Solutions

It’s a Bird. It’s a Plane. No, it’s Ballooning Interest Rates Flying High.

A Conversation with Dr. Frank Nothaft

As a topic of conversation, interest rates have come to the forefront of the nation’s consciousness in recent weeks as the Fed has incrementally raised the rates of federal funds, widely affecting prices. However, not all industries are equally impacted. Real estate is one sector where many people are watching closely to see whether the ballooning interest rates will cool off the red-hot real estate market with the force of a summer breeze or if they will usher in a polar vortex and change the investment appeal of property in the United States.

In this episode, host Maiclaire Bolton Smith sits down with CoreLogic’s Chief Economist Frank Nothaft to discuss the effects of the current rise in interest rates on the property market.

Maiclaire Bolton Smith:

Welcome back to Core Conversations: a CoreLogic Podcast, where we dive into the heart of what makes the property market tick. I’m Maiclaire Bolton Smith, your host and curious observer of all things related to property — from affordable housing to market trends to the impacts of natural disasters to climate change — I want to converse about it all.

Interest rates — We have spent the last two years talking about record-low interest rates, but now the tables have turned. Quite rapidly, interest rates have ballooned up and are flying high. These soaring rates have put upward pressure on prices that have inflated at the highest annual rate since 1982. All of this has prompted the Federal Reserve to step in and raise the interest rate for federal funds. For years, interest rates have hovered at near-zero. Then in the first five months of this year, the Fed increased its rates by three-quarters of a percentage point.

And this was only the beginning of planned interest rate hikes. In March, the Fed announced that it intends several hikes over the course of 2022, raising federal fund rates to nearly 2%. Rate hikes to federal funds will have a cascading effect since they are foundational for other interest rates in industries like auto, property and banking. As a result, nearly all consumer goods will be touched, which has the potential to raise prices in the process. However, one of the areas where this change will be felt acutely is the property market. This sector of the economy may be the most sensitive to interest rate hikes because of the size of a mortgage loan and the resulting increase in monthly payments.

To help untangle the relationship between the current rate of inflation, interest rates and the effects on the property market, we once again welcome back CoreLogic’s Chief Economist Dr. Frank Nothaft. Frank, welcome back to Core Conversations.

Frank Nothaft:

Well, thank you so much, Maiclaire. Thanks for having me back.

MBS:

Always happy to have you back. So, Frank, you’re likely well-known to our listeners, but before we dive into this highly-talked-about topic here, can you just remind our listeners a little bit about your background and your role here at CoreLogic?

FN:

Oh, absolutely. I started off my career at the Federal Reserve Board in Washington, DC, and I was working on property markets and mortgage markets at that time. From there, I went to Freddie Mac and I was Chief Economist at Freddie Mac for a number of years before I came here to CoreLogic, and I’ve been Chief Economist here at CoreLogic. Part of what my team does is use the various products and data analytics that we do have here at CoreLogic in order to follow the trends and latest developments in the housing and mortgage markets, and use that information to generate projections as to what we expect to transpire in the marketplace.

MBS:

Fantastic. And one of the reasons why you are one of our favorite guests here on Core Conversations. So, let’s start by setting the stage and explaining why rising rates have such an outsized effect on the property market. I guess a few questions are: How fast have mortgage rates risen over the last year and what do the rising rates mean for borrowers and, really, the economy at large?

FN:

Oh, I tell you, Maiclaire, mortgage rates have really shot up. If we’re looking at 30 year fixed rate mortgages, they’re up by more than two percentage points just from the beginning of this year.

MBS:

Wow.

FN:

If we go back to last year, at the start of last year, we have the record-low, rock bottom mortgage rates for 30 year fixed. From that time to now, mortgage rates are up more than two and a half percentage points. Which makes really a big change for what it costs to obtain a mortgage. The last time we had such a rapid increase in mortgage rates in such a short period of time was way back in the early 1980s. So, we haven’t really seen an increase of this magnitude over such a short period of time in close to 40 years.

MBS:

Wow. That is really remarkable. And why it is such a story as well, too. I guess, often we talk about the Consumer Price Index, the CPI, and what percentage of the CPI do mortgage payments or rental payments, really, what percentage do they represent?

FN:

Oh, that is such an interesting question, Maiclaire. And it’s because actually, the way housing costs show up in the Consumer Price Index is not through mortgage payments, it’s not through housing prices, it is through rental payments. And so housing costs show up in terms of the amount of rent that tenants pay and the owner’s equivalent rent. And what that means is that what the government does in the inflation metric is they estimate or they impute what the equivalent rent would be for an owner-occupied housing unit, so that’s the way housing costs show up in the Consumer Price Index. And right now the housing costs represent about one-third of the overall Consumer Price Index. And if you look at the core of the CPI — and a lot of economists prefer to look at the core because it excludes food and energy, which tend to be very volatile on a month-to-month basis — so, if you look at core CPI, housing costs represent about 40% of the overall core CPI. And that’s all coming through in terms of the rental payments, the rental costs.

MBS:

That’s fascinating. I really did not realize or understand that that’s how that worked. Why do they do it that way? Why do they essentially figure out how much you rent your own home from yourself or renting it, I guess, from your mortgage?

FN:

Well, partly the government felt that using house prices or mortgage rates tend to be very volatile and do not capture the true cost of the shelter services that the owner or occupant is gaining or receiving from living in the home. And so, to put it on a comparable basis to what the government was measuring for rental homes, the government decided, okay, we’ll use a similar procedure, but we’ll impute or estimate what an equivalent rent would be that the owner/occupant would be paying to themselves in order to live in that home.

MBS:

Wow. That’s really interesting. I guess a lot of times when we talk about mortgages, we think about them in the state of fixed-rate mortgages, but not everyone has fixed rate mortgages. There are also adjustable-rate mortgages. So, what do these changes mean for people with adjustable-rate mortgages?

FN:

Well, it actually means that the interest rates are going to go up on the adjust rate mortgages, especially if they come to the adjustment date. Because typically the way an adjustable-rate mortgage on a home works here in the United States is that there’s an initial period where the rate is fixed but then once you hit the adjustment date or the anniversary date, then the interest rate adjusts to the current new short-term interest rate plus an index or a margin above that. And so with short term interest rates rising, that means that homeowners who currently have an adjustable-rate mortgage and who are approaching their adjustment date, they’re going to see their interest rate rise.

FN:

Now, the most common adjustable-rate mortgage in the United States right now is what’s called the 5/1 hybrid ARM. And it’s called a hybrid ARM because it has an initial fixed-rate period, and that’s what the five represents. On a 5/1 hybrid ARM, you have an initial fixed-rate period of five years, and then it becomes a one year adjustable. So, if you have a 5/1 ARM, you actually have your interest rate fixed for five years, and then it’ll adjust depending on what’s happened with short-term interest rates.

MBS:

That’s really interesting. It’s not something that we’ve really talked about before about these adjustable-rate mortgages. So, if we think back to just interest rates in general, part of the reason or the idea behind increasing interest rates is so that the government can temper inflating consumer prices and we’ve seen just consumer prices shooting up all over the place. However, when it comes to real estate, won’t these higher rates theoretically lead to even higher monthly payments for many of the home buyers?

FN:

Oh, absolutely. Especially if you’re a current home buyer. If you’re in the marketplace to buy a home and finance it with a mortgage, absolutely. You’re facing much higher interest rates and you’re facing much higher mortgage payments. And really it’s a double-whammy if we compare today’s home buyer with someone who was in the market one year ago looking to buy a home. A double-whammy in the sense that home prices are up big time and now we’ve got mortgage rates up as well. So, home prices are up about 20% in the CoreLogic Home Price Index for the United States. Now you add on the fact that mortgage rates are now up roughly two and a half percentage points or more from this past year. That means that to buy a similar or comparable house as last year, the typical homeowner is facing a monthly mortgage payment that’s about 50% bigger than it was a year ago. And that’s because of a double-whammy of home prices up and mortgage rates up.

MBS:

Wow. That’s shocking. Those are numbers that people don’t want to hear. I think of this from the perspective of new home buyers or people just looking for a newer, larger home, does this mean that we can expect that fewer people are going to be able to afford a new home or afford a mortgage and maybe there will be fewer people getting into the property, into the housing market? I know we had this shortage of properties and high demand where a lot of people were looking for properties when interest rates are so low, now we’re in this opposite place where there’s people that are maybe wanting to sell, there’s more inventory now, but maybe homes are going to sit on the market because people actually can’t afford them.

FN:

Well, you really hit the nail on the head, Maiclaire, because that’s really the issue. For a lot of prospective home buyers, they’re really feeling the squeeze because with monthly principle and interest payments roughly 50% larger than they would’ve been a year ago to buy the same type of home, that really takes a big bite out of the monthly income. It’s a big portion of the monthly budget that a family has to plan for. And so there’ll be some families who will say, “Gee, I just can’t swing that right now,” and they’ll pull back and pull out of the home purchase market. And so, what we do expect to see over the course of the next several months is some weakening of demand, some slackening of a homebuyer demand as this erosion of affordability really starts to take a toll.

FN:

So, as we get into the second half of 2022 and into 2023, I think we will see some weaker demand. We’ll see also that homes that are listed for sale on the market, they’ll probably stay on the market longer than what we had seen over the last few months. They’ll stay on the market longer and instead of having 5, 10, 15, 20 contracts come in, we still may only see one contract come in. So, that’ll restore some balance in terms of negotiation between the prospective home buyer and the home seller. As you know, for much of the last year we’ve been in a seller’s market. Sellers have listed their home, gotten multiple contracts in a short period of time and home buyers were bidding against each other. I think that’s going to change and we’re going to see that change over the coming months.

MBS:

Wow. Definitely a different story than we’ve heard for the last couple of years for sure. So, it makes my mind think too, we talked about rent a little bit earlier too, this is not just impacting homebuyers, this is also impacting renters as well too. I had a visit with a friend this weekend and he said that his rent just went up 20% from last year.

FN:

Wow 20%. Whoa, [inaudible 00:12:28].That’s big time!

MBS:

Huge increase. So, this is something that I’m expecting is probably going to impact the rental market as well.

FN:

Oh, absolutely. And we’ve heard stories exactly like that. At CoreLogic we do have a Single-Family Rent Index so we can really track and measure closely what’s happening with single-family rent growth. So, your friend is actually in a market where rents are rising more rapidly than what we see in our national index. So, with our CoreLogic Single-Family Rent Index, we saw that on average, rents are up about 13% in the national market, national composite index. But it varies a lot by market. There are some markets where rents rising 20%, 25%, even 30% or more over the past year. And that makes it very challenging for those families who are in the rental market to be able to afford to rent. And even if they can afford to pay those rents, what it means is that it makes that much harder for them to save up the nest egg that they ultimately need in order to transition into first time home ownership.

FN:

And that’s the big challenge right now in the marketplace because with home prices up 20% over the last year in our national composite index, in our Home Price Index, that means the nest egg that a prospective first time home buyer needs to have is roughly about 20% higher than it was a year ago. Where does that nest egg go? That goes to the down payment, that goes to the closing costs and that goes to the rainy day funds— the savings that you need to have after you settle on the home. But with rent up so much, especially in some markets, it just makes it that much more challenging for a first time home buyer to amass that nest egg that they need in order to buy a home.

MBS:

Yeah. Definitely. Those are staggering increases. I guess the question is, are there areas of the country that are seeing higher increases than others? Is this a regional issue? We see that with property prices. Is it the same with some of the increases?

FN:

Yeah. We’re seeing some of the biggest increases in markets where generally there’s a lower cost of living and has been attracting some of the internal population migration that we have seen in the United States during the last two years during the pandemic. So, if we look around the Mountain States out west, or we look at some of the southern states, that’s where we’re seeing some of the biggest increases in rents and home prices. So, for example, in our rent index, Miami is just topping the charts right now with rent growth of 30% or more over the last few months. And looking out toward the west, Phoenix continues to be a hot market with rents and home prices up significantly. And following north all the way up the mountain range, Boise, Idaho, continues to be a market where home prices and rents are up significantly over the last couple of years.

MBS:

Wow. It’s so interesting. We’ve talked about unconventional metros in some of our previous podcasts of people moving because of these huge work from home initiatives and people having the ability to be remote from their jobs is it’s not these major centers where people generally flock to for jobs. So, that’s really, really interesting.

FN:

It is, I tell you. The pandemic has been such an interesting period for exactly those reasons that you have said. During the pandemic, a lot of families wanted to move out of high population density urban cores and move further out where they could have more social distancing from their neighbors. And with remote work, they needed to have more space inside their home in order to have their home office and in some cases to have their home school room as well.

MBS:

Classroom. Yeah.

FN:

And so, that’s really increased the demand for interior space and the demand for single family homes, whether it’s for purchase or for rent.

MBS:

Yeah, absolutely. And that’s something you and I have talked about before Frank, on other episodes of this podcast too, of the need for more space. My family is a classic example of this. Now having two of us working from home during the pandemic and we had a baby during the pandemic. So there’s not enough space in our house anymore. And I know that a lot of people are in that same boat of needing extra space and needing to find bigger properties. So yeah, it’s really interesting. And I think, if we focus back on the rent as well, again, I think back to a couple of episodes ago in Episode 34, we had Principal Economist, Molly Boesel from your office, talk to us about myths in the housing market. And if you haven’t listened to that episode, I do encourage you to. I think it’s my favorite of the season so far.

MBS:

And she mentioned that the answer to this, the million dollar question of whether the U.S. Is currently in a housing bubble is basically no, we’re not. But however, if we look at the Single-Family Rent Index and some of these numbers that you’ve just mentioned to us, we are seeing larger jumps than we’ve ever seen or had seen in many, many decades. How long do you anticipate this trend lasting considering the measures the Fed is taking to stave off any further inflation?

FN:

Oh, and I tell you, it’s a great question. And there is a lot of concern about overheated housing markets and prices and rents getting too high. And I do think we’re seeing the cresting of the price growth and rent growth in the marketplace this spring. And what we’re going to see in coming months is a moderation in home price growth. It’s not going to be immediate, but we will see that moderation and our current forecast for home price growth in our national index over the next 12 months, so that would be through to the spring of 2023, is a much slower rate of price growth with prices rising about 5% or so from the spring of 2022 to the spring of 2023. So, with prices rising, I guess I’d have to agree with my colleague Molly that no, we’re not in the housing bubble. We don’t see national home prices declining or falling in any way. And most markets I think will be just fine. I don’t think we’re going to see a price decline in most markets.

FN:

Something to keep aware of though is that even if prices are rising in a national index, typically we do see some local neighborhoods, some local markets, where home prices are declining, and that’s actually very typical. That’s typically what we do see even if the national index is rising. There may be 5% or 10% of all communities in the U.S. where prices are actually stagnant or falling. So, we will see some price corrections, some declines in some places of the country. We’ll probably see some rents beginning to ease as well, but no bubble nationwide, no broad-based price decline. And I’ll tell you the main reason why that’s the case, Maiclaire. It’s because we have an underbuilt housing market in the United States. And currently the vacancy rate for housing is at a generational low. So, it’s very, very different from the situation we saw back in 2006, 2007 and 2008, where we had the start of the Great Recession and the U.S. housing market was in a price bubble. Back then, in 2006, 2007, 2008, we had an overbuilt housing market and vacancy rates that were high and rising. It’s completely different this time around.

MBS:

I’m glad you drew that analogy because I think that’s really important because any time there’s something volatile in the property market, people always go back to the great recession of the 2007 -2008, in there. So, I’m glad you made that comparison. But I think, one other thing that comes to mind — and I did not expect this conversation to focus so much on rental rates and how rental rates really were related and impacted, I didn’t quite understand the relation prior to us having this conversation — but I guess one thing is rising rental rates, and are there any headwinds that may frustrate the federal attempt to lower inflation back to that 2% target that it’s trying to get to?

FN:

Oh. Hey, I’m really glad you brought that up, Maiclaire. And I really think that is going to be an issue for the Fed and for any of the government policymakers in coming months because of the fact that housing costs represents such a big part of the Consumer Price Index. As we talked about earlier, it’s about one-third of the overall Consumer Price Index and about 40% of the core Consumer Price Index. Forty percent represents housing costs, especially as manifested in terms of the rent data. So, with rent rising at such a rapid rate, that has yet to be fully incorporated into the metrics for the Consumer Price Index. And I’ll tell you why. It gets a little technical, but what the analysts who create the Consumer Price Index are doing is they want to measure what’s the change in the average cost of housing across the entire housing stock.

FN:

And because the typical length of a lease in the residential market is about 12 months, about a one year lease, basically they’re capturing one-twelfth of the rise in market rents each month to reflect the fact that typically a tenant has a 12-month lease. So, the increase in rent, in housing costs in the Consumer Price Index, is much, much lower than what we’re seeing with the CoreLogic Single Family Rent Index. The rent metric in the Consumer Price Index has been trending up and I’m afraid it’s going to continue trending up in the next several months. And that’s going to be a headwind that frustrates the Fed’s attempt to bring down the overall inflation rate even more quickly.

MBS:

Yeah. It’s so interesting. And I guess it leads to the next question too, of… We talked about potential consequences of you’re going to need 50% more money to be able to afford your mortgage than you would have in the last couple of years, but are there any other things that people should consider? Any other consequences, I guess, for both homeowners and renters, if inflation rates aren’t tamed and if they do continue to skyrocket?

FN:

Well, if inflation rates remain elevated we may see, and this is a big concern the Federal Reserve has, we may see that inflation expectations no longer remain anchored at 2% per year. So, that’s been the Fed’s goal for a long time. In fact, prior to this run up in inflation, the average inflation rate has been running about 2% for two decades, Two percent per year. And the Fed has succeeded in keeping inflation expectations anchored at that 2% per year level. Their concern is, what if inflation expectations rise? What if they go to 4% per year or higher? What that means is that the overall market interest rates will be much higher than they had been for the last 20 years.

FN:

You can think of it this way. If you are an investor in bonds or mortgage-backed securities, if your expectations for inflation are now two percentage points higher for the next decade than they had been previously, then you’re going to need a yield or a return on investments in bonds, in mortgage-backed securities that’s roughly two percentage points higher in order for you to make the same type of return on your investment. So, that means interest rates, including mortgage rates are going to be elevated and remain roughly two percentage points higher, in my example, than they had been in the past. So, that makes housing costs a lot more expensive and challenging for homebuyers and for prospective first time homebuyers.

FN:

Another issue, and that’s a really interesting one, Maiclaire that we’re beginning to look at, is what a lot of real estate agents refer to as the “lock-in effect” of higher interest rates. And I’ll tell you what they mean by that. So many homeowners have either bought a home over the last couple of years or refinanced into a low-rate mortgage. So, almost half of all the homeowners in the country have a mortgage rate of 3.25% or lower. So, now mortgage rates are up around 4.25%, 4.5%. What if they get up to 5%. There are a lot of existing homeowners who want to keep their low-rate, cheap mortgage that they took out over the last couple of years and they’ll be reluctant to list their home for sale and move and relocate because that means when they buy their next home, they’re going to be paying on a mortgage that’s a lot more expensive.

MBS:

A lot more, yeah.

FN:

So, what we may see is that there are a lot of homeowners who were planning to list their home for sale over the next two, three years but now may be dissuaded from doing so because mortgage rates are so much higher than what they are currently paying on their mortgage on the home that they currently live in.

MBS:

That is such an important point right there. And my brain is going in a million directions too because I was thinking, “Oh, darn, I was thinking, we needed to buy a new house soon because we’ve outgrown ours.” But you’ve just convinced me that’s not going to happen, Frank, because everything is so much more expensive because of the mortgage rates. But it just shows how volatile the industry is and why it’s so important to really pay attention and track these types of metrics. So, I guess a couple other things too, one, second-to-last question I do want to get to is, what would happen if inflation does slow down? Where would that leave homeowners if inflation did go down from the skyrocketing where we’re currently seeing it?

FN:

Well, I think that’d be good for everybody, whether you’re a homeowner or a renter. It’s really very hard on a family’s pocketbook when home prices or when the cost of everything is going up so quickly. So, I think that’ll help longer term to keep interest rates, including mortgage rates, much lower and lower than they have been in recent weeks. So, I think that would be really good news. The only question is, can the Federal Reserve achieve an economic scenario where inflation does slow down, does get back to the Fed’s 2% inflation per year target without causing a recession? I think they may be able to pull it off, but that is the big question right now. How much of economic slowdown might occur from the actions the Fed takes to raise interest rates? Will that trigger a recession? And if it does, how severe would that recession be?

MBS:

Yeah. And I think that’s the million-dollar question there right now. And we might need to get you back at the end of the year, Frank, to take a look and see what actually did happen. Just to wrap up here, I guess, can we maybe finish off with a bit of a macro view on short-, medium- and long-term effects of rising interest rates for both renters and homeowners?

FN:

Yeah, sure. So, I think the real challenge in the short-term is the fact that with home prices up so much and with mortgage rates up as much as they’ve risen over the last few months, it has rapidly eroded affordability for homebuyers, especially for first time homebuyers and probably means that we will see a reduction in home buying demand, especially among first time homebuyers. And unfortunately, that’s what we’re seeing in the early data for the spring 2022 homebuying market. We’re seeing a little bit of pullback from first time homebuyers because the increase in costs has weeded out some prospective homebuyers.

MBS:

Sure.

FN:

I think longer term, I remain hopeful that the Fed will be able to contain inflation. So, longer term, and by longer term I mean thinking out two years from now, not just a few months, but by 2024, I do think we’ll see that the Fed’s got inflation under control and we’ll see some lower interest rates by then, but it’s not something that’s going to be achieved in the next few weeks or in the next few months.

MBS:

Well, this has been so interesting, Frank. And it’ll be interesting to see how things unfold over the next couple of years and not expecting big changes in inflation over the next couple of weeks or months, but let’s see how it does play out over the course of the next couple years. Thank you so much, Frank, for joining us today on Core Conversations: a CoreLogic podcast.

FN:

Yeah. Thanks for having me, Maiclaire. Great to catch up.

MBS:

Always wonderful to have you here and look forward to having you back again. And thanks for listening. I hope you’ve enjoyed our latest episode. Please remember to leave us a review and let us know your thoughts and subscribe wherever you get your podcast to be notified when new episodes are released. And thanks to the team for helping bring this podcast to life, producer Jessi Devenyns, editor and sound engineer, Romie Aromin and Social Media duo of Sarah Buck and Makaila Brooks. Tune in next time for another Core Conversation.

© 2022 CoreLogic,Inc., All rights reserved.

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