How Rising Interest Rates Shape the Real Estate Market in 2023

The real estate market in 2023 has faced various challenges amid shifts in the economic landscape, primarily driven by the resurgence of inflation. To address this issue, the Federal Reserve (Fed) implemented substantial interest rate hikes aimed at slowing down the overall economy and mitigating inflationary effects. However, these rate increases directly affected the housing sector, resulting in higher mortgage rates and larger monthly payments for homebuyers.

Rising interest rates have posed significant challenges to affordability in the real estate market. Data from the National Association of Realtors (NAR) reveals that the median existing-home price in the United States reached $388,800 in April 2023, representing a 1.7% increase compared to the previous year.¹ As a result, the Housing Affordability Index, which measures the ability of a typical family to afford a home, decreased to 96.2 in April 2023, a decline from 104.1 in the same period last year.² The increased cost of homeownership has caused affordability to become a pressing concern, leading to a dampened demand for homes and a modest drop in home prices from their peak in mid-2022. This decline occurred despite a shortage of new and existing homes in the market. These challenges raise significant questions about their potential impact on the broader economy and investment prospects.

Home values are now in a state of uncertainty. While homeowners typically expect their property values to appreciate over time, the current market conditions necessitate improvements in affordability. According to Rob Haworth, senior investment strategy director at U.S. Bank, "We're waiting for affordability to improve to open the door to more buyers. That will require either mortgage rates declining, home prices falling, or incomes rising more quickly."

Rising interest rates have posed significant challenges to affordability in the real estate market.

The dynamics of home prices are primarily driven by the interplay between supply and demand. In recent times, the supply of homes has lagged behind demand, especially in certain markets across the country. Before 2022, this imbalance, combined with low interest rates, propelled home prices higher. However, the situation changed when the Fed implemented its new monetary policy in early 2022. By November of that year, the average 30-year mortgage rate exceeded 7% for the first time in over two decades. Consequently, housing market activity slowed down, resulting in a decline in average home prices nationwide.

Based on the S&P CoreLogic Case-Shiller 20-City Composite Home Price Index, home values began to fall in July 2022 for the first time in over ten years. Although there was a slight rebound in February 2023, home prices remain lower than their peak, with a nationwide decline of 6.6%. While earlier predictions anticipated a potential decline of 10-15% in average home prices, the actual decline may be more gradual. The downward trend in home values may persist for some time.

The housing market slowdown is further evident in declining mortgage applications for new home purchases, reaching a 28-year low in late February.³ Limited housing inventory has prevented a significant depreciation in home values, as existing homeowners are hesitant to sell their properties and incur higher mortgage rates.

Existing home sales experienced a brief resurgence in February 2023, rising by 14.5% compared to the previous month.⁴ However, sales declined again in March and April, indicating an ongoing slump in activity. From a peak of 6.49 million in January 2022, existing home sales dropped to 4.28 million in March 2023, reflecting a substantial decrease of 31.5% in sales activity.⁵

Despite some fluctuations, mortgage rates remain relatively high. After peaking in November 2022, the average 30-year mortgage rate in the U.S. has fluctuated, standing at 6.39% as of mid-May 2023.⁶ These elevated mortgage rates increase borrowing costs, potentially dampening housing market activity.

In addition to affecting individual homebuyers, higher financing costs also pose challenges for builders involved in new home construction. Higher financing expenses act as barriers, limiting the supply of new homes. However, there has been a modest uptick in new home construction in April, suggesting improved sentiment among homebuilders, which could help meet current demand.

To improve affordability and stimulate homebuying activity, mortgage rates need to decline, home prices need to fall, or incomes need to rise more quickly. Historically, improved affordability has accelerated homebuying activity. However, there is a possibility that mortgage rates could remain elevated for some time, sustaining higher borrowing costs and impacting home affordability.

Before the pandemic, housing demand surged as millennials entered the market. However, rising home prices created affordability concerns, particularly for first-time buyers. With higher mortgage rates exacerbating affordability issues, potential homebuyers may choose to delay their purchasing plans and opt for renting instead. The return of millennial-driven demand is expected once this temporary blip subsides, but the duration of this phase remains uncertain.

The return of millennial-driven demand is expected once this temporary blip subsides, but the duration of this phase remains uncertain.

Rising interest rates have presented significant challenges for real estate investment trusts (REITs). As interest rates increased, REITs faced repricing, resulting in underperformance compared to other sectors. The S&P Developed REIT Index returned -17.85% for the 12-month period ending in April 2023, while the broader S&P 500 returned 2.26%. The attractive interest rate environment has made U.S. Treasury securities more appealing to investors than REITs, leading to diminished demand. REIT performance varies across different segments of the real estate market, with apartments showing steadier demand compared to office and retail properties. Although challenges persist, significant price corrections have already occurred in the REIT market, presenting potential opportunities for investors willing to take on associated risks.

In conclusion, the real estate market in 2023 has been greatly influenced by rising interest rates, which have posed significant challenges to affordability. This has resulted in a dampened demand for homes and a modest drop in home prices, despite a shortage of inventory. The dynamics of home prices are driven by the interplay between supply and demand, and the imbalance between the two has affected the market. Mortgage rates remain high, impacting borrowing costs and potentially slowing down housing market activity. The challenges in affordability and rising interest rates have also affected real estate investment trusts (REITs), causing underperformance compared to other sectors. Despite these challenges, there have been some price corrections in the REIT market, offering potential opportunities for investors. The return of millennial-driven demand is expected once affordability improves, but the duration of the current phase remains uncertain.