As inflation continues to be reined in, prospects run high for an easing of interest rates in 2024. That could bring a much-needed boost for both the residential and commercial real estate markets — particularly, beleaguered office markets. But the recovery process will take time, according to Susan Wachter, Wharton professor of real estate and finance.
“While 2023 has been extremely painful, 2024 will see some easing of the pain, and abatement. By the end of 2024, I see considerable relief ahead,” she said in an interview with Wharton Business Daily. (Listen to the podcast above). “Stay alive to ’25.” In other words, the year ahead will be a period of waiting for a critical mass of positive developments before housing market activity resurges in 2025. Lower inflation and interest rates will also spell lower home ownership costs and, with additional supply coming online, the potential for lower rents for multifamily, she said.
Those promised gains will bring much-awaited relief to both the residential and commercial real estate markets. Both those markets had a tough year in 2023, as Wachter noted. For instance, high interest rates had made home mortgages expensive, and a shortage of housing inventory made matters worse. In commercial real estate, sky-high interest rates and the shift to remote work have decimated all but the Class A office markets. Adding to the office market pile-on, small and midsized banks turned risk-averse and drastically reduced their lending to commercial real estate.
While the office space markets will continue to undergo a period of readjustment, the housing markets are poised for some cheer, although not affordable prices. “By 2025, more people will be able to [buy homes]. As a result, we will see housing prices once again on the rise,” Wachter noted.
Read an edited transcript from the conversation below.
Transcript
Wharton Business Daily: How do you put a framework on what we’ve seen in the housing markets in 2023?
Susan Wachter: The year 2023 has been very difficult for residential real estate. The housing market came to a screeching halt starting in late 2022 because of the Federal Reserve’s action [of raising interest rates]. Above 7% mortgage rates together with low inventory that resulted from a locked-in effect froze housing markets.
Housing sales activity has not been this low in decades. And at the same time, housing prices are elevated in inflation adjusted dollars, leading to all time high costs of owning. The cost to become a homeowner made it impossible for millennials, who are at the edge to purchase their first time home, to achieve homeownership. There is not much good to say about 2023.
The Housing Inventory Challenge
Wharton Business Daily: How could the housing inventory problem be resolved, especially when it involves several factors like interest rates, and the cost of labor and materials?
Wachter: There are two sides to the inventory issue. One is existing inventory, which is totally governed by the lock-in problem (where existing homeowners do not move because they have locked in their mortgages at much lower rates than the prevailing interest rate). This is a problem that lower inflation and interest rates will solve. The supply side in terms of new buildings will continue to suffer from high costs. Labor costs will continue to be a challenge, and labor availability is a challenge. Access to buildable lots is also a problem.
But construction is happening. In fact, we’re seeing more construction as a percentage of housing sales than we’ve seen in decades. The construction industry is part of the solution. The bigger problem is the lock-in effect. People will not move because they don’t want to give up a 3% mortgage rate and take on a 7% rate. That will be solved by interest rates declining.
Wharton Business Daily: Even if interest rates decline from 7% to 5%, it will still not be enticing for somebody who is locked into a 3-3.25% mortgage rate.
Wachter: It will make a difference. Because we do have people who have mortgages at 4% or 4.5%. So, if interest rates hit 5%, that in itself has the potential [to give rise to] a remarkable turnaround. Not only will the interest rate and the mortgage rate go down, but housing mortgage costs will also go down and housing prices will moderate as inventories rise. So, the two points of pain will translate to points of gain.
While 2023 has been extremely painful and 2024 will be a continuation of that, by the end of 2024, I see considerable relief ahead. That is mostly because inflation is under control. Over the last six months, we’ve [almost] solved [the problem of rising] inflation. Annually, inflation is 4%, but over the last six months, annualized, it’s 2.5%. It will take six months for it to hit the mortgage market. But once it does affect long-term interest rates, it will also [narrow] the huge gap between mortgage rates and the 10-year [Treasury rate], which is very unusual. That gap will also deflate.
So, we’ll see a good-size potential decline in mortgage rates, which will go a long way towards solving the [inventory] problem. That is because at the same time that the cost of a mortgage goes down, housing prices are likely to ease simply because we will have more housing on the market. We have people who have, today, mortgages that are at 5.5%, 5% and 4.5%. As mortgages start going down to 5%, then, “buying down” (obtaining a lower interest rate through buyer or construction firms assistance) from 5% to 4.5% is a lot easier than buying down from 7% to 5%, which is what we’re seeing. It is not so difficult to get to a 4.5% rate, when the markets are [looking at] 5%. It’s the good news for 2024.
Wharton Business Daily: Many builders are offering incentives like buy-downs because they have properties out there that they want to move.
Wachter: Yes. Buy-downs are happening because they have to happen for sales to occur. But there is limited capacity to get that done. But we’re going to see a dramatic decline in 10-year rates over the next 12 months which will bring rates far closer to historic levels.
Wharton Business Daily: Do builders need to look at the types of properties that they’re putting out in the market?
Wachter: They are. There’s a shrinkage in house size. There are smaller lots. Builders are responding to the increased need for that less expensive starter home.
Why Relief Will Take Another Year
Wharton Business Daily: So you’re optimistic, then, as we look at next year, in terms of what we may be able to see – with maybe the caveat of interest rates coming down.
Wachter: Yes, that’s a caveat. I am hopeful on 2024, but the sad part of it is it’s really “Stay alive to ’25.” It’s at the end of 2024 when we will see relief. It will take time for these issues to resolve, and for inflation to be solved. I see that coming, but the Fed isn’t going to announce that it’s over by its action until it’s over and inflation returns to its 2% goal.
Wharton Business Daily: What do you think this all means, then, for the amazing run-up we’ve seen in the last few years in multi-family properties?
Wachter: It’s a great cure for higher housing costs, the potential oversupply of multi-family properties. We’re seeing [multi-family housing] rental price points come down. That’s also a good thing for [reducing] inflation, because a very large (nearly 40%) of the CPI is rent-equivalent.
Rents are not likely to fall a lot in 2024. But as 2024 continues, this [multi-family] oversupply problem will put downward pressure on rents as well as potentially on multi-family housing prices. It’s quite unlikely that we will see housing prices continue on this unbelievable, upward trend. They’re not likely to be down much, again, because of supply restrictions. But once we get relief on supply, we’ll see more activity, if not significant price declines.
At that point, again, because interest rates are down, demand will increase, I don’t see tremendous relief on prices. But it will be relief when interest rates go down, nonetheless, and prices don’t rise proportionately, which is unlikely, given the likely easing of inventory supply.
Wharton Business Daily: What’s the expectation for the current homeowner, as to the value of their home, and where it may end up in the next couple of years? Are the [price] increases that they saw a couple years ago fairly safe at this point?
Wachter: [Those price increases are] built in, because there has been a major transformation, a major shift in the role of housing for families. People want more space, they want more housing. They want owner-occupancy, even though at this price point, many millennials who would like to be homeowners, are not able to buy. By 2025, more people will be able to [buy homes], and we will see housing prices once again on the rise, but at a moderated rate.
Commercial Real Estate
Wharton Business Daily: Where is commercial real estate headed? Companies are reassessing their footprint; remote work has obviously played a role in that.
Wachter: There’s a great deal of uncertainty. The commercial real estate markets could stay frozen throughout this year. In fact, we could have more distress in the commercial office space market, as we have this wall of debt that needs to be refinanced, at still high interest rates.
Banks are pulling back, especially at regional banks, and small banks in commercial real estate lending. And 50% of the money for commercial lending comes from these banks. They’re pulling back at a time when mortgages need to be refinanced.
But resolving that problem in the office space market is way ahead of us. We don’t see sales. We don’t even know what prices should be. Where is the price that’s low enough to see activity come back to that market? We don’t see that yet.
If you are a commercial office space REIT, you’re hurting. That’s a potential pain point and we don’t know how that’s going to play out, for the economy as a whole and for banks in particular. I don’t see a negative feedback loop to the extent we saw, for example, in 2009. We could, of course, if we had a recession like in 2009. But the good news is it looks like the consumer is resilient. If we have a recession, it will be mild. And interest rates will come down as a result more than otherwise.
In the logistics space market, [however], it’s a different story. Data centers and logistics are booming, and as interest rates come down, they will continue to do extremely well.
Wharton Business Daily: How much, then, has the Fed had to track the real estate market in making decisions on interest rates?
Wachter: I think Fed [officials have] become real estate economists. Macroeconomists are now appropriately focused on real estate.
