Owning a home has been an integral part of realizing the American Dream, but a combination of forces is thwarting that goal for many. The key conspirators: relentlessly high housing prices; high mortgage rates that rise along with interest rates but don’t fall in tandem; a mortgage lock-in phenomenon that restricts the supply of homes available for sale and thus pushes up home prices; tight zoning laws; and higher construction costs. Efforts are being made to ease the supply constraints, but the biggest benefits will come from taming inflation.
Wharton experts delved into those issues at an event titled “Real Estate, Interest Rates, and the Shifting American Dream” on December 4, 2024. The panel included Joseph Gyourko, Wharton professor of real estate, finance, and business economics and public policy, and Susan M. Wachter, Wharton professor of real estate and finance, and co-director of the Penn Institute for Urban Research. Wharton real estate professor Maisy Wong moderated the event. It was the third event in a new Wharton series called “Policies That Work.”
Watch the full panel or read some key takeaways below:
Why Haven’t Mortgage Rates Dropped?
Mortgage rates reflect the premia that lenders and investors want to cover the risks they face, including the inflation rate and inflation expectations, interest-rate volatility, and a prepayment rush if interest rates decline.
The Federal Reserve in August 2024 began reducing the short-term Fed funds rate, with the latest cut putting that in the 4.5% to 4.75% range, but the 30-year mortgage rate has stayed at about 7%. The Fed funds rate reflects the overnight rate at which banks lend to each other to meet reserve requirements. “Whether the Fed cut short-term rates or not … you should be expecting 6% to 7% mortgage rates for a while,” said Gyourko.
Mortgage rates don’t move in tandem with the Fed funds rate because they follow a different math. Investors who bring the money for mortgages use as a reference point the 10-year Treasury bond rate, which is now at 4.28% and already factors in risks associated with inflation and productivity growth.
But they have to be compensated for the additional risks brought on by the longer tenure of a 30-year mortgage. Those risks go in both directions: One is the risk of a higher inflation rate, where borrowers hold on to lower mortgage rates and don’t refinance, which is called the mortgage lock-in effect.
“Whether the Fed cut short term rates or not … you should be expecting 6% to 7% mortgage rates for a while.”— Joseph Gyourko
“That’s exactly what we’ve seen in the crisis that we’re in right now,” said Wachter. “Everyone is holding on to their 4%, 5%, 3% mortgage, decreasing supply, but the hoped-for decline in rates which will ease supply increases the risk to the investor, due to prepayments, and this is keeping the mortgage rate premia over the 10-year [Treasury] at a high.”
If interest rates fall, that is not good news for those investors, because it will bring a prepayment risk: Borrowers will refinance their homes at the new low rates, and repay their older and more expensive mortgages.
“So, in a volatile environment, we’re stuck with 6% to 7% [mortgage] rates for now and in the coming months, despite the fact that the Fed has decreased [the funds rate] by 25 basis points,” Wachter said.
How High Mortgage Rates Are Causing a Housing Scarcity
Higher mortgage rates are causing a housing scarcity, Wachter noted. With the mortgage lock-in effect, people are staying put in their homes. That has reduced the supply of homes for sale, which in turn has raised home prices.
The reduction in mobility from the lock-in effect is large, with Gyourko putting that drop at between a quarter and third. Gyourko noted that 80% to 90% of all homes sales each year are from the existing stock, so a 30% drop in the share of existing owners who move each year implies that over one-quarter of the homes listed for sale are not available now.
Newly built homes have rushed to fill that gap, and their supply as a share of total purchases has increased substantially to an all-time high, Wachter said. But such new construction isn’t sufficient to significantly ease the housing supply crunch. What makes that worse in some supply-constrained coastal markets such as Boston, San Francisco, and Los Angeles is a near freeze on new housing construction, thanks to strict zoning and permitting rules. In housing markets with easier permitting, new construction is increasing densification, and those homes — which may include multi-story apartments and townhouses — are costlier to build.
Housing demand now runs high, and supply is tight. “We’ve got a tailwind from our demography; the millenniums are at their peak homeownership years, and they’re buying,” Wachter said. But she expected that trend to change over the next decade with the pent-up demand exhausted. In early signs of that coming change, “we’re seeing demand for higher education dropping now … and going forward, we’re going to see this translate into a decline in demand for starter homes, but that is in the long-term and not relevant for this generation of first-time homebuyers,” she predicted.
“[The] hoped-for decline in rates which will ease supply increases the risk to the investor, due to prepayments, and this is keeping the mortgage rate premia over the 10-year [Treasury] at a high.”— Susan M. Wachter
Tackling the Affordability Challenge
Gyourko cited estimates by an engineering consulting firm called RSMeans that an entry-level, 1,800-square-foot home in the Atlanta suburbs cost $250,000 to build in 2020, including land and the developer’s profit; that same home cost $302,000 in 2023 — a 21% increase, without adjusting for inflation. Most of that increase was because “labor costs shot through the roof,” and not so much because of land and material costs, he explained.
Wachter pointed out that while that RSMeans estimate is the average cost, developers today are maxing out production and charging at the marginal cost price, which is higher than the average cost. “The equivalent new home today, compared to 2019, is 50% more expensive,” she said.
In an effort to meet the market need, developers are building more affordable homes by reducing the sizes of the homes and scaling down on the finishes. “For the first time, the price of a new home is not at a premium to existing homes, which tells us that the construction firms are building to the market,” Wachter said. Homebuilders are cutting the size of homes and using smaller lots. In addition, recently, margins have been coming down, as builders face buyer price resistance. “We are at a 40-year low in measures of affordability, which is why the young generation is having difficulty in becoming homeowners.”
“We used to be quite affordable,” Wachter said, recalling that the average ratio between income and the price of a home in the U.S. used to be around 3:1, where a household with $30,000 in annual income could afford a $100,000 home. But that ratio has gone up to levels of 5:1 and higher, especially “in markets where the jobs are,” she said. Even so, the U.S. is more affordable than most of the rest of the world, especially in China’s tier one cities, Singapore and South Korea, where that ratio can be 10:1 or more.
Alternatives to Increasing Housing Supply
“We always think supply is one way that can help us improve affordability,” Wong said. While tough zoning laws, mortgage lock-ins, and densification cramp the housing supply, some alternatives are emerging. One is big-name developers offering single-family rentals as an option to owning a home; it is noteworthy that institutional owners such as Invitation Homes and American Homes 4 Rent have entered a market segment that has traditionally been a mom-and-pop activity, Gyourko said.
“People may want to live where opportunity is. That’s also a part of the American Dream. And renting can give you access to opportunity.”— Maisy Wong
Single-family rentals are also a viable option for young families with kids that want to be in a single-family home in a good school district, but don’t have the financial means to buy one. “Owning a home is historically something we connect with as the American Dream,” said Wong. “But people may want to live where opportunity is. That’s also a part of the American Dream. And renting can give you access to opportunity.”
Many states are experimenting with solutions to increasing housing supply. One is to permit homeowners to build what are called “accessory dwelling units” in their backyards. California, New York, and Washington are among the states that allow such construction. “This is another way of becoming a homeowner and getting some cash from renting,” Wachter said.
In another move to ease supply constraints, some states have also begun to restrict the ability of localities to have tight zoning laws, Gyourko said. But such solutions to increasing housing supply will need active government intervention with political support; market forces alone will not solve the problem, he stressed. “In the United States, there’s not an informal housing sector. So, permits are where this stuff starts,” he added.
Construction technology is also chipping in: Companies like Greystar are moving into modular construction of apartment buildings, which brings benefits such as increased productivity, reduced waste, and faster time-to-market.
Wachter listed inflation control as the topmost pre-requisite to easing higher mortgage payments along with reducing constraints on housing supply. “[It is] very painful to get inflation down, but getting inflation down and getting inflation expectations down is a necessary part of the solution,” she said. “Once we have longer-term expectations of inflation resolved back to the 2% level, then we’ll have not just 10-year rates, but also the mortgage rate will drop as interest rate volatility will decline, and we’ll have a freeing of the supply and an increase in mobility.” If taming inflation leads to lower interest rates, the mortgage lock-in effect will also be erased, leading to a substantial increase in housing supply, she added.
