Greater Phoenix Blue Chip

FED’S MOVE BRINGS HOPE BUT NOT AN IMMEDIATE SOLUTION

Third Quarter, 2024

Elliott Pollack

Last week the Federal Reserve cut interest rates (as measured by the Federal Funds Rate) for the first time since March 2020.  This should be great news for interest-sensitive sectors such as single family and multifamily housing.  But there are many issues at play here that suggest the impact of the decline in interest rates will be more muted than the historic norm.  Let’s discuss some of those factors.

First, the good news:

1. The Fed controls short-term rates but not longer-term rates such as the 10-year Treasury Rate. This is important because the 30-year mortgage rate is more related to the 10-year treasury rate, and 10-year rates are not expected to decline as much as the Fed Funds rate over the next year.
2. But as shown in chart 1, the spread between those two rates fluctuates over time depending on where we are in the business cycle. Normally, the spread is between 180 and 200 basis points; but now, it is currently near all-time high levels. The spread is expected to narrow, and the interest rate on 10-year treasuries is expected to decline over the next year. This is good news for mortgage rates.
3. This is true even though mortgage rates peaked at 7.79% in 2023 and have since declined by 170 basis points ,while the 10-year rate has declined by 124 basis points. Much of the decline in the spread lies in front of us.

Now, for that not so good news:

1. While all of this should help improve the very low level of single family affordability that we now face, housing affordability, while improving, is likely to be an ongoing problem.
2. Upward pressure on single family home prices is likely to continue. There is a significant shortage of housing in America at the moment. This is the mirror image of the glut of housing that existed after the housing bubble of 2005-2006 which left the market severely overbuilt. It has taken all of this time for the market to go from overbuilt to underbuilt.  This shortage is exacerbated by the fact that 60% of active mortgages are at 4% or below.  Those homeowners with such a low mortgage rate are not likely to move except for extreme circumstances.  This has kept the supply of housing in most Multiple Listing Services across the country near historic low levels (see charts 2 and 3).  This makes it tough to find an affordable home to buy.  And while a lot of housing turnover is really just musical chairs, the effect on keeping prices high is quite real.
3. Again, housing affordability continues to be a major negative factor for buyers (see charts 4 and 5). While housing should be in an explosive period given the age demographics of the U.S. population and the pent-up demand, a good deal of that demand is overcome by the inability of buyers to find a home that they can afford.  Even those who can’t buy at the moment are facing higher rents that put pressure on the rest of their budget and will keep many on the sidelines for a long time.  Those affordability issues are not only related to supply and demand.  They are also related to the rapid increase in government-mandated impact fees and regulations that have added many thousands, if not tens of thousands, of dollars to the cost of a new home.  The regulatory factor seems to be worse not only at the local level but at the federal level as well.  This trend is not likely to soon reverse. And while the ideas coming out of Washington may help with the down payment for a first-time home buyer, other ideas will do nothing but build additional bureaucracies that will run up prices.  That’s why the saying “I’m from the government and I’m here to help you” is synonymous with “Wanna buy a watch?”
4. The problems are more than what is discussed above. Over the past five years, median housing prices have increased by over 50% while incomes have risen only by 30%.  In fact, as can be seen in chart 6, the median sales price to family income ratio is at a very high level by historic standards.  It will take a significant decline in rates to offset that fact.
5. Given the significant pent-up demand, the relatively low levels of housing activity in the last few years will make it difficult to find enough skilled labor to build enough homes to eat into the shortage that exists. This, combined with a supply chain that is not used to the level of housing activity that will be needed, will also keep upward pressure on new home prices.
6. While the decline in rates is good news, it is still difficult for an existing home to compete with a new home builder. This is because a new home builder can offer a more competitive product in terms of floor plan and size, and can also buy down rates.  Yet, this is still good news and will help.
7. Let’s not forget apartments and other rental housing are a very important piece of the puzzle. It can take 3-4 years from concept plans for a rental product to reach the reality of that project being built and available.  Since interest rates were considerably lower 3 years ago, a significant number of units were permitted then and are now hitting the market when absorption rates are lower. Due to current higher interest rates, the number of units permitted is now considerably lower and those lower number of units are expected to hit the market in a few years when absorption rates are higher.  So, while pressure on rental rates is downward today, it is likely to change to upward pressure later in the decade.

While overall this might sound negative, this article was written to give some perspective on what should be the start of a catch-up period for all kinds of housing.  We need more built now.  There is significant pent-up demand.  We need governments at all levels to help the situation by not enacting counterproductive measures that negatively affect affordability. This would include better control over impact fees, less regulation, staying away from failed policies like rent control, and having more of a backbone when it comes to dealing with NIMBYs. We need to recognize that we have issues to overcome.  But, hopefully, this is the start of something that, while taking longer than it should, will be a reversal that is sorely needed in America.

GREATER PHOENIX BLUE CHIP: RESIDENTIAL