Housing Prices Teeter on the Edge: Mortgage Rate Buy-Downs Are Propping Up Prices

Mortgage Rate Buy-Downs Distort Housing Market Prices

One of the most effective incentives offered by builders is mortgage rate buydowns. These involve permanently reducing the interest rates on 30-year fixed-rate mortgages from 8% to 5.75%. PulteGroup disclosed that their incentive package, primarily consisting of mortgage rate buydowns, accounted for 6.3% of the average selling price of $549,000 in Q3, translating to approximately $35,000 per house. This effectively reduces the buyer's out-of-pocket cost, making homes more affordable and attractive to potential buyers.

This strategy is essentially a form of financial engineering, allowing home builders to sell houses at seemingly high prices while actually selling them for less. For instance, a house might be listed for $500,000, but with the mortgage rate buy-down, it's effectively sold for $450,000. This discrepancy doesn't show up in the headline numbers, which only reflect the listed price, not the actual selling price.

The National Association of Home Builders reported that about 3 in 10 builders surveyed in October reduced home prices, while 62% offered sales incentives more broadly. Some builders are offering rates as low as 4.99% on a 30-year Federal Housing Administration home loan or adjustable-rate mortgages with rates as low as 3.99% in the first year.

According to the Commerce Department, new-home sales rose by 12.3% to an annual rate of 759,000 in September, surpassing expectations. This increase in new-home sales comes at a time when sales of previously-owned homes continue to decline. A recent report from Redfin, a real estate company, stated that existing-home sales are on track to be the slowest since 2008.

This has significant implications for the real estate market. It artificially boosts the comparable sales (comps) in a neighborhood, which in turn inflates the value of other homes in the area. This can lead to homeowners having an inflated sense of their home's value and purchasing power. As mortgage rates stay elevated home builders can no longer afford to offer these incentives without taking a loss. This could lead to decreased demand for homes, putting downward pressure on nominal prices and potentially leading to a significant downturn in the real estate market.

Housing Prices & Sales

The Case-Shiller Home Price Index, which adjusts for inflation, shows that housing prices peaked in April 2022 and have been on a downward trend since. If you take into account the mortgage rate buy-downs, the actual selling prices of homes are even lower than what the index suggests.

The mortgage rate lock-in effect is suppressing demand. This is where prospective buyers are facing financial strain due to higher rates, while sellers have fewer reasons to list their homes. As a result, the number of previously-owned homes for sale is significantly lower than the pre-pandemic average, with only 1.13 million homes available at the end of September, compared to the usual average of about 2.5 million, according to historic NAR data.

According to the National Association of Realtors (NAR), home sales this year are projected to reach 4.15 million, marking the lowest annual count since 2008. Despite this, there is some positive news as a leading indicator of future home closings unexpectedly increased in September. The NAR reported a slight increase of 1.1% in the pending home sales index, which tracks contract signings for existing homes.

According to Moodys Analytics, home prices are expected to fall by 10% from their peak to trough. Goldman Sachs also expects home prices to decrease for the remainder of 2023 due to high mortgage rates and low inventory. The bank projects a 0.8% decrease in home prices by December 2023.

In contrast, CoreLogic, a leading provider of real estate data, predicts that home prices will not fall next year. They expect an overall increase of 3.7% compared to 2022. This is supported by the fact that home prices have already risen by 5% between January and August of this year. In the four-week period ending on October 8th, homes tracked by Redfin were sold for a median price of $370,000, which is 2.7% higher than the same period last year.

Mortgage Rates

The 10-year Treasury yield reached its lowest level since September 22, standing at 4.510%, following the release of October's Labor Department jobs data, which came in below expectations. If the recent decline in Treasury yields continues, experts predict that Freddie Mac's rate next week could drop by as much as a quarter of a percentage point or more to around 7.5%. While this may only save the buyer of a $400,000 home approximately $60 a month, it does provide a glimmer of hope that rates have stopped rising and may even continue to decline if inflation settles and the Federal Reserve remains on the sidelines.

Several industry forecasters, including the Mortgage Bankers Association, National Association of Realtors, and Fannie Mae, anticipate that mortgage rates will reach their peak in the fourth quarter and decline in 2024. For example, the Mortgage Bankers Association expects mortgage rates to average 7.2% by the end of 2023 and fall to an average of 6.1% by the end of 2024. Lawrence Yun, chief economist for the National Association of Realtors, suggests that if spreads between Treasury and mortgage rates were to return to historical averages, mortgage rates would currently range from 6.2% to 6.7%.

With the 30-year mortgage rate staying close to 8%, mortgage demand has dropped to its lowest level since 1995. This rise in rates has led to a decrease in both home-buying and refinancing activity. The market composite index, a measure of mortgage application volume, has seen a significant decrease from its value a year ago.

Alternative Financing

Evidence that high mortgage rates has put pressure on home buyers is the surge in alternative products for buyers to purchase houses. Adjustable-rate mortgages (ARMs), which offer lower initial rates now account for the highest share of overall mortgages since November 2022. Buy-Now-Refinance-Later are now being offered by lenders. This allows buyers to refinance their mortgage in the future if rates drop, without having to pay significant closing costs. Seller financing is also emerging as an attractive option for buyers. In this arrangement, the buyer and seller sign a promissory note outlining the terms of the payment agreement.

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