Interest Rates Impacting Real Estate

Mortgage Rates Rise, Home Sales Fall

The 30-year mortgage rate is now hovering around 7% after the Federal Reserve hiked the Fed Funds Rate to 3.7% to 4.0%. With the rise in interest rates the number of real estate transactions has fallen significantly. After a strong surge in residential home prices we also have begun to see price declines, although year-over-year comparisons remain positive. 

60,000 Home Deals Fall Through

The number of new home sales and listings fell 25% and 22% year-over-year in September. According to RedFin about 60,000 home-purchase agreements were cancelled in September or around 17% of total homes under contract. 

Mortgage Rate Spreads High

Although 30-year mortgage rates are around 7%, the yield on both a 30-year Treasury and 10-year Treasury bond is closer to 4%. Some of the spread is the difference in credit quality between the U.S. government and a home buyer. However, other factors have also driven a widening in the spread. 

Worried that rates may go even higher investors, including commercial banks have been selling mortgage backed securities. The Fed has also stopped buying mortgage backed bonds with respect to prior quantitative easing. With less demand to own mortgage debt packaged in securities, sellers of mortgage debt are having to offer higher rates. 

But Credit Spreads Narrow

As mortgage spreads have widened, credit spreads remain tight. Credit spreads remain below 5%. For comparison in 2020 with the COVID pandemic the spread reached almost 11%. In this case the credit spread is the difference between high yield corporate bonds and Treasury bonds.

For example right now BB junk bonds yield over 7% versus high grade corporate bonds at about 5%. Bonds rated below BB have even higher yields based on likelihood of default. When investors worry over credit defaults and recession risk junk bond yields tend to rise, Treasury bond yields fall and the spread widen. Right now credit spreads are not signaling credit stress or imminent recession.

Yield Curves Mixed Signals

A healthy yield curve will show a spread between short-term and long-term debt. Typically investors receive more yield for lending money for a long time, versus a short time. A 30-year Treasury bond will typically yield more than 10-year or 3-month Treasury debt. That makes sense.

But at the moment yield curves are largely flat. As of my writing this the 30-year, 10-year, 2-year and 3-month are yielding 4.25%, 4.17%, 4.71% and 4.04%. The 10-year / 2-year curve is actually slightly inverted with 2-year yields higher than 10-year yields.

An inverted yield curve is a signal of a possible recession. But it’s the 2-year 3-month that is largely flat that has a 100% successful forecasting record IF it inverts and even when it does invert past recessions are not always imminent. But if the Fed keeps hiking we probably will see such an inversion.

Recession Indicators

There are no 100% methods for predicting recessions. Despite the popularity of depicting the first half of the year as recessionary due to two quarters of negative GDP growth, this isn’t accurate. Growth was basically flat. Even on a pure GDP basis subsequent revisions could move one of those quarters to slightly positive. The first half didn’t meet the full definition of a recession. 

But how can you predict when there will be a meaningful economic downturn? We’ve touched on two useful indicators. First is a widening of credit spreads partly driven by worries of increasing defaults. We have not seen this yet. 

Second, is yield curve inversions, particularly of the 10-year 3-month curve followed by a yield curve steepening. Such a steepening with yields of shorter-term debt falling would happen when the Fed reduces the Fed Funds Rate currently between 3.7% and 4.0% after recently being at the zero bound, in order to stimulate a weakening economy.

At the moment the Fed looks to continue to increase rates with market participants expecting another 50 basis hike at the next meeting. So, it does not appear a recession is around the corner yet. However, in the interest rate sensitive residential home market, conditions are likely to continue to weaken. In the commercial real estate market there is more reason for optimism given the nature of the market relationship between rental income and financing costs. However that topic is big enough to warrant a separate article.