Five Questions With: Nadia Evangelou Senior Economist & Director of Forecasting, National Association of Realtors

With the Federal Reserve poised to ratchet up short-term rates by 75 to as much as 100 basis points later this month and inflation currently at a four-decade high of 9.1%, fears in the investment and real estate communities are that a recession could be on the horizon.

While the current economy differs widely from the last recession in 2007-2008 as this economy has strong consumer demand and low unemployment, rising costs that are causing the Fed’s quick intervention is of great concern.

As housing activity has slowed, affordability has declined sharply in 2022. The National Association of Realtors reported recently its housing-affordability index fell to 102.5 in May, which was the lowest level since the index dropped to 100.5 in July 2006. All indications are that conditions will go from bad to worse for many first time homebuyers this year and into 2023.

Recent economic data prompted economists with the National Association of Home Builders earlier this month to forecast that rising inflation and higher interest rates will be key factors leading the U.S. into a “modest economic recession” next year.

In its bi-weekly e-newsletter Eye on the Economy, the NAHB Economics Group stated, “We foresee a modest economic recession in mid-2023 given tightening financial conditions and increased economic uncertainty. Higher interest rates will undoubtedly slow housing and business investment, acting as a drag on economic growth.” The NAHB Economics Group headed by Chief Economist Robert Dietz added that the U.S. unemployment rate is expected to rise from near cycle lows to above 5% in 2023, “while broader-based inflation will ease further as the economy slows.”

To provide some perspective, Real Estate In-Depth turned to the National Association of Realtors, specifically Nadia Evangelou, senior economist & director of forecasting, to answer “Five Questions” on the health and prospects of the residential and commercial markets this year.

Evangelou focuses on regional and local market trends including the effects of changing demographic and migration patterns to forecast housing activity. She has been involved in research and analysis about local housing affordability conditions and local solutions to increase housing inventory. She also studies the effects of federal policies on the real estate market for NAR. Evangelou holds a master’s degree in Applied Economics from Johns Hopkins University, as well as advanced degrees in International European Economics and Public Administration.

Real Estate In-Depth: With the June inflation rate at the highest level in four decades, what impacts will this have on the residential and commercial markets going forward?

Evangelou: We see that inflation continues to run at a 40-year high. In the meantime, we see that inflation is affecting prices at the pump and at grocery stores, but has spread to housing as well. Owning and renting have become more expensive. Mortgage rates have increased more than two percentage points since the beginning of the year. The monthly mortgage payment has increased by about $500 since the first week of January when rates were about 3.2%. Rents are rising fast as well. As a result, potential first-time buyers need to spend more out of pocket on rent, they also need to spend more on mortgage payments if they want to buy a home. Meanwhile, nearly 20% of the first-time buyers already spent 60% and more of their income on rent. Therefore, rising rents and inflation make it more challenging to save the money needed to make the transition into homeownership for these renters.

But, that is one side of the coin. On the flip side, what you need to keep in mind is that real estate is a good shelter from inflation and it is more attractive in a more inflationary period. With a fixed-rate mortgage, the monthly payment remains the same (stabilizing housing costs). Homes also appreciate (in value) faster than inflation. Data has shown that, for example, commercial real estate, like other tangible assets, appreciates in value proportionally to inflation. Specifically, dividend increases from REITs have outpaced inflation in the past almost 20 years. If inflation is the result of strong economic growth, which is what is happening now, it is a good thing for commercial real estate.

Further, as many (home) buyers are priced out, we see that more people continue to rent. This trend benefits commercial real estate. However, as homebuying becomes less affordable, we expect the housing market to slow in 2022. In fact, home sales have dropped the last four months as many buyers can no longer afford to buy a home… We expect home sales to drop 9% in 2022, so we will have 5.5 million to 5.6 million homes sold in 2022.

Real Estate In-Depth: As the Federal Reserve continues to ratchet up short-term rates, where do you see the rates for residential and commercial mortgages by year’s end and into 2023?

Evangelou: Inflation and mortgage rates are the two main drivers of the housing market. … According to Freddie Mac, the 30-year benchmark fixed mortgage rate rose to 5.51% from 5.3% the previous week. And with the potential of more aggressive rate hikes from the Federal Reserve at the end of the month, mortgage rates will likely rise again further. However, I don’t expect to see the same sharp increases (in rates) that happened in the spring. Why? When the Federal Reserve raised its short-term interest rates in March, mortgage rates surged about 80 basis points in the following three weeks. The 30-year fixed mortgage rate rose from 3.9% to 4.7% by the end of March. However, when the Federal Reserve raised its interest rates again in May by 50 basis points, mortgage rates increased by a level of 20 basis points and rates (eventually) fell to 5.1% by the end of May. The data shows that the effect of the Fed’s rate hike on mortgage rates was smaller in May than in March and this is the trend from the last rate hike in June.

It seems that mortgage rates have already priced in the effect of some of the upcoming rate hike, so even with this increase of rates, mortgage rates will continue to be historically low. We believe that interest rates will surpass 6% sometime in July and reach 6.5% by the year-end.

Real Estate In-Depth: Do you believe a recession is in our future and if so, can you give a timeline and how severe will the downturn be?

Evangelou: Everybody is wondering if there will be a recession later this year. I am by nature optimistic, but data also shows that there is no evidence of a recession right now. Savings rates have come down a bit, but household and business balance sheets look good. From the job market, we see low unemployment. It is back to the pre-pandemic level of 3.6%. A lot of people are working, so they have income every month. … In the housing market we have different conditions than we had back in 2007 and 2008 when there was an oversupply of homes (on the market for sale). Now, we have a severe housing shortage. To give you an idea, back in 2007, there were about four million homes (on the market). Today, there are a little over 1 million homes. Now, we have more strict financing so borrowers can pay their mortgages. The conditions right now are totally different in the housing market compared to 2008 (the last recession). So, we don’t expect to have a recession in the near future.

Real Estate In-Depth: While volume has decreased in the residential market, prices continue to rise. Do you see any relief in terms of decreasing rates of home affordability anytime soon?

Evangelou: Unfortunately, affordability will continue to decline. The outlook is for mortgage rates and home prices to continue to rise. Borrowing costs will continue to increase in the coming months, eroding affordability even further. However, as I mentioned before, I don’t expect rates to rise as much as they did in the previous month. They will rise, but at a slower pace. Home prices will increase by about 8% for 2022 compared to 2021 when prices rose by 17%. We don’t expect to experience another year of double-digit home price appreciation. We don’t see (the lack of) affordability to ease anytime soon because the outlook is for both mortgage rates and home prices to continue to rise.

Real Estate In-Depth: On the commercial side, have increased costs impacted the volume of commercial financing deals and do you expect some multifamily and commercial projects delayed due to higher development costs?

Evangelou: We have higher interest rates and inflation and higher prices are having a mixed impact on demand for commercial real estate. The pace of construction has slowed in the industrial and retail markets as consumers have cut back on spending due to inflation. However, higher mortgage rates and the continued return of workers to the office have increased the pace of absorption of multifamily units and office space.

Moreover, we also see that due to high interest rates, investor acquisitions over the past 12 months based on the data we have for May 2022 have decreased somewhat compared to same period during the first quarter of 2022; although the investment level is still above the pre-pandemic level. To give you an idea, the total acquisitions of multifamily, office, industrial and retail properties totaled about $580 billion in the last 12 months ended May 31 (2022) and that was about 7% below from the 12 months ended March 2022.

On the whole, commercial real estate is still expected to do well, despite high interest rates and inflation. Keep in mind that rising mortgage rates are boosting rental demand. Rents are high and growing fast. Commerce continues to boost the demand for logistics space. As for the demand for office space, even though workers don’t need to be back every day, we see that there is a continued return of workers to the office, even in hybrid modes like two or three days a week. … Demand for office space is returning and we see the big cities, the urban areas are coming back to life.