Higher interest rates will seriously weaken high-end real estate
Wealthy real estate investors will move their money out of ultra-high-end properties when better investment opportunities become available.
What defines ultra-high-end varies by location, but in general these are houses not subject to large mortgages, often purchased completely in cash. Ultra-high-end homes are not purchased by working class people toiling to pay off a mortgage, so changes in mortgage terms and rates effect the resale value of these properties less than the financed purchases at lower price points.
When lenders “innovate” with mortgage terms, or when traders in the bond market moves mortgage rates, these changes influence the amount borrowers can finance. For example, during the housing mania, the Option ARM allowed borrowers to leverage 10 times their incomes or more, and the result was a massive price bubble that deflated when Option ARMs proved unsustainable.
Many people are concerned the market displays signs of a new bubble. A decade ago, housing bulls were completely and catastrophically wrong, and nobody wants to repeat the mistakes of yesteryear. The latest housing bubble (if we can call it that) is different in that the artificially high prices are built on stable loan products. Prices are about 30% too high relative to income, but the cost of ownership relative to rent is normal because mortgage rates are so low. But will they stay low? (See: We’ve reached a permanently low floor in mortgage interest rates)
Rising Interest Rates
If mortgage rates rise, properties priced under $1.5 million will suffer because rising mortgage rates reduce the amount financed buyers can borrow and bid. What most people don’t realize is that rising interest rates (not necessarily mortgage rates) hurts the ultra-high-end real estate market too.
Properties over $1.5 million (or make that $4 million in the Coastal California) are ultra-high-end, and the rich often buy these properties as a safe haven to preserve their wealth. The cash buyer of a $5 million property cares little about mortgage rates; however, cash buyers is greatly impacted by the desirability of competing asset classes where they might earn a better return on that money.
Some wealthy individuals will buy trophy homes for their consumptive value, but over the last several years, many wealthy people bought these homes as investments despite their lack of current cashflow.
Over the last seven years, the wealthy have enjoyed a 100% increase in the value of their equities holdings and a significant bump in the value of their real estate. Further, they enjoy a low 20% capital gains tax rate, so they can easily liquidate one investment class in favor of another. This means the wealthy have the money to buy real estate if they want it — and sell it if they don’t.
Also over the last seven years, the federal reserve held long-term interest rates near zero. This policy nearly eliminated any cash returns on available investments: savings account pay just over nothing, 10-year Treasuries recently hit 2%, and bond yields are extremely low across the spectrum. Relative to these investment alternatives, high-end residential real estate — with it’s historically low cash returns — is a better investment; therefore, wealthy people buy expensive homes and inflate prices. Couple that with the dumb money flowing in from overseas, and ultra-high-end residential real estate is doing relatively well.
But what happens if real estate isn’t the best alternative? What happens with the rest of the economy does improve and investors find competing opportunities with better returns? Wouldn’t the wealthy sell investment homes to pursue these better alternatives? And wouldn’t that outflow of money put pressure on high-end prices?
With the federal reserve’s move to raise interest rates in December, ultra-high-end housing shows signs of weakening.
The luxury home market may be losing some of its luster.
Average sales prices for homes listed at $1 million or more fell 1.1 percent in the first quarter compared with a year earlier, marking the biggest decline in more than two years, according to Redfin.
The decline at the top marks a stark contrast with the broader housing market, which continues to gain strength. The bottom 95 percent of the housing market saw prices jump 4.7 percent in the first quarter compared with a year ago.
Sales volume of homes priced at $1 million or more rose 4.9 percent — marking slower growth than the rest of the market, where sales volume grew 6 percent.
Perhaps this was due to a change in the mix as more houses near the bottom of the price range sold than those at the top, but neither the top nor the bottom of the high-end market was strong as sales declined overall.
The weakness at the top of the housing market marks a big shift in the housing economy. After the financial crisis, luxury housing was the strongest segment of the market due to the strong recovery of the wealthy. Now, with stock markets more volatile, demand slowing from overseas buyers and a surging supply of high-priced homes, the top of the market is now among the weakest.
It could also be that the wealthy are choosing to invest elsewhere.
“For years, the high end was driving sales and price,” said Nela Richardson, chief economist at Redfin. “Now, the demand is at the middle and lower price range.”
Back in early 2014 I reported that Home sales are up for the top 1%, the bottom 99%, not so much. Times have changed.
She added that after 2009, the asset-rich benefited from rising values.
Yes. Most of the quantitative easing money flowed into asset values.
“There was so much stability in asset growth that the wealthy felt comfortable making a large purchase,” she said. “That stability is over.” …
Sales of homes priced at $5 million or more fell 0.2 percent compared with a year ago — the biggest decline since 2013. There were 420 sales of homes priced at $5 million or more in the quarter.
Inventory of homes priced at $1 million or more increased 3.3 percent compared with a year ago, to 70,962. The supply of homes priced at $5 million or more jumped 13 percent — the biggest inventory rise in more than three years.
“There is oversupply at the high end, especially in certain pockets and cities,” Richardson said. …
“They should be flying of the shelves,” she said. “But these homes are just sitting there.”
This is why I believe the wealthy are investing in other asset classes. They are all still doing well, so the rich don’t lack the resources to buy this homes: they lack the desire. And the only reason I can see that they would change their behavior is if they found better alternatives.
All that supply at the top, coupled with a more anxious buying class, has created some big price cuts for mansions and penthouses. An $18.8 million home in Los Angeles ended up trading for $10 million in the first quarter, while a $14 million home in The Woodlands, Texas, ended up selling for $7 million.
The highest-priced sale in the quarter (outside New York) was the $45 million sale of a 2.2-acre estate in North Laguna, California, called Twin Points. The estate features sweeping ocean views, a Polynesian-themed main residence, pool and motor court. It was originally listed for $75 million.
The ultra-high-end was seeing a great deal of WTF asking prices as people put silly price tags on homes just in case someone really, really rich and stupid came along. For a while this worked, but the strategy fails now. Someone, somewhere finally realized a house isn’t worth what they paid for it: it’s worth what the next buyer will pay for it. The pool of greater fools is empty.