Welcome to the August edition of The Appraisal, a newsletter on real estate tech. My writing focuses on the 30+ public companies operating at the intersection of real estate and technology. In this edition, we’ll review the Real Estate Tech Index’s recent performance (which is up nicely since my last post) and go deeper on a topic that impacts most companies within the index — mortgage rates. Enjoy!
The Real Estate Tech Index is up 41% in 2023 and 24% over the last year — outperforming most major indices. That’s a promising improvement over 2022, in which the index declined 42% over the year.
A few categories within the index are having particularly a particularly strong 2023 — namely Brokerage & iBuying, which is up 146% this year. Opendoor is up more than 4x on the year, driven by solid Q1’23 earnings and a growing investor sentiment that the US housing market is stabilizing — home prices grew 0.4% sequentially in Q1’23 and housing inventory is no longer falling.
Redfin and Compass have also had a strong showing through the first seven months of the year, up 234% and 82%, respectively. Both companies are down meaningfully from their peak, but investors seem cautiously optimistic after both companies have committed to expense discipline and a drive towards profitability amidst transaction volume headwinds (existing home sales are expected to decline 14% year-over-year to 4.3 million). WeWork, Sonder and Vacasa are the biggest losers so far in 2023, down -83%, -54%, and -44%, respectively. I’ve covered WeWork in depth in a prior edition of this newsletter — a dilutive restructuring, CEO/CFO changes, and slow return to work trends have scared off most investors at this point.
Overall, a solid last two months for the Real Estate Tech Index, which appears to be rebounding from a nadir in 2022. Of course, questions remain about the housing market, the broader economy, the interest rate environment (more on that below), and the ability of (mostly) cash-burning technology businesses to pivot into profitability — so expect continued volatility and perhaps consolidation and reorganization as we round out the year.
If you have any colleagues that may find The Appraisal valuable, please feel free to share this newsletter. Thank you and enjoy!
Highlight of the Month — A Primer on Mortgage Rates
In 2022, the Fed began aggressively hiking interest rates in an effort to curb inflation. As a result, average mortgage interest rates have climbed upward — from as low as 2.7% in 2021, to 7% in July 2023. Mortgage rates of course have a direct impact on housing affordability — every percentage point increase in rate decreases buying power by more than 11%. And as a rates rise, demand for housing drops — existing homes sales this year are down more than 35% from 2021.
Given the impact of mortgage rates on the overall housing market, I decided to dedicate this post to the topic — how are mortgage rates determined, what drives the spread between treasury rates and mortgage rates, and, looking forward, what structural changes to the mortgage market may impact rates?
Mortgage rates today are largely a function of buying and selling activity within the mortgage-backed security (MBS) market. MBSs are bonds which represent ownership interest in a pool of underlying mortgages. The US MBS market is one of the largest and most liquid global fixed-income markets, with more than $11 trillion of securities outstanding and $200 billion+ in daily trading volume. This also means that mortgages can be held and traded by investors globally (as opposed to held on bank balance sheets as was common in the 1980s).
Agency MBS represents the majority of MBS issuance — these securities are unique in that they carry a government-backed credit guarantee from one of three housing agencies: Fannie Mae, Freddie Mac or Ginnie Mae. Because the Federal government backstops these mortgages from any principle losses, they are considered to be very safe assets analogous to Treasury bonds. However, there is typically a spread or “risk premium” between prevailing mortgage rates and treasury yields. Over the last decade, average rates for 30-year mortgages have, on average, remained 150-170 basis points higher than the 10-year Treasury bond yield. This spread is driven by three primary factors:
Demand dynamics: Because MBSs are sold within liquid financial markets, meaningful changes to demand for these securities can drive MBS spreads up or down. For example, the presence of the Fed as an active buyer of MBS during the pandemic (as part of its broader QE efforts) drove down spreads meaningfully, contributing to record-low interest mortgage rates. We’ll go deeper into today’s demand dynamics in a moment.
Prepayment risk: While Treasury bonds pay principal only upon maturity, MBSs allow borrowers to refinance or sell their homes, leading to early loan repayment without penalty. Consequently, investors lose access to future interest payments, and may have to reinvest at lower market rates. This uncertainty of timing is known as prepayment risk, and investors require compensation for this risk, contributing to the spread relative to risk-free government bonds. Prepayments typically spike during periods of declining interest rates.
Duration risk (or negative convexity): In periods of rising interest rates, mortgage borrowers are often less likely to move or refinance, extending the expected duration of their mortgages (MBS investors typically model a 5-7 year repayment timeline). This can lead to a duration mismatch for holders of MBS between short-term liabilities (such as deposits) and long-duration MBS. This is precisely what got SVB into trouble earlier this year.
I mentioned above that mortgage spreads have historically tracked in the 150-170 basis point range. Over the last year, however, spreads have widened meaningfully, reaching 307 bps in July (see chart above) — contributing to higher mortgage rates for borrowers.
What’s behind this spike? We are in the midst of a structural shift in the mortgage market, driven by policy changes at the Fed and changing demand dynamics amongst major holders of MBS — banks — in the wake of recent regional bank failures.
Who are the Largest Holders of Mortgage-Backed Securities?
At the onset of the pandemic in March 2020, the Federal Reserve quickly responded to significant financial market disruption, seeking to provide stability in a variety of ways. This included large-scale purchases of agency MBS. From March 2020 through June 2021, the Fed increased its agency MBS holdings from $1.4 trillion to $2.3 trillion. This led to spread tightening early on in the pandemic, as detailed by the Dallas Fed.
However, the Fed quickly reversed course in 2022, announcing a plan to “significantly reduce the Federal Reserve's securities holdings” in effort to tame inflation (also known as Quantitative Tightening). As part of this new strategy, the Fed has set a $35 billion monthly cap for MBS run-offs — you’ll see in the chart above that its total MBS balance has dropped by about $200 billion over the last year. Because the single largest holder of MBS effectively “dropped out” as a buyer of net new issuances, spreads increased to the 250-300 basis point range in 2022 and have stayed elevated over the last year.
Beyond the Fed, banks are collectively the largest holders of mortgage-backed securities in the U.S. At the average bank, agency MBS holdings represent about one-quarter of total assets. However, the demise of SVB shined a big spotlight on the “duration risk” associated with holding MBS and the asset/liability mismatch that is present between long-dated MBS and customer deposits which can be withdrawn rapidly.
The recent bank failures have reset bank demand of MBS in the short-term as banks shift their focus towards liquidity preservation. And with yields rising rapidly, the macro environment has made it less attractive for institutions to hold MBS given their preference for shorter-maturity bonds. This may further driver mortgage spreads higher (in the short-term at least) as banks pull back from the MBS market.
30-year mortgage rates typically track 10-year Treasury yields. Agency mortgage-backed securities do not have credit risk (backed by Fed guarantee), but there is often a 150-170 bps “risk premium” between mortgage rates and 10Y yields due to MBS prepayment risk, duration risk and demand/supply dynamics.
MBS spreads have increased to 300+ bps in 2023, driven by changing demand dynamics amongst the largest holders of MBS (Fed and banks) and general economic uncertainty.
The single largest holder of MBS (the Fed) has paused its buying efforts; any future decision to actively sell its $2T+ MBS portfolio may lead to further market disruption and spread widening.
Banks are acting much more conservatively when adding MBS to their balance sheets, as a result of recent bank failures including SVB and other regional banks.
So we are in a moment where housing affordability is about as bad as it’s ever been, supply is tighter than demand, and consensus is growing around a “higher for longer” policy when it comes to interest rates. We also have the looming threat of the Fed becoming an MBS seller, which may widen spreads further driving up borrowing rates for prospective homeowners. The macroeconomic effect of the MBS spread widening could be important by slowing the housing market, which is already being cooled substantially by the effect of tighter-than-expected conventional monetary policy.
Thanks for reading! This post just scratches the surface of the interesting and dynamic MBS market, which has important downstream impacts on the average American homeowner. As always, please feel free to share feedback or thoughts on the newsletter — you can respond to this email directly or shoot me a note at email@example.com.
Note: Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.
Thanks for reading The Appraisal! Subscribe for free to receive new posts and support my work.