Witnessing others amass wealth through real estate motivates people to become homeowners and create wealth for themselves. People who watch their friends’ children playing in a quiet neighborhood with a nice backyard often desire to provide their families with the same sort of environment.

“There’s always the chance that rates drop or normalize to a more natural rate.”

Recent research further validates these beliefs. A Bankrate survey from earlier this year found that 74% of respondents view homeownership as an essential element of the American dream. This holds a greater significance than any other measure of financial stability, including a secure retirement, a thriving career or even a college degree. And a 2019 study published in the International Journal of Consumer Studies indicates that a positive relationship between homeownership and life satisfaction exists, even when respondents were concerned about affording their mortgage.

When coupled with traditional supply- and-demand drivers, psychological and emotional factors enable people to paint a mosaic of potential and probable outcomes in various economic environments. For instance, alongside pent-up demand, the rising interest rate environment has also curtailed supply, resulting in a buildup of deferred sales activity. At some level of reduced interest rates, this has the potential to unleash a torrent of housing supply.

Deferred sales

Using the U.S. Treasury yield curve, one can estimate the “natural interest rate” for the 30-year fixed mortgage. As of Dec. 8, 2023, the natural rate could be estimated to be approximately 69 basis points below the actual Freddie Mac survey rate of 7.03%.

With this information, it’s reasonable to anticipate this variance to normalize over time, with the actual rate approaching the expected natural rate. This normalization could occur through a combination of rising U.S. Treasury yields and/or declining mortgage rates, although it’s impossible to predict the timing and specific factors driving this convergence.

The outlook for mortgage interest rates holds implications for supply, demand, new construction, affordability and home values. While much of this is driven by simple mathematics, psychological and emotional factors inevitably come into play.

From late 2019 to early 2022, there were about $10.5 trillion in new mortgages originated in the U.S., with an average interest rate of about 3.5%. Americans locked in at these rates are not in a hurry to sell their homes and lose their low-rate financing.

It’s a phenomenon called the “lock-in effect,” which greatly affects the balance between the number of homes listed for sale and the number of people who want to buy them. In addition to pent-up demand that occurs when housing affordability declines, the lock-in effect produces a “deferred sales impulse” among those who want to sell but are unable or unwilling to do so in the current interest rate environment.

Case in point: The number of homes available for sale is more than 40% lower than historic averages dating back 25 years, and various indicators like vacancy rates and the time it takes for homes to sell are at or near historic lows. These metrics indicate that there is an overwhelmingly undersupplied housing market relative to today’s demand.

How might this deferred sales impulse change in the coming months? And how can lenders and the originators who work with them possibly benefit from buyers who are emotionally and financially compelled to purchase even in a high interest rate environment? It’s constructive to consider possible scenarios that could take shape in the coming months based on where rates may trend.

Dream scenario

Let’s assume that mortgage financing costs continue heading north — above 8% for the 30-year fixed mortgage. If so, fewer people will be able to afford to buy, resulting in increased rental demand. The number of properties for sale, buyers and total sales will shrink. This would further depress inventory levels and disincentivize prospective sellers. Builders would likely feel less confident too, leading to fewer homes being built.

If mortgage rates remain close to where they are currently — between 7% and 7.5% — more people will still want to purchase homes even though they cost more to finance. As a result, housing inventory will continue to fall short of demand. Builders would be cautious but hopeful. This means that more new residences could be constructed, with home prices leveling out or trending up.

On the other hand, there’s always the chance that rates drop or normalize to a more natural rate (refer back to the estimate that the 30-year fixed mortgage rate should be roughly 69 basis points below the Freddie Mac survey rate of 7.03%). In this case, home prices become more palatable, increasing buyer interest and affordability. Builder confidence would likely increase but, assuming that housing supply remained low, prices would likely rise.

The dream scenario for buyers is when mortgage rates drop below the natural rate and land below 6%. Many on-the-fence sellers would list their homes, buoyed by the prospect of more affordable financing on their next property.

Consequently, inventory levels would rise to meet demand in some markets while outpacing demand in others. Builders would be motivated to increase construction. The effect on home values would vary from market to market. In areas with fewer buyers, home prices might go down due to excess supply, while in other locations, prices might spike due to excess demand.

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While the range of outcomes for mortgage lenders and secondary market investors is wide, today’s probability-weighted outlook is arguably more favorable than what was faced circa 2021 when rates were low, credit spreads were tight and prices were high. As residential housing inventory numbers remain low, offering short-term, high-yield construction loans (with yields exceeding 10%) to builders is one example of an appealing investment opportunity.

Investors should keep their emotions in check when committing to a money-making opportunity. But they also should consider that many potential homebuyers are driven by emotional and psychological factors, even when rates, prices and supply levels are less than desirable. ●

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To better forecast where the market is headed, it’s constructive to recap recent factors and events. Existing homes fetched record prices at the midway point of 2022, with the U.S. median sales price reaching as high as $413,800 before tapering off by year’s end, according to the National Association of Realtors (NAR).

This midyear peak was up nearly 13% year over year. Mortgage interest rates, meanwhile, skyrocketed during the course of last year, with the average 30-year fixed-rate loan jumping from 3.4% in January to a peak of 7.1% in October, according to Bankrate.

This one-two punch to the gut of prospective homebuyers had a major impact on affordability and led to a significant reduction in housing demand. In the final two months of last year, NAR reported that existing home sales declined by roughly 35% on an annualized basis. Faced with affordability challenges, many would-be first-time homebuyers were forced to remain in an already crowded rental market with vacancy rates near historic lows (5.8% as of Q4 2022, according to census data).

Inventory issues

While demand is often cited for the reduction in housing activity, supply-side factors are of equal or more weight, as the unsold inventory of existing homes totaled less than 1 million this past January. Unless mortgage rates decline, homeowners who refinanced in recent years will be unlikely to sell their homes and give up their low-cost financing. This “rate lock-in effect” is likely to keep the supply of existing homes well below the 20-year average of roughly 2 million units.

Existing home sales slipped for the 11th consecutive month to a seasonally adjusted annual rate of 4 million at the end of January, NAR reported. It’s numbers like these that likely prompted NAR chief economist Lawrence Yun to predict that existing home sales will decline by 6.8% from 2022 to 2023, with much of the slowdown expected to happen in the first three months of this year. Looking more closely at NAR’s 2023 forecast, the trade group expects home prices to remain flat compared to the prior year, with the number of units sold and the aggregate dollar volume to drop by 7%.

In short, lower demand coupled with persistent inventory shortages are expected to result in a lackluster year in home sales activity. To complicate matters, inflation is likely to remain high, fueled in part by an undersupplied labor force. Adding to this ambiguity is widespread uncertainty caused by Federal Reserve policy, stock market volatility, geopolitical instability and recessionary worries.

Rate sensitivity

The good news for prospective buyers is that these factors could coalesce to place downward pressure on mortgage rates in the second half of 2023, which would likely put upward pressure on demand. Lower rates mean better affordability and greater purchasing power, but this will undoubtedly come with several bouts of volatility. For example, as of Feb. 8, 2023, the rate for a 30-year fixed rate loan was averaging 6.27%, according to Bankrate. This was considerably higher than the 3.85% average during the same week in 2022, but it was nearly a percentage point lower than its peak a few months earlier.

Fast forward three weeks. As of Feb. 27, 2023, the rate increased to 7.02% as sticky inflation numbers and resilient labor market data resulted in the Federal Reserve doubling down on the “higher for longer” policy narrative.

In January, Freddie Mac reported softening in mortgage rates and, according to NAR, January pending home sale figures increased 8.1% over December. Over the course of the next 12 to 24 months, if mortgage rates steady at levels at or below 6% as many expect, pent-up demand from the renter cohort could be released into an undersupplied housing market, putting further upward pressure on property values

Note that the 30-year mortgage rate spread relative to the 10-year Treasury yield remains near its widest level on record. This kind of disparity does not tend to endure for long periods. As a result, many experts believe there will be a normalization that will conform to historic levels, especially as the market adjusts to be more comfortable with the Federal Reserve’s current rate policy.

If this spread tightens as expected, mortgage rates should drop further into the mid- to high-5% territory. In February, the Mortgage Bankers Association forecast a much more affordable rate climate, with the 30-year fixed rate projected to average 5.3% in 2023. Other trusted authorities aren’t as optimistic: Freddie Mac anticipates an average rate of 6.2% this year while Fannie Mae calls for a figure of 5.9%.

Reasons for caution

While some things come down, others can go up — like mortgage delinquencies and foreclosures, which tend to increase as consumer savings and disposable income weaken. The year-end 2022 foreclosure-market numbers from Attom Data Solutions indicate that more than 324,000 U.S. properties had foreclosure filings last year, a rise of 115% from 2021 but a decrease of 34% from the pre-pandemic period in 2019.

Last year’s foreclosure filings also were 89% below their 2010 peak of nearly 2.9 million. Due to the substantial amount of home equity accrued by homeowners, as well as a robust default-management toolkit available to mortgage servicers, experts aren’t concerned about a significant increase in foreclosure activity that could result in a high level of distressed-property sales in 2023.

Other increases expected this year include more Fed rate hikes as the central bank continues its aggressive effort to curb inflation. Long-term growth could be hindered by further increases in short-term rates. Note, for example, that 10-year Treasury yields dropped to a low of about 3.4% this past February after peaking at 4.2% in October but have since reverted back to 3.9%.

Looking ahead, investors need to be cautious about these and other factors. This includes a potential recession and continued unpredictability that could influence mortgage rates, buyer demand, affordability, inventory, market liquidity and home sales activity. Assuming that the nation does not veer into a protracted recession, inflation is kept in check and Fed rate hikes begin to wane, mortgage market volatility should subside. This will result in lower credit spreads and a further decrease in mortgage rates — a prospect that home shoppers eagerly await. ●

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