Why Elevated Interest Rates Will Escalate Housing Costs
Numerous individuals, including Jerome Powell, who oversees the Federal Reserve, have long assumed that high interest rates would lead to more affordable housing.
The conventional wisdom suggests that higher rates would render homes less accessible, ultimately driving prices down. However, this line of thinking overlooks a critical concept. In reality, high interest rates may trigger a temporary dip or stabilization in housing prices, but over the long term, they are bound to result in higher prices.
This is primarily due to the fact that elevated interest rates make the construction of homes more costly. Consequently, fewer individuals and developers will have the financial means to embark on construction projects, ultimately resulting in a decline in housing inventory. The United States is already grappling with a substantial housing shortage, which has led to significant price hikes. A reduction in new construction will exacerbate this shortage, further driving up prices in the future.
Have High Rates Historically Reduced Real Estate Prices?
Many, including Powell, assume that high interest rates lead to a drop or plateau in property prices. In 2022, Powell made the following statement:
“Housing is significantly affected by these higher rates, which are really back where they were before the global financial crisis,” Powell said during a news conference. “The housing market was very overheated for a couple of years after the pandemic, as demand increased and rates were low. The market needs to get back into a balance between supply and demand.”
It’s important to note that interest rates were lower at that time than they are now, and mortgage rates are considerably higher than they were before the global financial crisis. Additionally, people were accustomed to higher interest rates during the 1980s and 1990s, whereas today’s prevailing rates are exceptionally low.
Historically, however, raising interest rates has never led to a decline in housing prices. In fact, there are multiple studies demonstrating that high interest rates have not caused property prices to decrease. The 1970s and 1980s witnessed some of the highest interest rates in recent history, with the 1970s also featuring the highest real estate market appreciation in the last century.
High interest rates may make homeownership more expensive, but they also tend to reduce housing inventory, as homeowners are hesitant to sell and lose their lower-rate mortgages. High interest rates often lead to a reduction in sales, but not necessarily in prices. Moreover, high rates can drive up costs in various aspects of the housing market.
How Do High Interest Rates Inflate the Cost of Home Construction?
Constructing homes in today’s heavily regulated environment is a challenging endeavor. Building codes and development requirements are becoming more stringent by the day. While the discussion of the impact of these regulations on construction costs is a separate topic, here’s why higher interest rates contribute to the increased expense of new construction:
- Material Costs: Nearly every company employs debt or sources materials from firms that use debt. An increase in the cost of borrowing leads to higher material costs, resulting in increased property prices. Supply chain issues with construction materials have also been witnessed, and addressing these issues becomes more challenging when borrowing money is costly.
- Labor Costs: High interest rates can also lead to increased labor costs, as workers may demand higher wages to offset the rising cost of living. Inflation, often exacerbated by wage increases, has been identified by Powell as a contributor to overall inflation.
- Debt Costs: Both individuals and home builders frequently rely on debt for construction. If the cost of debt rises, it becomes more expensive to build.
How Do High Interest Rates Reduce New Construction?
High interest rates not only raise construction costs but also reduce the volume of new construction projects. As mentioned earlier, while property prices may not necessarily decline, sales usually decrease with higher rates. Higher interest rates make selling properties more challenging, making builders wary of initiating new construction projects. Constructing a house can take over a year, and if builders are concerned about demand, they may postpone or reduce their construction efforts.
Moreover, higher interest rates result in increased construction costs, as discussed earlier. If the cost of building rises, builders may hesitate to commence new projects, as they may be uncertain about whether the market can support the higher prices. Historically, the market has indeed sustained higher prices even in the presence of higher interest rates, but it remains a significant risk to take.
The graph below illustrates single-family new construction starts. After the housing crash, building reached record lows and was gradually returning to normal when interest rates surged. The significant drops in new construction in 2022 are apparent, and while there has been some recovery, it is far from sufficient to meet demand.
How Does Reduced New Construction Drive Up Prices?
The United States, like many regions worldwide, faces a housing shortage. Governments continually impose stricter building and development regulations and then wonder why there is a scarcity of construction. When housing is in short supply, more people vie for fewer available properties, inevitably driving prices higher. As construction dwindles, prices continue to rise, while the population continues to grow and relocate in search of unavailable housing.
While Powell may have believed that higher interest rates would render housing more affordable, he may not have fully considered their long-term impact. Higher interest rates are almost certain to curtail new construction and increase construction costs, ultimately leading to higher prices in the long run. The longer rates remain elevated, the more severe the issue becomes. Delaying a rate reduction, even if it is currently warranted, could exacerbate the problem.
In summary, higher interest rates are likely to exert a negative influence on the construction industry, increasing borrowing costs, project financing expenses, and labor expenses. Consequently, new construction is expected to decline, exacerbating the existing inventory problem and potentially leading to even higher housing prices in the future.