Interest rates are in the middle of their biggest increase in many years. This is going to have a massive impact on the housing market and related equities such as the SPDR Homebuilders ETF (NYSEARCA:XHB).
It starts with headline mortgage rates. The average interest rate on a 30-year fixed mortgage has risen from 3.2% early last year to more than 5% now. This has a massive effect on affordability.
It’d be easy to take that data and conclude another 2008-style housing bust is on the way. But that’s probably not the case. For one thing, banks have maintained much higher lending standards this time around, so don’t count on a huge wave of bad loans crashing into the financial system. And more specifically, there are certain mitigating factors that can support the market as well.
With that in mind, here are some factors to consider when analyzing how rising interest rates will impact the housing market.
Beware of Particularly Overvalued Markets
A key consideration is that real estate remains a highly localized market. It’s true that mortgage rates are rising at a similar clip nationally. However that won’t cause the same impact in each specific market. That’s because housing demand is primarily driven by migration to or from a region, along with local affordability. Some analysts suggest that markets that boomed over the past two years are particularly prone to downside risk now.
A study in May by researchers at Florida Atlantic University and Florida International University found that, out of the U.S.’s 100 largest urban areas, four have housing markets that are at least 60% overvalued. An additional 11 markets were at least 50% overvalued.
According to this study, the single most overvalued market in the nation is that of Boise, Idaho. The median house there now cost $516,548 at the time, but should cost just $299,202 based on historical pricing in that city. It appears the rush of remote workers who moved to Boise during the pandemic caused the market to end up way off balance.
Other most overpriced markets included No. 2 Austin, No. 3 Ogden and No. 4 Las Vegas. All of these cities also attracted a significant number of remote workers over the past two years. By contrast, traditionally expensive markets such as New York and San Francisco came out as more fairly priced according to this study, as prices inflated much less in recent years compared to their long-running baseline levels.
Higher Rates Will Limit Housing Mobility
Previously, home owners were happy to refinance their mortgages or move to new houses entirely at the drop of a hat. This will change in a world of much higher mortgage rates.
A $500,000 30-year mortgage at a 3.3% rate would run approximately $2,100 per month. At a 6.6% interest rate, that same $500,000 mortgage would cost $3,100 per month, or fully a thousand dollars a month extra. Mortgage rates aren’t up to 6.6% yet, but they could easily get there with a few more Federal Reserve rate hikes.
This means that anyone considering a move will have to mentally add many hundreds of dollars a month to their housing expenses to buy a home at the same price as the one which they currently own. This will reduce labor flexibility significantly. Many people will decline to take jobs in different cities since the added housing expense will negate the positive effects of the new job.
Demographics Will Eventually Support the Housing Market
While there are clear negatives for the housing market, don’t bet on another crash like 2008. Prices haven’t risen as dramatically as during that bubble, nor have lending standards eroded nearly as sharply.
Also of utmost importance is that there is a huge structural shortage of housing supply. From 1995 up through 2008, the U.S. started building at least 1.5 million new houses each year. Following the 2008 bust, however, many homebuilders went bankrupt and banks were reticent to lend against new construction.
This led to housing starts plunging to just 500,000 or so for several years during the housing crash. America only got back to 1 million annual units in 2014, and it finally reached the 1.5 million level — the old baseline — in 2020. This shortage of new housing construction led to millions of missing houses, in aggregate, compared to what the American economy normally would have turned out.
At the same time, the sizable millennial generation is getting older. Many people of that age group are looking to get married, have kids and establish households of their own. These future buyers will provide a lot of firepower to support the housing market despite the impact of sharply higher interest rates.
The Bottom Line
The housing market is already showing concrete signs of slowdown, such as in building permits, mortgage applications and housing market search activity. The Federal Reserve’s rate hiking campaign will almost certainly cool off the previously red hot market. But it probably won’t be a nationwide bust, unlike 2008.
Counterintuitively, the coming housing market slowdown could actually hit cities like Austin, Las Vegas and Boise the hardest. These cities rapidly attracted an influx of remote workers. However, as mortgages get increasingly expensive, the advantages of those cities will fade compared to cheaper options.
The sharp rise in mortgage rates will cause many people to stay in their existing homes, as it will be too expensive to move given the dramatically higher interest expense attached to new mortgages. And finally, the millennial buyers that are waiting in the wings should provide meaningful support to the housing market after its initial cooling off period over the next 12 months.
On the date of publication, Ian Bezek did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.