The 25-basis-point Fed rate cut in early November 2024 will help the construction and housing markets, although more cuts will help. Home mortgage rates will lower somewhat, but some buyers still want to wait for more favorable rates unless they have found the house they want and feel that the risk of losing it outweighs a slightly lower mortgage rate.
The Fed sees that the American economy is almost at the 2% inflation target, but going overboard on rate cuts might reignite inflation, something they do not want to do. Also, bond investors who are happy with high-interest returns from bonds and the money markets will prefer to move their money to risk on assets like stocks, crypto or other riskier ventures if the bond returns fall back to the just-above-zero returns of previous years.
The real challenge is how the 10-year Treasury bond yields are doing as well as other factors that could impact the housing markets. As a general statement, if investors and lenders are happy with the 10-year Treasury yield, they would rather keep their money there safely than risk it on things like real estate construction projects, which have a checklist of things that could go right or wrong.
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It is important to note that while the Fed directly influences short-term rates, it is the market that drives long-term bond rate prices depending on their outlook and demand/supply considerations. But in general, when future bond cash flows are not to their liking, this is when bondholders look to other riskier assets or cash flow-generating projects (such as real estate).
While the office sector cash flows have been decimated by less demand due to work-from-home and artificial intelligence as well as layoffs, the housing market demand is nondiscretionary. People need a place to live, whether they rent or buy a house. As the population grows, and local economies have good, well-paying jobs for them, people generally want to move up the social ladder. They also want their children to be able to buy their own houses.
Unfortunately, as interest rates were raised by the Fed these past few years, fewer people are inclined to sign up for long-term mortgages, especially if their paychecks are strained by car, credit and student loans as well as rent, food, groceries and energy bills.
Real estate developers, noting how fewer people are leasing offices or buying houses with mortgages, have also cut back somewhat in certain geographies on their efforts. Real estate is heavily debt-financed, and many loans have a debt-service coverage ratio (DSCR), which is calculated by taking the net operating income and dividing it by total debt service that includes the principal and interest on a loan.
Thus, if the developer is earning $1.5 million on the property annually, and the debt service payment is $1 million annually, then the DSCR is 1.5 for that property under a loan. A DSCR of 1.2 to 1.25 is generally the acceptable range. A higher DSCR allows the lender and borrower to sleep well, while anything less than 1.0 is problematic and could trigger some negative contract clauses.
It is important to note that there are huge housing supply backlogs in many areas, exacerbated by less construction that occurred during the pandemic years. However, the sudden rise in interest rates made homebuying prohibitive for many who were just starting to recover from a decreased income stream during the pandemic years as well as high inflation brought about by too much money in the economy due to the government cash injections.
Now that inflation is starting to cool off and approach the Fed's 2% target, everyone (except bondholders) prefers that the rates go back to the point where mortgages become affordable on a monthly payment basis. Higher interest rates, while benefiting bondholders, work against both homebuyers and real estate developers because the more expensive debt raises the pressure on both.
The construction and housing industry is a major contributor to the American economy and gross domestic product (GDP). Lower interest rates will give it life again as this will likely create more homebuyers and demand, more incentives for developers and thaw a static market with few buyers and sellers.
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The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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