A lot of people including Jerome Powell who runs the Federal Reserve assume high interest rates will make housing cheaper. They believe that higher rates make houses less affordable and therefore, prices will decrease. There are many things wrong with this line of thinking, but they are missing an incredibly important concept. High rates may cause a temporary drop or leveling off in prices, but over the long term, they are certain to cause higher prices. This is because higher interest rates make it more expensive to build houses. As a result, fewer people and developers will be able to afford to build, which will lead to a decrease in inventory. We already have a massive shortage of houses in the United States which has caused big increases in prices. Reducing building will make that shortage even worse and make prices higher in the future.
Have high rates lowered real estate prices in the past?
Many people including Powell assume high rates make prices drop or level off. This is one of Powell’s quotes from 2022:
“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.”
When he said this, rates were lower than they are now and mortgage rates are much higher than they were prior to the global financial crisis. People were also used to higher rates from the 80s and 90s back then whereas people are used to very low rates now.
However, historically raising interest rates has never lowered housing prices. There are even multiple studies that show high interest rates have never caused prices to drop. The 70s and 80s had some of the highest interest rates in our history and the 70s also had the highest appreciating real estate market in the last 100 years.
High rates make it more expensive to buy homes but they also reduce the inventory because people do not want to sell and lose the lower rate they currently have. High interest rates often reduce sales but not prices. High rates also make many things more expensive.
Here is a video I did two years ago talking about what raising rates would do to the real estate market:
How do high interest rates make building a house more expensive?
Building houses is not easy in today’s government-regulated environment. Building codes and development requirements get stricter by the minute. The harder you make it to build or develop, the higher new construction costs are but that is another topic. Here is why higher rates cause new construction to be more expensive:
- Material costs: Almost every company uses debt or sources supplies from companies that use debt. If the cost of debt increases, that means the cost of supplies increase, and prices therefore increase as well. We have seen many supply chain issues with construction materials as well. It is really hard to fix those issues and expand production when the cost of borrowing money is so high.
- Labor costs: Labor costs can also increase when interest rates are high. This is because workers will demand higher wages to compensate for the higher cost of living. We hear all the time how inflation has made it tough on the poor and middle class. However, raising wages to battle inflation causes more inflation. Powell has said numerous times wage increases are one of the big causes of inflation.
- Debt costs: Most people use debt to build houses and home builders use debt as well. If the cost of debt increases, that increases the cost of building.
How do high interest rates decrease new construction?
Not only do high interest rates increase the cost of new construction, but they also decrease the number of new builds. I mentioned before how prices usually do not decrease with high rates but sales often do. While prices may not decrease, or only decrease for a short amount of time, sales almost always decrease with higher rates. It is harder to sell houses because of the higher rates which makes builders wary to build more. It can take more than a year to build a house and if the builders have a concern about real estate demand, they will hold off and not risk building or building as much.
With higher rates, we also see higher construction costs as discussed earlier. If the price to build goes up, that will also make builders hesitant to start new builds. How can they be sure the market with higher rates will support the higher prices? Historically, the market has supported higher prices even with higher rates but that is still a big risk to take!
The graph below shows single-family new construction starts. We saw record low building for years after the housing crash and we were starting to get back to normal when interest rates spiked. You can see the huge drops in new builds in 2022 and while it has increased some, it is nowhere close to where it needs to be to catch up to demand.
How does less new construction raise prices?
The USA has a housing shortage as do most areas of the world. The governments keep making it harder to build and develop and then wonder why there is less building! If there is a shortage of housing, that means more people are fighting over fewer houses, and that increases prices. The less building there is, the higher prices will go as the population will keep increasing and moving around the country looking for new housing that is not available.
Powell may have thought higher rates would make housing more affordable, but I am not sure if he considered the long-term impact higher rates have. They will most certainly decrease new construction and raise the cost of construction which in the long-term will increase prices. The longer rates are high, the worse the problem will get. Ever heard the term kicking the can down the road? They may not want to lower rates now because a buying frenzy could ensue, but the longer they wait the worse they are making the problem.
Overall, higher interest rates are likely to have a negative impact on the construction industry. This is because they will make it more expensive to borrow money, finance projects, and hire workers. As a result, we can and have seen a decrease in new construction which will make the inventory problem worse, which will most likely make housing even more expensive in the future.