Dec222014

If mortgage rates rise in 2015, will house prices drop?

If mortgage interest rates move up, either house prices will fall or sales volumes will fall unless wages go up significantly.

Assuming a consistent payment, higher mortgage rates decrease the size of the loan and reduce the amount borrowers can bid on real estate; therefore, if rising mortgage rates results in smaller loan balances, then either sales volumes will go down, or house prices will go down, or perhaps some combination of both. This isn’t speculation; it’s basic math.

interest_rate_impact

So which outcome seems more likely? If we had a free market without government and lender manipulation, prices would fall, perhaps precipitously depending on the market; however, we don’t have a free market, and our government, federal reserve, and a cartel of too-big-too-fail lenders are manipulating the housing market in an effort to drive up house prices. Since must-sell shadow inventory morphed into can’t-sell cloud inventory, I think it likely that home sales will be depressed for several years. If we had cleared the market, hedge funds and other investors would have purchased millions of homes, and sales volumes would have been much higher. Of course, this would have bankrupted the banks, so another path was taken, but this path has consequences. If the plan is to sell these homes to owner-occupants and higher prices — a group struggling with high unemployment, low savings, high debt levels, and poor credit scores — then it’s going to be a long, slow slog.

cloud-inventory

At today’s 4% interest rates, borrowers can comfortably leverage over five times their yearly income. The 30-year average for interest rates is 8%. At that interest rate, a borrower can only leverage three times their yearly income. The old rules-of-thumb about borrowing three-times income are relics of a bygone era. But what happens if those interest rates come back? Four percent interest rates are not a birthright. In fact, interest rates have only been this low one other time in the last two hundred and twenty-two years.

As is evident in the very long term chart of interest rates above, the interest rate cycle is very long. Alan Greenspan presided over a twenty-five year period of declining interest rates. Much of the increase in value of real estate is attributable to decreasing borrowing costs over that time. Inflation was relatively tame, so Greenspan always had the luxury of lowering interest rates to increase economic activity. Those days are gone.

During the cycle of rising interest rates, central bankers raise interest rates to combat inflation and protect the value of the currency, but they are always one step behind. When Yellen finally does start raising interest rates, we will be embarking on the next multi-decade rising cycle where inflation is a constant problem, unless you believe the federal reserve will raise rates to cool an improving economy absent inflation, something that’s never happened before.Yellen_fed_reflation

If interest rates go on a sustained rise, financing home purchases will become more expensive. The real question then is whether or not these rising costs due to rising interest rates are compensated for by rising wages. If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices will fall again. Given the choice between inflation and falling house prices, which do you think Yellen will chose? After the all-out effort they have made to prop up house prices over the last several years, I suspect they will chose inflation and steady house prices over falling house prices, come what may.

Higher rates equal lower sales or lower prices

The long-term decline in mortgage rates has artificially improved affordability. (See: Housing market impact of 25 years of falling mortgage interest rates)

For example, the average monthly interest rate from 1993 to 1999 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.

So now let’s assume mortgage rates will revert to the mean. What will a long-term rise in interest rates do to home prices? Interest rates must rise from about 4.5% to 7% to apporach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.

In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market, it seems more likely to me that sales will fall and remain depressed for a very long time.

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