Why a slowing real estate market is a growing concern

The real estate market in the United States has been booming for well over a decade, with home prices rising steadily, and commercial properties experiencing strong demand until COVID hit.

Recent trends suggest that the strength in housing may be coming to an end, with declining residential real estate activity and commercial real estate markets showing increasing signs of stress. This situation is likely to have larger economic impacts than is currently realized by investors.

The total real estate market in the US is massive, with an estimated value of around $36 trillion. This market is not only important in terms of its sheer size, but also because it has significant impacts on the broader economy.

Real estate activity accounts for around 6% of GDP. When adding housing services the total share of GDP is 15.9% or about $4.1 trillion dollars worth of economic activity per year. As a result, declining activity in this sector can have a drag impact on the broader economic environment.

One of the key factors driving the decline in real estate markets is rising mortgage rates, which have risen at the fastest pace on record from trough to peak.

As more people struggle buy a new home, the number of new and existing home sales is likely to further decrease, which can have a negative impact on property values and further exacerbate the decline in activity in this sector as sellers struggle to offload inventory.

Rising rates have doubled of the cost of home ownership, which is pricing out many potential buyers. This undermines demand which can have an additional negative impact on property values and overall activity in the real estate market. Last year we saw mortgage rates top 7% in November, the highest levels we had seen since April of 2002.

In addition to rising rates, which put pressure on all real estate markets, reduced office space utilization is also likely to have a significant impact on the commercial real estate market.

Commercial real estate contributed $2.3T to US economic activity in 2022, supporting 5.1 million jobs and $831.8 billion in personal earnings, according to NAIOP. As more people work remotely, there is less demand for commercial office space.

Companies are cutting back on office space as they attempt to save money. Some of the world’s largest companies, like Google, are even reducing office space utilization by having workers share office space and work on a hybrid in-office and remote schedule.

Additionally, with more retail stores closing and warehouse space being idled, there are other areas of increasing vulnerability in commercial real estate. All of which can lead to declining rents and falling commercial property values.

As a result, we’re already seeing signs of stress in commercial real estate, and the Fed does, too, identifying commercial real estate as an area of vulnerability within the banking system during their January minutes

.Finally, rates staying higher for longer means that prices really do need to come down meaningfully. The Federal Reserve's recent decision to increase interest rates is likely to have a negative impact on the real estate market, as higher rates can lead to declining property values and reduced demand.

All of these factors suggest that declining residential and commercial real estate markets are likely to have larger economic impacts than is currently realized. Not only will this impact the real estate market itself, but it can also have a drag impact on the broader economy.

Interestingly, this is exactly what Jerome Powell's Federal Reserve wants to see. The Fed has directly identified a housing bubble as a key problem that has not only generated unwanted wealth impacts that are keeping labor force participation subdued but also because high home prices are contributing to inflation. By allowing the real estate market to cool down, the Fed is hoping to address these issues and promote a more sustainable economic environment.

The declining residential and commercial real estate markets in the US are likely to have negative economic impacts, with rising delinquency rates, reduced office space utilization, doubling in the cost of home ownership, and higher interest rates all contributing to this trend.

As this trend continues, it will be important for investors to carefully monitor the impacts on both companies and the overall economy. There may be opportunities for more adventurous and risk-tolerant investors on the short side, and eventually, opportunities to get back into investments in both companies and properties as well with better forward returns from lower pricing.