Interest rates are in the midst of their biggest increase in many years. This is going to have a massive impact on the housing market and related stocks such as the SPDR Homebuilders ETFs (NYSEARC:XHB).
It starts with overall mortgage rates. The average interest rate on a 30-year fixed mortgage has risen from 3.2% at the start of last year to over 5% now. This has a huge effect on affordability.
It would be easy to take this data and conclude that another 2008-style housing bust is on the way. But that’s probably not the case. For one thing, banks have maintained much higher lending standards this time around, so don’t count on a huge wave of bad debt crashing into the financial system. And more specifically, some mitigating factors may also support the market.
With that in mind, here are some factors to consider when analyzing the impact of rising interest rates on the housing market.
Beware of particularly overvalued markets
A key consideration is that real estate remains a very localized market. It’s true that mortgage rates are rising at a similar pace nationally. However, this will not have the same impact on each specific market. Indeed, housing demand is primarily driven by migration to or from a region, as well as local affordability. Some analysts suggest that the markets that have boomed over the past two years are now particularly exposed to downside risk.
A May study by researchers at Florida Atlantic University and Florida International University found that of the 100 largest urban areas in the United States, four have housing markets that are at least 60% overvalued. Eleven other markets were overvalued by at least 50%.
According to this study, the most overvalued market in the country is in Boise, Idaho. The median home there now cost $516,548 at the time, but should only cost $299,202 based on historical prices in that city. It appears the rush of remote workers moving to Boise during the pandemic has caused a market imbalance.
Other most expensive markets included No. 2 Austin, No. 3 Ogden and No. 4 Las Vegas. All of these cities have also attracted significant numbers of remote workers over the past two years. In contrast, traditionally expensive markets such as New York and San Francisco have proven to be fairer according to this study, as prices have inflated much less in recent years compared to their long-standing benchmark levels.
Higher rates will limit housing mobility
It used to be that homeowners were happy to refinance their mortgage or move into new homes in no time. This will change in a world where mortgage rates are much higher.
A $500,000 30-year mortgage at 3.3% would cost about $2,100 per month. At an interest rate of 6.6%, that same $500,000 mortgage would cost $3,100 per month, or a thousand dollars more per month. Mortgage rates are not yet at 6.6%, but they could easily get there with a few more rate hikes from the Federal Reserve.
This means that anyone thinking of moving will have to mentally add several hundred dollars a month to their housing expenses to buy a home for the same price as the one they currently own. This will significantly reduce labor flexibility. Many people will refuse to accept jobs in different cities, as the additional housing expenses will negate the positive effects of the new job.
Demographics will eventually support the housing market
While there are obvious downsides to the housing market, don’t bet on another crash like the one in 2008. Prices haven’t risen as dramatically as they did during that bubble, and lending standards don’t have not eroded as strongly.
It is also of utmost importance that there is a huge structural shortage of housing supply. From 1995 to 2008, the United States began building at least 1.5 million new homes each year. However, following the 2008 collapse, many homebuilders went bankrupt and banks were reluctant to lend on new construction.
This led to housing starts falling to just around 500,000 for several years during the housing crash. America only returned to 1 million annual units in 2014, and it eventually hit the 1.5 million level – the old benchmark – in 2020. This shortage of new housing construction has led to millions of homes missing, in total, compared to what the US economy normally would have turned out.
At the same time, the important millennial generation is aging. Many people in this age group are looking to get married, have children and start their own homes. These future buyers will provide great firepower to support the housing market despite the impact of the sharp rise in interest rates.
The housing market is already showing concrete signs of slowing, such as building permits, mortgage applications and housing market research activity. The Federal Reserve’s rate hike campaign will almost certainly cool the previously hot market. But it probably won’t be a national meltdown, unlike 2008.
Against all odds, the coming downturn in the housing market may actually hit cities like Austin, Las Vegas and Boise the hardest. These cities quickly attracted an influx of remote workers. However, as mortgages become more and more expensive, the advantages of these cities will fade compared to cheaper options.
The sharp rise in mortgage rates will encourage many people to stay in their current homes, as it will be too expensive to move given the significantly higher interest charges on new mortgages. And finally, millennial buyers waiting in the wings should provide significant support to the housing market after its initial period of weakness over the next 12 months.
As of the date of publication, Ian Bezek had (neither directly nor indirectly) any position in the securities mentioned in this article. The opinions expressed in this article are those of the author, subject to InvestorPlace.com publishing guidelines.