Rising Interest Rates Are Causing the Real Estate Market to Lose Liquidity

A house's real estate for sale sign shows the home as being "Under Contract" in Washington on Nov. 19, 2020. (Saul Loeb/AFP via Getty Images)

Commentary 

In February, we wrote in The Epoch Times that rising inflation and the ensuing increase in mortgage rates would reduce the value of American homes. We spoke to real estate experts on the topic as well and encouraged homeowners who wanted to sell to move quickly. We’re now seeing transaction volume dwindle as fewer deals are taking place. There are several reasons for this.

Housing Becoming Less Affordable

Depending on the details of a transaction, a traditional 30-year mortgage currently carries an interest rate of around 5.3 percent.  While historically, mortgage rates in the 5 percent to 6 percent range were considered attractive, after almost a dozen years of the U.S. Federal Reserve keeping the Fed Funds Rate at or around zero, people have gotten used to ultra-low mortgage rates. The 5.3 percent rate we’re seeing now may not be high, but the near doubling of mortgage interest rates in just a few months is the fastest increase on record.

To give you a sense of what this means to the average homeowner, if a new buyer were to pay $500,000 for a house, they’d typically pay $100,000 in cash, and finance the remaining $400,000 with a mortgage. For simplicity of calculation, we’re going to ignore transaction costs which can add 7 percent to 10 percent to the actual price paid. A few months ago, a traditional 30-year mortgage at 2.875 percent would have cost $1,660 per month. Now, with higher interest rates, that same home purchase would carry a monthly payment of $2,221, a 34 percent increase.

So, either the seller has to reduce the price, or the buyer has to allocate about one-third more to their largest expense to buy the same home. The seller may not care that costs have gone up for the buyer, but the buyer still needs to qualify for the higher mortgage payment in order to complete the transaction. The banks are going to have to start rejecting mortgage applications that would have been easily approved at the end of 2021.

We have spoken to mortgage brokers who are finding a sneaky way around banks rejecting their clients for the higher monthly payments. They’re falsely claiming that the house is being purchased for rental purposes. In that case, the bank doesn’t rely on the credit quality of the home buyer; but rather, on the projected rent of the property to decide if the monthly payments make sense.  The problem with this is that the homeowner does intend to occupy the property and may not be able to make future mortgage payments. The ensuing credit problem could be a smaller version of what we saw in the housing market in 2008.

New houses are up for auction in Rancho Cucamonga, Calif., on Jan. 28, 2008. (David McNew/Getty Images)

Homeowners ‘Stuck’ in Their Homes

Many homeowners who would naturally be putting their homes up for sale, are now “stuck”. It’s a common trend for older people to sell the large home where they raised their families, and downsize to something that’s more manageable for two people and the occasional guest. The problem is that this move may no longer be affordable.

Let’s go back to the above example of a $500,000 dollar house where the owner refinanced at 2.875 percent and has monthly payments of $1,660. If that homeowner wants to sell and buy a smaller home, they’d need to pay less than $375,000 to have the same payment at today’s higher interest rates. In other words, homeowners might sell their large home, buy a much smaller one, and end up with similar monthly payments. Because this is an unattractive proposition, many of these homeowners are staying put instead of putting their house up for sale.

All of this results in less inventory on the market which is keeping prices high for now. Eventually, the housing market will start to clear at lower prices and people who want to move will do so.

Abandoned New Construction

Many people like to design a new home custom-made for their exact needs and preferences. The problem here is that new construction typically takes between 1-2 years to complete. Deals that were struck when mortgage rates were below 3 percent have become unaffordable during the construction process. The buyer who signed the contract to buy the new home may no longer be able to afford or qualify for the new mortgage with rates above 5 percent. These deals are starting to break at the last minute.

In an Epoch Times piece on Argentina and Inflation, we wrote about how high inflation made pricing mortgages impossible. Eventually, the banks simply stopped making these loans, and all home purchases there are made with cash.  Because so few people can afford the entire purchase price of a house at one moment in time, it’s become practically impossible for even well-educated professionals with good jobs to afford a home.  What we’re seeing here in the United States is a small version of the much larger problem in Argentina.

A newly-constructed home is offered for sale in Chicago, Ill., on May 15, 2017. (Scott Olson/Getty Images)

Sticky Prices and Human Irrationality

In a “rational” world, prices adjust to a new reality quickly. Humans are often irrational and tend to believe assets they own are “worth” whatever the highest price is that they’ve seen for that asset. We see this in the stock market all the time. Often, when a company misses earnings expectations and reduces guidance, we see the stock price slide over a period of days. While the share price should adjust quickly, people often don’t want to accept the reality that the market is valuing their assets at a lower price.

This trend is particularly pronounced in the housing market where people have an understandable attachment to the home they may have lived in for decades.  We just heard a story of a beautiful home in a Connecticut suburb. The owner listed the house for $1.9 million and accepted an offer of $2.2 million. Due to higher interest rates, and market volatility, the buyer declined to sign the contract and walked away from the deal. The backup buyer disappeared as well.  The homeowner still hasn’t reduced the asking price because, in their head, the home is now worth $2.2 million (or at least the $1.9 million their originally asked).

Absent a buyer who’s looking for exactly that home and is either price-insensitive or desperate to move quickly, the most likely outcome is that home will sit on the market until the seller reduces the price.

Conclusion

Falling liquidity and failing transactions are the first sign of the break in the housing market we warned about in February. Eventually, the market will clear, but if interest rates remain at these levels, or keep increasing, affordability will be the key issue determining price. The next step is likely to be a reduction in housing prices.