Section 1.1: Impact of High Interest Rates

The situation with interest rates is straightforward. Following a recent inflation surge, the Federal Reserve increased interest rates considerably. Consequently, as Treasury yields rose, mortgage rates followed suit. This shift effectively doubled mortgage payments for prospective buyers compared to just a few years ago. With most incomes remaining relatively stable, affordability has plummeted, measured by the ratio of monthly income to monthly mortgage payments.

Interestingly, home prices haven’t decreased alongside rising rates. Economic theory suggests that higher costs lead to lower demand, which should, in turn, drive down prices. The intent behind increasing interest rates was to curb inflation and reduce prices by slowing economic activity. However, the economy didn’t decelerate as expected, and home prices remained high, creating a perplexing scenario characterized by both elevated prices and high borrowing costs.

Section 1.2: The Role of Limited Supply

It's important to consider why home prices have remained stable or even risen in some regions. The primary reason is the lack of available homes for sale. Homeowners are understandably hesitant to sell, as doing so would require them to replace their low-rate mortgages of 2%-3% with current rates near 7%.

From an investment perspective, homeowners are effectively benefiting from holding their properties while being negatively positioned on a mortgage bond. Unfortunately, they can't cash in on this unrealized profit. For instance, if someone has a $1 million mortgage with 26 years remaining, the bond associated with that mortgage would have lost a significant amount of value as rates increased. This unrealized gain keeps many homeowners from listing their properties, further constraining supply and maintaining high prices. With expectations that interest rates might drop soon, potential buyers feel pressured to purchase before prices rise again, despite higher current payments.

Section 1.3: Escalating Ancillary Costs

Another layer of complexity for homebuyers is the escalating costs associated with homeownership, including property taxes, renovation expenses, and homeowner’s insurance. As property values rise, so do property taxes. Renovation costs have also surged due to inflation, affecting labor and material prices.

Homeowner’s insurance adds another burden, particularly for those looking at properties in risk-prone areas. When my fiancé and I sought insurance for a house in a hilly region, we found it frustratingly difficult to secure coverage. Many insurance companies now classify homes in fire-prone areas as too risky to insure, especially in parts of California and Florida susceptible to natural disasters.

This presents a significant challenge for buyers, as obtaining a mortgage requires proof of insurance on the property. Ultimately, we resorted to the California FAIR plan, which is intended for high-risk cases, and the basic quote was over $8,500 annually. When factoring in comprehensive coverage, total insurance costs can exceed $12,000 per year.

Given that high interest rates, limited supply, and rising ancillary costs are converging, home affordability is likely at a historical low. This is why institutions with substantial financial resources, such as private equity firms, are increasingly investing in real estate. They have access to cheaper capital than average buyers and see the combination of low affordability and increased demand for rentals as a lucrative opportunity. Additionally, real estate serves as an effective hedge against inflation and generates rental income, making it an attractive investment.

In summary, these dynamics contribute to a growing divide where wealthier individuals continue to accumulate properties while many potential buyers are effectively priced out of the housing market.