Changes loom on the financial horizon, with recent Fed decisions re-shaping the economic landscape for 2022.
The December meeting of the Federal Reserve unleashed a “shot heard ‘round the world”, with the agency announcing an explicit new commitment to combating rising inflation, including the tapering of economic stimulus measures implemented during the height of the pandemic in 2020. With increased interest rates almost a certainty in the near future, how will real estate owners and investors be affected?
The Lay of the Land
You’d have to find a uniquely isolated part of the world in order to escape the news that inflation has ripped higher in 2021, pushed up by late-pandemic economic recovery, surging consumer spending, higher employment rates, and a continued low-interest-rate environment. The most recent Consumer Price Index reading showed a 6.8 percent rise across all expense categories, according to the US Bureau of Labor Statistics. Inflationary costs were led by a whopping 33.3 percent increase in energy prices and the upsurge clocks in as the fastest increase in inflation since 1982.
As the current reading shoots well ahead of the Federal Reserve’s two percent target inflation rate, it came to no one’s surprise that board members at the December 14/15 meeting agreed to drastically slow deployment of economic stimulus. The Reserve now plans to reduce monetary injections by $30B per month over the next four months, ending the current accelerated program in March of 2022.
Reducing the disbursement of cash into the economy will then allow the Federal Reserve to begin a slow but steady increase in interest rates, with most economists projecting three hikes coming down the pike next year.
In the Interest of Rates
Presently, the Federal Reserve is purchasing upwards of $120B per month of Treasury bonds and mortgage-backed securities, pushing down the effective interest rate for everyone from corporations to homebuyers. For those in real estate, it’s the trickle-down to mortgage interest rates that has yielded the most fruit over the past few years. The inception of Fed stimulus in 2020 triggered a drop in 30-year fixed rates from an average of 3.62 percent in January 2020 to just 2.68 percent by that year’s end, according to data from Freddie Mac. Rates under those same terms have risen to just slightly over 3 percent in 2021, still staking out historic lows.
All of these ultra-low rates have helped homebuyers stretch their purchasing dollar, allowing them to increase their home-purchase allowances without blowing their monthly budgets. Home prices have responded in kind: data from Zillow shows that home prices in the United States rose over 19 percent in the last year, with some locations rising as much as 40 percent. This strong price growth has put fire under the feet of home buyers who fear sitting idly by as they are priced out of their local housing market, which in turn has only added to attractive returns for real estate owners and investors. But with the stimulus flood now slowing to a trickle, what can the real estate industry expect, and how should portfolio strategies respond?
The Housing Shortage
Conventional wisdom suggests that any uptick in interest rates is a bad sign for real estate, the housing market as a whole being so sensitive to the cash-flow health of its many participants. But a number of factors may help sustain growth in real estate prices in 2022, despite the potential drag of higher mortgage interest costs. Why? Two words: housing shortage.
One of the primary drivers of recent housing strength has been the unwavering power of pent-up consumer demand. As Millennials age into their prime homebuying years, this generation (the largest in U.S. history) is facing chronic shortages of entry-level homes in most local markets. Tales of bidding wars, buyers playing fast and loose with contingencies, and jaw-dropping prices on less-than-ideal homes have been all over the news for the last few years, but the attention-grabbing headlines point to a painful reality: the U.S. housing supply is millions of units short of balance, and the deficit is only expected to grow.
While an increase in mortgage interest rates will undoubtedly temper the white-hot housing market somewhat—National Association of Realtors Chief Economist Lawrence Yun expects 30-year rates to reach 3.5 percent next year—demand is still estimated to exceed supply for years to come. This ongoing pressure explains projections for home price increases of up to 11 percent in 2022 (according to Zillow), even after taking the consequences of recent Fed actions into account.
Another reason pressure from homebuyers hasn’t retreated, even in the face of historic home price increases, is that renting hasn’t proved to be any sort of refuge from inflationary costs. Although increases in rental costs slowed somewhat in November 2021, rental rates this past year saw an average growth of nearly 20 percent year-over-year for one-bedroom units. Even renters aren’t clear of increasing housing costs, and those who are aspiring homeowners may be eager to escape the rental cash burn and move into the other side of the housing equation.
So what does all of this mean for real estate as we move into 2022?
Putting It All Together
The absolutely torrid growth in real estate prices and rental rates that we saw in 2021 most likely won’t be matched in 2022, as Federal Reserve efforts to moderate price volatility take effect and cool down some of the frothiest aspects of the housing market. But don’t count out growth altogether; persistent housing shortages, strong generational incursion into homeownership, and steady growth in rental rates will all play a role in sustained returns for those invested in housing.
The emphasis for the coming year, though, is on the downshift toward slower price gains, particularly as home buying dollars continue to drift away from top-tier geographic areas and into smaller, more affordable cities. Homebuyers are clearly going to benefit from any moderation in-home price growth, but owners will continue to reap the benefits on both sides of the housing spectrum, from asset appreciation as well as steady growth in rental income.
Financial effects aside, the biggest consequence of the recent Federal Reserve decision may well be the chance it affords everyone to pause, reflect on their current real estate strategies and portfolios, and redefine their goals in light of the emerging economic reality.