Residential Magazine

Find Clarity in This Murky Housing Market

Volatile mortgage rates may determine housing demand and inventory levels

By Jack Macdowell

The residential real estate market is still recovering from a tumultuous year that saw home price records broken and whiplash-inducing spikes in mortgage rates. Home purchase activity is expected to dip substantially in 2023 for several reasons, including decreased buyer demand and continued low levels of for-sale inventory.

To better forecast where the market is headed, it’s constructive to recap recent factors and events. Existing homes fetched record prices at the midway point of 2022, with the U.S. median sales price reaching as high as $413,800 before tapering off by year’s end, according to the National Association of Realtors (NAR).

This midyear peak was up nearly 13% year over year. Mortgage interest rates, meanwhile, skyrocketed during the course of last year, with the average 30-year fixed-rate loan jumping from 3.4% in January to a peak of 7.1% in October, according to Bankrate.

This one-two punch to the gut of prospective homebuyers had a major impact on affordability and led to a significant reduction in housing demand. In the final two months of last year, NAR reported that existing home sales declined by roughly 35% on an annualized basis. Faced with affordability challenges, many would-be first-time homebuyers were forced to remain in an already crowded rental market with vacancy rates near historic lows (5.8% as of Q4 2022, according to census data).

Inventory issues

While demand is often cited for the reduction in housing activity, supply-side factors are of equal or more weight, as the unsold inventory of existing homes totaled less than 1 million this past January. Unless mortgage rates decline, homeowners who refinanced in recent years will be unlikely to sell their homes and give up their low-cost financing. This “rate lock-in effect” is likely to keep the supply of existing homes well below the 20-year average of roughly 2 million units.

Existing home sales slipped for the 11th consecutive month to a seasonally adjusted annual rate of 4 million at the end of January, NAR reported. It’s numbers like these that likely prompted NAR chief economist Lawrence Yun to predict that existing home sales will decline by 6.8% from 2022 to 2023, with much of the slowdown expected to happen in the first three months of this year. Looking more closely at NAR’s 2023 forecast, the trade group expects home prices to remain flat compared to the prior year, with the number of units sold and the aggregate dollar volume to drop by 7%.

In short, lower demand coupled with persistent inventory shortages are expected to result in a lackluster year in home sales activity. To complicate matters, inflation is likely to remain high, fueled in part by an undersupplied labor force. Adding to this ambiguity is widespread uncertainty caused by Federal Reserve policy, stock market volatility, geopolitical instability and recessionary worries.

Rate sensitivity

The good news for prospective buyers is that these factors could coalesce to place downward pressure on mortgage rates in the second half of 2023, which would likely put upward pressure on demand. Lower rates mean better affordability and greater purchasing power, but this will undoubtedly come with several bouts of volatility. For example, as of Feb. 8, 2023, the rate for a 30-year fixed rate loan was averaging 6.27%, according to Bankrate. This was considerably higher than the 3.85% average during the same week in 2022, but it was nearly a percentage point lower than its peak a few months earlier.

Fast forward three weeks. As of Feb. 27, 2023, the rate increased to 7.02% as sticky inflation numbers and resilient labor market data resulted in the Federal Reserve doubling down on the “higher for longer” policy narrative.

In January, Freddie Mac reported softening in mortgage rates and, according to NAR, January pending home sale figures increased 8.1% over December. Over the course of the next 12 to 24 months, if mortgage rates steady at levels at or below 6% as many expect, pent-up demand from the renter cohort could be released into an undersupplied housing market, putting further upward pressure on property values

Note that the 30-year mortgage rate spread relative to the 10-year Treasury yield remains near its widest level on record. This kind of disparity does not tend to endure for long periods. As a result, many experts believe there will be a normalization that will conform to historic levels, especially as the market adjusts to be more comfortable with the Federal Reserve’s current rate policy.

If this spread tightens as expected, mortgage rates should drop further into the mid- to high-5% territory. In February, the Mortgage Bankers Association forecast a much more affordable rate climate, with the 30-year fixed rate projected to average 5.3% in 2023. Other trusted authorities aren’t as optimistic: Freddie Mac anticipates an average rate of 6.2% this year while Fannie Mae calls for a figure of 5.9%.

Reasons for caution

While some things come down, others can go up — like mortgage delinquencies and foreclosures, which tend to increase as consumer savings and disposable income weaken. The year-end 2022 foreclosure-market numbers from Attom Data Solutions indicate that more than 324,000 U.S. properties had foreclosure filings last year, a rise of 115% from 2021 but a decrease of 34% from the pre-pandemic period in 2019.

Last year’s foreclosure filings also were 89% below their 2010 peak of nearly 2.9 million. Due to the substantial amount of home equity accrued by homeowners, as well as a robust default-management toolkit available to mortgage servicers, experts aren’t concerned about a significant increase in foreclosure activity that could result in a high level of distressed-property sales in 2023.

Other increases expected this year include more Fed rate hikes as the central bank continues its aggressive effort to curb inflation. Long-term growth could be hindered by further increases in short-term rates. Note, for example, that 10-year Treasury yields dropped to a low of about 3.4% this past February after peaking at 4.2% in October but have since reverted back to 3.9%.

Looking ahead, investors need to be cautious about these and other factors. This includes a potential recession and continued unpredictability that could influence mortgage rates, buyer demand, affordability, inventory, market liquidity and home sales activity. Assuming that the nation does not veer into a protracted recession, inflation is kept in check and Fed rate hikes begin to wane, mortgage market volatility should subside. This will result in lower credit spreads and a further decrease in mortgage rates — a prospect that home shoppers eagerly await. ●


  • Jack Macdowell

    Jack Macdowell is the co-founder, managing member and chief investment officer at the Palisades Group. He is responsible for leading all investment activities, including research, portfolio allocation and risk-management functions. Prior to founding Palisades, Macdowell held various leadership roles at buy-side companies focused on mortgage and securitized credit. He has sell-side experience with Credit Suisse First Boston and RBC Capital Markets.

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