may need to find other capital sources to meet their needs.

The process ahead to recover from the recent banking issues will likely require a relaxing of federal regulations, in particular those relating to troubled debt restructuring. This refers to the renegotiation of terms between a debtor and creditor in an effort to reduce or delay repayments while avoiding bankruptcy. Changes to troubled debt restructuring will require guidance from the Fed and the FDIC.

In the interim, borrowers could discover a bit of flexibility coming from banks, which may be more amenable to making deals. Other elements that could serve as solutions are additional collateral and more cash in properties to backstop loans. Banks will likely need to add people with experience in handling troubled loans (such as brokers, consultants, attorneys, or experts in commercial real estate and receivership) to work through the turmoil that may be on the horizon.

● ● ●

Many real estate and finance experts view the banking issues that emerged in the spring of 2023 as more akin to a crisis in confidence. Eventually, the situation should stabilize and reveal a market that is fundamentally in a better place. Commercial real estate may suffer in general, but some markets will fare better than others. Many high-growth markets are still undersupplied in housing. Supply and demand will continue to drive success.

How thin the capital markets are will be clear when funds are truly needed for some projects. Distress obviously impacts supply, and when the floodgates open, it could be a feeding frenzy as those with dry powder jump in. The stress being felt in the mortgage markets will be a negative drag in the short term. But in the medium to long term, there are expected to be opportunities that smart investors can capture.

The sound advice for mortgage brokers and their clients is to stick to the fundamentals, use moderate leverage and include conservative underwriting assumptions. If they adopt this approach, they’re less likely to be caught without a chair when the music stops. ●

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Mortgage rates have continued along their volatile path since the beginning of the year with instability in no small part now being driven by turmoil in the banking system. On the other hand, the availability of existing homes for sale continues to churn along at historically low levels and is also being impacted by mortgage rate gyrations more so than at any time in recent history.

The reason that the supply of existing homes for sale is heavily dependent on mortgage rates is because 95% of borrowers with outstanding mortgage debt have a rate below 5%, according to CoreLogic data. More than 80% have a rate below 4% while nearly half (42%) of existing mortgages are locked in at rates below 3%. Given that the current mortgage rates for the vast majority of potential home sellers are significantly higher than their locked-in rate, there is no incentive for them to sell their home and give up their super low rate.

The chart on this page illustrates the evidence of the impact of mortgage rates on for-sale inventory. When rates started creeping up in the summer of 2022, the level of new for-sale listings started to decline notably. In the first six months of last year, the number of new listings entering the market was only 3% below the levels seen during the same period in 2021, CoreLogic data shows.

But as mortgage rates surged in July 2022, the number of new listings began to trend 20% below 2021 levels and dropped by more than 30% by the end of the year. The early weeks of 2023 saw barely any improvements in new listings, which were about 20% below 2022 levels and more than 30% below pre-pandemic levels of 2019 and early 2020.

While the dearth of homes for sale has been the Achilles’ heel of the housing market, particularly for those regions that have had very little new construction activity, the silver lining for the remainder of this year — which already appears fraught with more volatility and uncertainty — is that low inventory will keep home price declines at bay. This is especially important when comparing the current banking crisis to the events that led up to the Great Recession and the home price collapse that followed.

A key difference in today’s housing market is that borrowers have locked in historically low-rate mortgages, most of which are 30-year fixed loans. Current borrowers have built up nearly four times as much home equity than in the pre-Great Recession days. Leading up to that downturn, some 24% of outstanding mortgages were adjustable-rate loans that borrowers could no longer afford following the rate reset, either due to loan characteristics or job loss. Today, however, less than 5% of outstanding mortgages have adjustable-rate features.

While the low supply of homes for sale may help the market at this point of the housing cycle — given an anticipated recession and the potential fallout from the banking crisis — it does not bode well for the market in the long term since it reduces affordability and market velocity. In addition, the availability of entry-level homes for first-time buyers will remain low as current owners hold on to their homes for longer. ●

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The chair of the Federal Reserve testified before Congress on Tuesday that recent moderation of the U.S. economy seems to have “partly reversed,” which could prompt more hawkish policy — including further interest rate hikes — from the central bank.

“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell told the Senate Committee on Banking, Housing and Urban Affairs. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.

“Restoring price stability,” he added, “will likely require that we maintain a restrictive stance of monetary policy for some time.”

Powell acknowledged that the effects of the Fed’s rate adjustments have had an adverse impact on demand in “the most interest-sensitive sectors of the economy,” including real estate. And while Powell said that inflation in housing remains too high, he also observed that the flattening of rents for recently signed leases suggests easing of housing inflation in 2023. Meanwhile, core goods inflation has fallen over the past year as supply chain issues have eased and tighter monetary policy has helped to rein in demand.

Powell noted, however, that “there is little sign of disinflation thus far in the category of core services excluding housing, which accounts for more than half of core consumer expenditures.” And while nominal wage gains are decelerating, they’re still hovering above rates consistent with the Fed’s 2% inflation target.

Powell’s remarks served as a clear indication that while the Federal Reserve has recently pumped the brakes on the largest of its interest rate hikes, it appears to have no qualms considering sharper increases again if it believes that the economy needs further tightening. Furthermore, they signal to observers and stakeholders to expect more rate hikes in the future, even if they remain in the range of 25 basis points.

Powell’s hawkishness led Marty Green, principal at mortgage law firm Polunsky Beitel Green in San Antonio, to quip that “much like Sherman’s March to the Sea, the Federal Reserve march to higher rates is inevitable based on current data.”

“Based on Chairman Powell’s testimony, neither the risk of higher unemployment nor the risk of tipping the economy into a recession will deter the Fed from raising rates sufficiently to get inflation down closer to its target level. If that means quickening the pace of increases once again, the Federal Reserve is prepared to do so,” Green said.

Federal Reserve officials are on tap to meet later this month to formulate new economic projections and determine the size of the next rate increase. A 25-basis-point hike still appears to be the most likely outcome, according to Green, although a 50-basis-point increase doesn’t seem out of the question if data on inflation and labor come in stronger than expected.

Either way, Powell didn’t telegraph a promising outlook for mortgage lending, according to loan officer Dick Lepre of CrossCountry Mortgage.

“For mortgage rates, this likely means that [they] will remain around 7% for a bit,” Lepre said. “None of this is good for the mortgage industry.”

Houtan Hormozian, founder and mortgage advisor at Crestico Funding, and president of the California Association of Mortgage Professionals, lamented that while it’s important to corral inflation, the Fed’s current tactics are hanging the reeling real estate sector out to dry.

“The housing market has become collateral damage,” Hormozian said. “The [negative impact on the] housing market by itself isn’t enough to slow down the inflation that the Federal Reserve is battling. … But ultimately, what we’re doing is just lowering the homeownership opportunities people have available.”

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Habib, whose company forecasts interest rates and the housing market for real estate professionals, believes that mortgage rates closely follow inflation numbers. And inflation, he believes, has peaked and will start heading downward just in time for the beginning of this year’s home purchase season. He’s not predicting a return to sub-3% rates, but the drop will be enough to entice movement in the housing market.

“This is the time to be aggressive in showing people the opportunity and getting the message out there, because all opportunities come from chaos.”

Habib spoke with Scotsman Guide about his sunny outlook on the housing market. He also circled a magic date on the calendar when he thinks interest rates will gain downward steam.

With the housing market uncertainty, how do you think things will fare this year?

Some of the most searched terms on Google trends are “housing bubble,” “recession,” “the Fed,” “inflation.” People are nervous. Real estate agents, mortgage professionals are all concerned because we’ve seen (sales volume) drops, certainly on the refinance side but also on the purchase side. Now a lot of people want to compare this to 2007 and 2008, but you really can’t do that.

Why not?

First of all, housing is going to be sensitive to interest rates. And interest rates are not going to be governed by what the Fed does but by inflation. Mortgage rates do what they always do: follow inflation up, follow inflation down.

And you expect rates to fall as inflation falls?

We’ll have a little bit of fluctuation, but rates should start to move lower on May 10th (with the release of the consumer price index that has April’s inflation numbers.) That’s when we’ll get that big tailwind and we will see a big drop in rates that will create a much better environment for buyers.

What happens if there are not enough homes for sale?

Prices go up. More buyers doesn’t mean as many as when rates were 3%, but more buyers than there was when it was 7%. [If I have a dream home], I’m not going to give up a 3% interest rate to go up to 6.25%. When rates were 7%, forget it. I’ll sit tight. But if rates start to come to 5%, maybe 4.75%, you know what? I’ll give up the 3% so I can put my family in the home of my dreams.

And you expect interest rates to go down to 5% this year?

I do. I’m not hanging my hat on 5%, but within a reasonable level, a quarter percent either way, yes.

Do you believe any mention of a housing bubble is nonsense?

We know what sells — sex and fear. So, it’s a version of fear porn. It has no basis in reality. Why is it a bubble? Because prices went up? That would mean everything would be a bubble.

What should mortgage originators do to position themselves in this market?

This is the time to sharpen your skills. This is the time to prepare yourself with tools. This is the time to be aggressive in showing people the opportunity and getting the message out there, because all opportunities come from chaos.

What are your thoughts on the stability of banks and other lenders in this market?

I feel for the people who have been let go. It’s awfully painful for a lot of companies to see this huge overall drop. From an originator standpoint, if you were doing eight transactions a month, you were doing great, but if that’s been cut to two, you still make more than 85% of the population in the United States, because only 15% earn a $100,000 a year. If you do two loans a month, you probably are earning $100,000 a year. ●

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