Housing market impact of 25 years of falling mortgage interest rates
It’s widely believed mortgage interest rates will rise in the future, perhaps for a very long time. The mainstream media is littered with articles about how this won’t hurt the housing recovery to provide loanowners and prospective buyers assurance that prices will keep rising. To better understand why rising interest rates are such a big issue to housing, it’s worth reviewing the impact falling interest rates have had on house prices for the last 25 years.
House prices and rental parity
The basis of all house prices valuations is rental parity, the price point where the cost of ownership equals the cost of a comparable rental. Rental parity is a tether on house prices because if resale values become detached from their fundamental values, once the kool aid intoxication wears off, prospective buyers benefit more from renting that owning, and prices invariably fall to this fundamental value support.
Examining the last 25 years of house prices and rental parity, the previous two housing bubbles become apparent. Starting in 1986 (a period before the data in the graph above), house prices detached from fundamental values, and borrowers and lenders inflated a housing bubble. The slow deflation of this bubble was only reversed when prices came to rest on the fundamental value of support provided by rental parity.
The period from 1993 through 1999 is a stable period where prices deviated little from this fundamental value. My monthly housing market reports use this period to establish the stable value of real estate prices in each market in my data coverage area (which will soon be all of Southern California). Each market differs in its relationship to rental parity. The most desirable markets are move-up markets where buyers port equity from a previous sale and support prices at levels above rental parity. The least desirable markets are discounted to rental parity. All markets display this same stable relationship from 1993 to 1999.
Another way to look at the market is to measure the deviation from the historic norm over time. The two housing bubbles are pretty obvious. The stable period from 1993 through 1999 has only one significant deviation, and that was caused by a sudden spike in interest rates in 1995, similar to the one we just witnessed over the last two months.
When financial bubbles collapse, most of the time, the value of the asset in question plummets below fundamental values. This phenomenon occurred as predicted as the Great Housing Bubble collapsed. In order to prevent a catastrophic (from the bank’s perspective) decline in nominal house prices, interest rates were lowered from 6.5% in 2006 to 3.5% in 2012. The nominal price chart doesn’t pick up the overshoot to the downside as dramatically, but the cost of ownership relative to rental parity does because rental parity considers the impact of lower interest rates.
Another way of looking at the data is to look at monthly rental rates and the cost of ownership directly. Again, the stable period of 1993 to 1999 shows little deviation between the two, but the housing bubbles show the obvious market distortions caused by the financial manias.
From this data, the impact of 25 years of falling interest rates can be deduced. Look carefully at the cost of ownership line. Notice that in 1989-1991, the monthly cost of ownership was about $2,000 per month at the peak of that housing bubble. In 2012, the cost of ownership was again $2,000 per month. Twenty-four years apart, the cost of ownership on a monthly basis was unchanged, yet house prices were nearly double. Why is that? Because in 1989, mortgage interest rates were north of 10%, and in 2012, they were 3.5%. All the appreciation from 1989 to 2012 was a direct result of declining interest rates. All of it.
So what would have happened if interest rates hadn’t changed?
Let’s go back to the stable period from 1993 to 1999. The average monthly interest rate during that period was 7.63%. The average monthly cost of ownership was $1,538. That combination would finance a loan of $223,011. Add a 20% down payment, and the home price would be about $275,000 ($278,763 to be exact). Over the last 12 months, the median monthly cost of ownership in OC was $2,102. If you plug in that number in place of the $1,538 from 1993-1999, the resulting home price would be $380,089. The last reported median home price for OC was just over $500,000. House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.
OC Houses have never been a good cashflow investment
Many people believe OC houses are a good investment. Perhaps with the artificial boost from ever-declining interest rates, home price appreciation has made them perform well as an investment, but based on their cashflow, OC houses have never been a good place to park money.
Capitalization rates (income divided by price) for all-cash investors hovered around 6% for much of the 1990s. That sounds great today, but in an investment environment with higher financing costs and superior competing investments, a 6% cap rate isn’t very enticing. During the housing bubble, cap rates fell below 3%, and only with the crash in house prices and the last big drop in interest rates has the cap rate exceeded the cost of mortgage debt. Over the last three years investors have been able to find cashflow positive properties in certain OC markets. That’s the first time this has happened as far back as my data goes.
Volatility requires an understanding of value and market timing
Most people don’t have the foggiest notion of what houses are worth. Most understand the world of financing works based on market comparable sales, but as evidenced by the three major housing bubbles of the last 40 years, comparable sales values often depart radically from the underlying fundamental value of rental parity. People who bought during those periods of inflated house prices endured a painful period of being trapped underwater in a house they are overpaying for on a monthly cost basis. Many lost their homes.
To combat this problem, I developed a market rating system designed to inform prospective buyers when market forces are favorable to home purchases. (For more information and detail, click here) By identifying the conditions that were prevalent during the good times and bad, it’s possible to forecast when conditions are favorable and when they are not.
People who bought homes in the past when the system was in the red often faced financial hardships caused by their decision. People who bought during the green periods either enjoyed significant appreciation, a low relative cost of ownership, or most often both.
I have been publishing these reports (in an ever-improving form) since September of 2011. The market timing system when bullish in late 2011 despite the falling prices at the time because the cost of ownership made owning attractive. Shevy and I told prospective buyers they could benefit from the low cost of ownership despite the likelihood of continued price declines. None of us had any idea the banks would suddenly and dramatically change policies, dry up the MLS inventory, and cause the housing market to bottom. However, based on value alone, we knew it was becoming a good time to buy a house.
Is it still a good time to buy?
As I demonstrated above, twenty-five years of falling interest rates have inflated house prices well above where they would be if interest rates hadn’t declined. By that metric, houses appear to be overvalued by 30%. However, that’s not the world we live in. Interest rates are low, and despite the recent spike, they are still well below the 7.63% of the mid 1990s, and in all likelihood they will stay low for quite a while. People who buy today may not experience much appreciation, particularly if mortgage interest rates go on a steady rise, but they are still locking in a cost of ownership below historic norms, and that has value.
So is it a good time to buy? If the buyer understands the real value they are obtaining is a roof over their head at a relatively low fixed cost, then yes, it is a good time. If a buyer believes they will see ongoing double-digit appreciation and make a fortune, rising interest rates are liable to disappoint them.
Over six years squatting in Newport Beach!
Ordinarily a peak buyer would experience a lot of pain. They overpay each month, and most often they are underwater for an extended period of time. However, due to the extreme can-kicking by the banks, some got to enjoy a free ride. The former owners of today’s featured property quit making payments before I began writing for the Irvine Housing Blog back in February of 2007. They lived without making a payment for more than six years in Newport Beach.Recording Date: 05/01/2013 Sales Price: $950,000 Foreclosure Record Recording Date: 03/27/2013 Document Type: Notice of Sale Foreclosure Record Recording Date: 02/14/2013 Document Type: Notice of Rescission Foreclosure Record Recording Date: 12/26/2012 Document Type: Notice of Default Foreclosure Record Recording Date: 08/05/2010 Document Type: Notice of Default Foreclosure Record Recording Date: 02/19/2010 Document Type: Notice of Rescission Foreclosure Record Recording Date: 06/25/2009 Document Type: Notice of Sale Foreclosure Record Recording Date: 03/16/2009 Document Type: Notice of Default Foreclosure Record Recording Date: 03/06/2009 Document Type: Notice of Rescission Foreclosure Record Recording Date: 04/17/2008 Document Type: Notice of Rescission Foreclosure Record Recording Date: 04/16/2008 Document Type: Notice of Default Foreclosure Record Recording Date: 01/23/2008 Document Type: Notice of Rescission Foreclosure Record Recording Date: 01/22/2008 Document Type: Notice of Default Foreclosure Record Recording Date: 08/07/2007 Document Type: Notice of Rescission Foreclosure Record Recording Date: 08/02/2007 Document Type: Notice of Default Foreclosure Record Recording Date: 06/12/2007 Document Type: Notice of Default
Now that’s gaming the system!
375 23RD St Newport Beach, CA 92660
$874,900 …….. Asking Price
$899,000 ………. Purchase Price
10/2/2006 ………. Purchase Date
($24,100) ………. Gross Gain (Loss)
($69,992) ………… Commissions and Costs at 8%
($94,092) ………. Net Gain (Loss)
-2.7% ………. Gross Percent Change
-10.5% ………. Net Percent Change
-0.4% ………… Annual Appreciation
Cost of Home Ownership
$874,900 …….. Asking Price
$174,980 ………… 20% Down Conventional
4.52% …………. Mortgage Interest Rate
30 ……………… Number of Years
$699,920 …….. Mortgage
$174,009 ………. Income Requirement
$3,555 ………… Monthly Mortgage Payment
$758 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$182 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$4,495 ………. Monthly Cash Outlays
($922) ………. Tax Savings
($918) ………. Principal Amortization
$294 ………….. Opportunity Cost of Down Payment
$239 ………….. Maintenance and Replacement Reserves
$3,187 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$10,249 ………… Furnishing and Move-In Costs at 1% + $1,500
$10,249 ………… Closing Costs at 1% + $1,500
$6,999 ………… Interest Points at 1%
$174,980 ………… Down Payment
$202,477 ………. Total Cash Costs
$48,800 ………. Emergency Cash Reserves
$251,277 ………. Total Savings Needed