Why Housing May Not Get as Hammered as Usual in This Rate-Hike Cycle

“Bottom line, this is the most interest-rate-sensitive sector of the economy, and it will probably struggle” in the first half of the year, says Markowska. Ian Shepherdson, chief economist at Pantheon Macroeconomics, points out that mortgage applications have already dropped by more than 10% from their peak; he says that such applications are likely to fall much further in the second quarter. “The market is turning down; expect a sustained weakening,” Shepherdson says.

Wall Street’s warnings are warranted, given the inflation problem that the Fed has only just begun addressing. Fed Chairman Jerome Powell suggested in a speech on Monday that the central bank is prepared to raise interest rates in half-point increments—perhaps as soon as its May meeting and possibly well above the so-called neutral rate that represents a just-right economy. While housing will no doubt soften as interest rates rise, there are a couple of reasons, apart from demographics and the work-from-home trend, to bet that it holds up better this time versus past tightening cycles.

First, consider what Roberto Perli, head of global policy at Piper Sandler , says about Powell’s “unmistakably more hawkish” tone, despite any new economic data at the time he publicly spoke. Voters of all stripes don’t like inflation, and politicians are probably letting Powell know, Perli says. “Political winds may shift quickly if Fed tightening slows down the economy,” he adds. “We have zero doubt that Powell would respond to that situation, just like he is responding to the opposite now.” In other words, Powell’s bark may be worse than his bite.

That isn’t to suggest that, for housing, a sharp economic slowdown is a good trade-off for lower mortgage rates. It is simply to say that the Fed may opt to protect growth at the expense of bringing consumer price inflation—now running at 7.9%—to within striking distance of its 2% target.

That’s a bet many are making. Investors keep plowing money into housing, despite growing macro risks, says Rick Palacios, director or research at John Burns Real Estate Consulting. In the most recent quarter, investor purchases surged 42% from a year earlier, and the firm says investors now account for 33% of U.S. home purchases—about five percentage points higher than the average share over the past decade.

While some traditional home buyers surely sped up their purchases before the Fed lifted rates this month, investors often buy homes in cash and aren’t directly affected by mortgage rates, Palacios says. Large investors are quickly taking share from the mom-and-pop investors that have long made up the vast majority of housing investors, and he estimates that roughly $60 billion in institutional money is currently aimed at the space. “Investor activity was crazy last year. It’s now even crazier,” he says.

The mania reflects investors’ elevated inflation expectations. They are buying real estate as hedges, parking cash in a place where they can raise rents as wages and overall prices climb. That is as supply-chain problems fail to improve in the way economists and policy makers have hoped. For home builders, Palacios says supply issues are worsening as China locks down again in response to rising Covid-19 cases and the war in Ukraine takes significant amounts of commodities out of the market.

That is all exacerbating a housing shortage that helped push prices about 20% higher last year. For perspective on how limited supply is helping home values, there were about a million more homes available for sale when mortgage rates last hit 4.5%, Palacios says. His firm recently lifted its 2022 home-price appreciation estimate to 12% from 8%.

Economists say rising prices, especially alongside rising mortgage rates, are a headwind for near-term housing activity. But given that housing makes up about 40% of the consumer price index, and because rent prices follow home prices by roughly 12 to 18 months, investors can expect housing to continue to push up inflation. Inflation should in turn push housing—nearly a fifth of gross domestic product—higher.

One way for stock investors to participate is through real estate investment trusts. Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management , recently suggested allocating more to the asset class, with a focus on residential. The iShares Residential & Multisector Real Estate exchange-traded fund (ticker: REZ) is one that gives exposure to apartments and single-family homes, among other investments.

Despite reasons to remain positive on housing, investors can’t dismiss that owner-occupied, and thus more mortgage-rate-sensitive, buyers still make up the majority of the housing market. And, says Palacios, as quickly as investors have driven up home prices, so too can they accelerate a housing downturn should the U.S. fall into recession. But given the number and zeal of housing investors, and given record-low inventory, Palacios says that investors would quickly put a floor beneath prices. “If anything, they’re eager to see opportunities come up because the market has been so hot,” he says.

It is a double-edged sword, as investors buying a bigger share of homes worsens the affordability problem confronting many buyers and translates to higher rents for those not willing or able to buy. For now, though, investors may help protect the housing market, related stocks, and the overall economy from some of the pain that rising rates otherwise make inevitable.

Write to Lisa Beilfuss at [email protected]