Real Estate Roundup: Feeling the Impact of Higher Rates

U.S. commercial real estate prices fell more than 11% between March 2022, when the Federal Reserve started hiking interest rates, and January 2024. The potential for steeper losses has chilled the market and still poses significant risks to some property owners and lenders.1

On the residential side of the market, the national median price of an existing home rose 5.7% over the year that ended in April 2024 to reach $407,600, a record high for April.2 Despite sky-high borrowing costs, buyer demand (driven up by younger generations forming new households) has exceeded the supply of homes for sale.

Here are some of the factors affecting these distinct markets and the broader economy.

Slow-motion commercial meltdown

The expansion of remote work and e-commerce (two byproducts of the pandemic) drastically reduced demand for office and retail space, especially in major metros. An estimated $1.2 trillion in commercial loans are maturing in 2024 and 2025, but depressed property values combined with high financing costs and vacancy rates could make it difficult for owners to clear their debt.3 In April 2024, an estimated $38 billion of office buildings were threatened by default, foreclosure, or distress, the highest amount since 2012.4

In a televised interview on 60 Minutes in February, Fed Chair Jerome Powell said the mounting losses in commercial real estate are a “sizable problem” that could take years to resolve, but the risks to the financial system appear to be manageable.5

Locked-up housing market

The average rate for a 30-year fixed mortgage climbed from around 3.2% in the beginning of 2022 to a 23-year high of nearly 8% in October 2023. Mortgage rates have ticked down since then but not as much as many people hoped. In May 2024, the average rate hovered around 7%.6

The inventory of homes for sale has been extremely low since the pandemic, but a nationwide housing shortage has been in the works for decades. The housing crash devastated the construction industry, and labor shortages, limited land, higher material costs, and local building restrictions have all been blamed for a long-term decline of new single-family home construction. Freddie Mac estimated the housing shortfall was 3.8 million units in 2021 (most recent data).7

Many homeowners have mortgages with ultra-low rates, making them reluctant to sell because they would have to finance their next homes at much higher rates. This “lock-in effect” has worsened the inventory shortage and cut deeply into home sales. At the same time, the combination of higher mortgage rates and home prices has taken a serious toll on affordability and locked many aspiring first-time buyers out of homeownership.

In April 2024, inventories were up 16% over the previous year, but there was still just a 3.5-month supply at the current sales pace. (A market with a six-month supply is viewed as balanced between buyers and sellers.) The supply of homes priced at more than $1 million was up 34% over the previous year, which may help affluent buyers, but won’t do much to improve the affordability of entry-level homes.8

New construction kicking in

Newly built homes accounted for 33.4% of homes for sale in Q1 2024, down from a peak of 34.5% in 2022, but still about double the pre-pandemic share. The growth in market share for new homes was mostly due to the lack of existing homes for sale.9

April 2024 was the second highest month for total housing completions in 15 years, with 1.62 million units (measured on an annualized basis), including single-family and multi-family homes.10 This may cause apartment vacancies to trend higher, help slow rent growth, and allow more families to purchase brand new homes in the next few months.

Renters are seeing relief thanks to a glut of multi-family apartment projects that were started in 2021 and 2022 — back when interest rates were low — and are gradually becoming available. In Q1 2024, the average apartment rent fell to $1,731, 1.8% below the peak in summer 2023.11

Effects weave through the economy

By one estimate, the construction and management of commercial buildings contributed $2.5 trillion to U.S. gross domestic product (GDP), generated $881.4 billion in personal earnings, and supported 15 million jobs in 2023.12 And according to the National Association of Realtors, residential real estate contributed an estimated $4.9 trillion (or 18%) to U.S. GDP in 2023, with each median-priced home sale generating about $125,000. When a home is purchased (new or existing), it tends to increase housing-related expenditures such as appliances, furniture, home improvement, and landscaping.13

Both real estate industries employ many types of professionals, and the development of new homes and buildings stimulates local economies by creating well-paying construction jobs and boosting property tax receipts. Development benefits other types of businesses (locally and nationally) by increasing production and employment in industries that provide raw materials like lumber or that manufacture or sell building tools, equipment, and components.

Shifts in real estate values, up or down, can influence consumer and business finances, confidence, and spending. And when buying a home seems unattainable, some younger consumers might give up on that goal and spend their money on other things.

If interest rates stay high for too long it could accelerate commercial loan defaults, losses, and bank failures, continue to constrain home sales, or eventually push down home values — and any of these outcomes would have the potential to cut into economic growth. When the Federal Reserve finally begins to cut interest rates, borrowing costs should follow, but that’s not likely to happen until inflation is no longer viewed as the larger threat.

1, 3) International Monetary Fund, January 18, 2024

2, 8, 10, 13) National Association of Realtors, 2024

4) The Wall Street Journal, April 30, 2024

5) CBS News, February 4, 2024

6–7) Freddie Mac, 2022–2024

9) Redfin, May 20, 2024

11) Moody’s, April 1, 2024

12) NAIOP Commercial Real Estate Development Association, 2024

What Stubborn Inflation Could Mean for the U.S. Economy

The U.S. Bureau of Labor Statistics April 10, 2024 released the Consumer Price Index (CPI) for March, and the increase in CPI — the most cited measure of inflation — was higher than expected. The rate for all items (headline inflation) was 3.5% over the previous year, while the “core CPI” rate, which strips out volatile food and energy prices, was even higher at 3.8%. The month-over-month change was also higher than anticipated at 0.4%.1

The stock market dropped sharply on this news and continued to slide over the following days, while economists engaged in public handwringing over why their projections had been wrong and what the higher numbers might mean for the future path of interest rates. In fact, most projections were off by just 0.1% — core CPI was expected to increase by 3.7% instead of 3.8% — which hardly seems earth-shattering to the casual observer. But this small difference suggested that inflation was proving more resistant to the Federal Reserve’s high interest-rate regimen.2

It’s important to keep in mind that the most dangerous battle against inflation seems to have been won. CPI inflation peaked at 9.1% in June 2022, and there were fears of runaway inflation like the 1980s. That did not happen, and inflation declined steadily through the end of 2023. The issue now is that there has been upward movement during the first three months of 2024.3 This is best seen by looking at the monthly rates, which capture the current situation better than the 12-month rates. March 2024 was the third month in a row of increases that point to higher inflation.

High for longer

While price increases hit consumers directly in the pocketbook, the stock market reacted primarily to what stubborn inflation might mean for the benchmark federal funds rate and U.S. businesses. From March 2022 to July 2023, the Federal Open Market Committee (FOMC) raised the funds rate from near-zero to the current range of 5.25%–5.5%, to slow the economy and hold back inflation. At the end of 2023, with inflation apparently moving firmly toward the Fed’s target of 2%, the FOMC projected three quarter-percentage point decreases in 2024, and some observers expected the first decrease might be this spring. Now it’s clear that the Fed will have to wait to reduce rates.4–5

Higher interest rates make it more expensive for businesses and consumers to borrow. For businesses, this can hold back expansion and cut into profits when revenue is used to service debt. This is especially difficult for smaller companies, which often depend on debt to grow and sustain operations. Tech companies and banks are also sensitive to high rates.6

In theory, high interest rates should hold back consumer spending and help bring prices down by suppressing demand. So far, however, consumer spending has remained strong. In March 2024, personal consumption expenditures — the standard measure of consumer spending — rose at an unusually strong monthly rate of 0.8% in current dollars or 0.5% when adjusted for inflation.7 The job market has also stayed strong, with unemployment below 4% for 26 consecutive months and wages rising steadily.8 The fear of keeping interest rates high for too long is that it could slow the economy too much, but that is clearly not the case, making it difficult for the Fed to justify rate cuts.

What’s driving inflation?

The Consumer Price Index measures price changes in a fixed market basket of goods and services, and some inputs are weighted more heavily than others. The cost of shelter is the largest single category, accounting for about 36% of the index and almost 38% of the March increase in CPI.9 The good news is that measurements of shelter costs — primarily actual rent and estimated rent that homeowners might receive if they rented their homes — tend to lag current price changes, and other measures suggest that rents are leveling or going down.10

Two lesser components contributed well above their weight. Gas prices, which are always volatile, made up only 3.3% of the index but accounted for 15% of the overall increase in CPI. Motor vehicle insurance prices made up just 2.5% of the index but accounted for more than 18% of the increase. Together, shelter, gasoline, and motor vehicle insurance drove 70% of March CPI inflation. On the positive side, food prices made up 13.5% of the index and rose by only 0.1%, effectively reducing inflation.11

While the Fed pays close attention to the CPI, its preferred inflation measure is the personal consumption expenditures (PCE) price index, which places less emphasis on shelter costs, includes a broader range of inputs, and accounts for changes in consumer behavior. Due to these factors, PCE inflation tends to run lower than CPI. The annual increase in March was 2.7% for all items and 2.8% for core PCE, excluding food and energy. The monthly increase was 0.3% for both measures.12

Although these figures are closer to the Fed’s 2% target, they are not low enough in the face of strong employment and consumer spending to suggest the Fed will reduce interest rates anytime soon. It’s also unlikely that the Fed will raise rates. For now, the central bank seems poised to give current interest rates more time to push inflation down to a healthy level, ideally without significant slowing of economic activity.13

All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful. Projections are based on current conditions, subject to change, and may not happen.

1, 3, 8–9, 11) U.S. Bureau of Labor Statistics, 2024

2)The New York Times, April 10, 2024

4) Federal Reserve, 2023

5) Forbes, December 5, 2023

6) The Wall Street Journal, April 15, 2024

7, 12) U.S. Bureau of Economic Analysis, 2024

10) NPR, April 18, 2024

13) Bloomberg, April 19, 2024

How long can Consumers Keep Carrying the Economy?

Consumer spending accounts for about two-thirds of U.S. gross domestic product (GDP), so it plays an outsized role in driving economic growth or slowing it down.1 For the last 18 months, U.S. consumers have kept the economy strong despite high inflation and rising interest rates. There is much discussion as to whether consumer spending will continue into 2024.

The Federal Reserve recently did not adjust interest rates. Raising interest rates has the same impact as increasing consumer spending. Both the level of consumer spending and increased interest rates help combat inflation. The Fed’s actions regarding interest rates try to balance numerous factors including consumer spending and employment. A reversal of spending and interest rates could lead to a recession

Measuring spending and inflation

The standard measure of consumer spending is personal consumption expenditures (PCE), released each month by the Bureau of Economic Analysis (BEA). Economists look at the monthly change in PCE  for the short-term trend and the year-over-year change for the longer-term trend.

September PCE increased 0.7% over August, a strong monthly growth rate and up from 0.4% in August over July. The September increase was 0.4% measured in “real” inflation-adjusted dollars, which indicates that consumers were spending more than the rate of inflation. The annual change in PCE was 5.9%, well above the 3.4% annual change in the PCE price index, which is the Fed’s preferred measure of inflation. (The Fed’s target for PCE inflation is 2%.)2–3

The pandemic effect

The current consumer spending story began with the pandemic recession, when a broad range of business activity stopped, and consumers received large government stimulus packages with little to spend it on. In April 2020, the personal saving rate — the percentage of personal income  that remains after taxes and spending — spiked to a record 32%, almost double the previous high. It declined as businesses reopened but remained above pre-pandemic levels until late 2021, when stimulus had ended, and high inflation made spending more expensive. The September 2023 saving rate was just 3.4%, well below the 6.5% average before the pandemic.4 While a low saving rate could be cause for concern in the long term, it indicates that consumers are willing to spend their income despite higher prices.

Why are consumers spending instead of saving?

Multiple explanations have been offered for this high-spending/low-saving pattern. Some lower-income consumers may be spending a larger percentage of their income because they must — they are spending more for basic needs due to high inflation. People with more disposable income might still be responding to pent-up demand for goods and services that were not available during the pandemic. And, after the tragedies and disruptions of the pandemic, some consumers may prefer to spend now and worry less about the future. The expensive housing market could be adding to this trend by making a typical saving goal seem unattainable to younger consumers.5

On a macro level, however, consumers may be spending instead of saving because they still have substantial savings. Although it was thought that pandemic-era savings were nearly exhausted, revised government data suggests there may be $1 trillion to $1.8 trillion in so-called “excess savings” still available. About half of this is likely held by households in the top 10% income bracket, but that still leaves a large savings buffer that could continue to drive middle-class spending for some time.6

The recently released Federal Reserve Survey of Consumer Finances revealed a similar story. The average inflation-adjusted median net worth of American families jumped by a record 37% from 2019 to 2022 — more than double the previous highest increase in the Fed survey, which is released every three years. Every demographic group saw substantial increases, but the largest by far was for consumers under age 35, whose net worth increased 143%. Because this survey only went through 2022, it does not capture the effects of continuing inflation in 2023.7

Wages and inflation

While pandemic-era savings may support consumer spending well into 2024, only wages can maintain strong spending for the long term. The question is whether wages will keep up with inflation without rising so quickly that they drive inflation even higher. For the 12-month period ending September 2023, average hourly earnings increased 4.2%. This was above the 3.4% PCE inflation rate over the same period, but down from the 5.1% pace of wage increases a year earlier.8 The fact that wage growth is keeping up with inflation while also slowing down bodes well for the goal of taming inflation with continued consumer spending.

Holiday spending

The winter holiday season, officially defined as November and December, accounts for about 20% of retail spending for the year, and is even more important for some retailers. An annual survey by the National Retail Federation found that consumers plan to spend an average of $875 this year on gifts, decorations, holiday meals, and other seasonal items. This is up from $833 in 2022 and slightly above the five-year average.9  Two broader surveys have found declines in consumer confidence in recent months, but it remains to be seen whether this leads to a decline in spending.10-11 While the winter holidays are not a “make or break” situation for the U.S. economy, this year’s holiday spending may provide clues to consumer behavior in the new year.

1–2, 4) U.S. Bureau of Economic Analysis, 2023

3, 7) Federal Reserve, 2023

5) The Wall Street Journal, October 1, 2023

6) Bloomberg, October 10, 2023

8) U.S. Bureau of Labor Statistics, 2023

9) National Retail Federation, 2023

10) The Conference Board, September 26, 2023

11) University of Michigan, October 27, 2023

Rising Oil Prices Could Be a Threat to the Economy

Oil prices have increased more than 30% since late June, driving up transportation costs for consumers and businesses and putting financial markets on edge. West Texas Intermediate crude, the U.S. benchmark for oil prices, was $93 per barre September 27, the highest level since August 2022. Brent crude (the global oil benchmark) rose above $96.1

Gasoline prices have followed suit. On September 27, the national average price for a gallon of unleaded gas was $3.83, up from $3.75 a year earlier. The price in California, the most expensive state for gasoline, averaged $5.89 per gallon.2

Market dynamics have impacted fuel prices in recent months. This adds concerns about broader inflation and the nation’s economic prospects.

Tight oil supplies

Oil prices are sensitive to shifts in the delicate balance between supply and demand in the global market. Much of the third quarter’s increase has been attributed to a combination of record-high global demand and coordinated supply cuts.3 On September 5, Saudi Arabia and Russia announced the extension of voluntary production cuts (1.3 million barrels per day combined) through the end of 2023. These cuts, which began in June, are on top of cuts that were previously put in place through 2024 by the Organization of the Petroleum Exporting Countries (OPEC), along with Russia and other allied oil producers (dubbed OPEC+). In total, supply cuts are expected to reduce global crude inventories by 3.3 million barrels per day in Q4 2023.4

OPEC is a coalition of 13 member countries, led by Saudi Arabia, which regulate their output to support oil prices. OPEC joined forces with the 10 OPEC+ countries in 2016 so they would have more power to influence prices. The two groups produced about 59% of the world’s supply of crude in 2022.5

Even so, OPEC does not have the iron grip on the oil market that it once wielded. Due to advances in shale drilling methods, U.S. oil production has more than doubled since 2011. The United States has been the top oil-producing nation since 2018 and was responsible for 20% of the world’s total in 2022. Saudi Arabia and Russia followed behind with 12% and 11%, respectively.6

Pain at the pump

Crude accounted for 57% of the nationwide cost of a gallon of gas in 2022, with the remainder reflecting refining costs, marketing and distribution, and taxes. Moreover, market conditions and gas prices vary widely by state and region.7

Gas prices also respond to seasonal demand shifts. For example, they tend to climb in the summer, when more drivers hit the road for vacations, then decline in the fall. In addition to the rising cost of crude, extreme heat in 2023 forced refineries in the Southeast to operate below capacity for safety reasons, pushing up prices even more than would be typical in the summer.8

On the bright side, the national average gas price is still below the record of $5.02 set in June 2022, when global oil costs spiked in the months following Russia’s invasion of Ukraine. And most states switch to a cheaper winter blend by October, which could deliver some price relief.9

Will U.S. drilling fill the gap?

Gasoline and heating oil (both derived from crude) are essential expenses for many households, which may leave them with less money to spend on other goods and services. A broad pullback in consumer spending — which accounts for about two-thirds of U.S. gross domestic product (GDP) — could take a significant toll on growth.10

Extended periods of high oil prices have been blamed for bringing on recessions in the past, and low prices have sometimes provided an economic boost. But this relationship has become more complex as the United States has expanded its presence in the global oil market. The United States has been called a swing producer because production levels often fluctuate in response to market prices. High oil prices tend to benefit producers by pumping up company profits, and they incentivize more hiring and drilling. A surge in drilling could have a positive impact on GDP that offsets some of the negative forces.

But more U.S. production is not guaranteed. With oil prices sitting above $100 per barrel for much of 2022, companies were reluctant to invest in drilling.11 In recent weeks, U.S. producers have reportedly added drilling rigs in the shale oil patch at the fastest rate since November of 2022, but it’s still unknown whether U.S. production will increase enough to lower prices.12

Inflation and the Fed

When fuel costs are high, businesses must decide whether to absorb them — lowering profit margins — or pass them on to consumers, which could reignite inflation across the economy.

Measured by the consumer price index (CPI), inflation increased 0.6% in August and was up 3.7% over the previous year. A 10.6% surge in gasoline prices was responsible for more than half of that monthly increase.13

The Federal Reserve has been raising interest rates aggressively to control inflation by slowing economic activity. Despite the rate hikes, the economy has remained surprisingly strong, so higher fuel costs may help the Fed’s efforts to slow the pace. Even so, the inflationary effects associated with rising oil prices appear to be another risk to the economic outlook that Fed policymakers must consider as they decide the future path of interest rates.

1) The Wall Street Journal, September 27, 2023

2, 9) American Automobile Association, 2023

3, 12) The Wall Street Journal, September 19, 2023

4) Bloomberg, September 12, 2023

5–7) U.S. Energy Information Administration, 2023

8) Associated Press, August 2, 2023

10) U.S. Bureau of Economic Analysis, 2023

11) The Wall Street Journal, February 24, 2022

13) U.S. Bureau of Labor Statistics, 2023

Have You Been Following the Debt Ceiling Debate?

President Joe Biden and House Speaker Kevin McCarthy met on May 22 to discuss raising the statutory limit on U.S. government debt, generally called the debt ceiling. There was not resolution although both termed the discussion “productive,”, and their respective negotiating teams continued discussions.1 Here are some answers to questions you may have about the issues behind the current impasse.

What is the debt ceiling? The debt ceiling is a statutory limit on cumulative U.S. government debt, which is the sum of annual deficits since 1835 — the only time the U.S. government had no debt — plus interest owed to investors who purchased  Treasury securities issued to finance the debt.2 It limits the amount that the government can borrow to meet financial obligations already authorized by Congress. It does not authorize future spending. However, raising the debt ceiling has been used in recent years as leverage to negotiate on the federal budget.

Why do we have a debt ceiling? A debt ceiling was first introduced in 1917 to make it easier for the federal government to borrow during World War I. Before that time, all borrowing had to be authorized by Congress in extremely specific terms, which made it difficult to respond to changing needs. The modern debt ceiling, which aggregates almost all federal debt under one limit, was established in 1939 and has generally been used as a flexible structure to encourage fiscal responsibility.3 Since 1960, the ceiling has been raised, modified, or suspended 78 times, mostly with little fanfare until a political battle in 2011.4

How much is the debt ceiling? The current limit was set by Congress at about $31.4 trillion in December 2021.5 The debt was less than $6 trillion in 2001, when it began to rise due to tax cuts and increased military and national security spending in response to 9/11. It has tripled since 2008, driven by reduced tax revenues and stimulus spending during the Great Recession and the COVID-19 pandemic.6

When will we reach the debt ceiling? The government reached the $31.4 trillion limit on January 19, 2023. Since then, the Treasury has been using short-term accounting tactics (called “extraordinary measures”) to allow spending for a limited period without raising the ceiling.7 According to Treasury Secretary Janet Yellen, this extension is expected to expire on or shortly after June 1, 2023.8 The so-called “X-date” could vary because tax revenues are not fully predictable. It has come more quickly than anticipated, due to postponement of the tax-filing deadline for disaster-area taxpayers in certain states and lower capital gains tax receipts.9

What will happen if the ceiling is not increased? The U.S. government will not be able to pay all its financial obligations. This has never happened, so it is difficult to predict exactly how it would play out. The Treasury could still pay some of its obligations from incoming revenues, but there would have to be choices regarding what bills would not be paid. These are some of the possible results.

• The government could default on its bond payments. U.S. Treasury securities are generally considered among the safest investments in the world because they are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. These securities are widely held by individual and institutional investors as well as local, state, and foreign governments. Even the possibility of defaulting on interest payments could disrupt global markets, and an extended default could have serious economic repercussions around the world. An estimate by Moody’s Analytics suggests that a one-week default could send the U.S. economy into a mild recession with the loss of 1.5 million jobs and real GDP contraction of 0.7 percentage point. A default through the end of July (which seems highly unlikely) could cause a deep recession with 7.8 million lost jobs and a real GDP decline of 4.6%. Any default, or even near-default, could result in downgrading the U.S. credit rating, as occurred in 2011. This would make borrowing more expensive, adding to the ongoing problem.10
• Government payments could be delayed. Social Security and Veterans benefit payments could be delayed, causing hardship to those who depend on them for immediate needs. The same is true for wages of U.S. government workers, and overdue payments to government contractors could mean they may not be able to pay their employees. Late reimbursements to Medicare providers could strain smaller hospitals and medical practices. Any past due payments would be made once the debt ceiling is raised, but the short-term consequences could be painful.

What are the issues in the negotiations? Public statements from negotiators indicate the key issues include caps on future spending, use of unspent COVID-relief funds, work requirements for certain social programs, and expediting rules for energy projects. Both sides have agreed to spending caps in general terms, but they differ on how caps should be structured. The 2011 debt ceiling impasse resulted in spending caps, which had mixed results over the long term.11 Any caps would only affect discretionary spending, accounts for just 28% of federal spending. Defense spending is almost half of that amount. The rest is mandatory spending, including Social Security and Medicare (which will account for nearly 35% of federal spending in 2023) and interest on the national debt.12

Will there be a resolution? It is impossible to know for sure, but both sides have clearly stated that they will not allow the U.S. government to default on its obligations. However, time is growing short, and any agreement must pass in both the House and the Senate, requiring at least some bipartisan support. Speaker McCarthy has said that an agreement must be reached early enough to give House lawmakers a required 72-hour period to review the legislation before the June 1 deadline.13 If an agreement is not reached by that time, a temporary measure could suspend or raise the ceiling for a limited period to provide more time for negotiations.

Should investors worry? Although a default could have serious market repercussions, the most likely scenario is that the ceiling will be suspended or raised close to the deadline. If so, any related market volatility is likely to be temporary.14 While the U.S. debt is a significant issue, your investment strategy should be based on your long-term goals and risk tolerance, and it’s generally wise to stay the course through political conflicts.

The  principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. Forecasts are based on current conditions, are subject to change, and may not happen.

1, 11, 13) The New York Times, May 22, 2023

2, 4, 6, 8) U.S. Treasury, 2023

3) Bipartisan Policy Center, 2023

5, 7, 12) Congressional Budget Office, February 2023

9-10, 14) Moody’s Analytics, May 2023