Jun242016

Raw land and finished lot values 26% above normal due to low mortgage rates

Finished lot prices tightly tether to new home prices. Both are elevated above historic norms due to low mortgage rates.

When mortgage rates first dropped from 6.5% in 2006 to 4.5% in 2009, I warned people that the interest rate stimulus was artificial, and while low rates inflate prices, they are a temporary stimulus with potentially painful withdrawal symptoms as the stimulus is tapered. Since conspiring bankers successfully manipulated the housing market in order to increase the collateral value backing their bad loans, the powers-that-be feel they have no choice but to stimulate housing even if that stimulus induces painful side effects.

For the most part, the manipulations of the housing market worked since 2012. By denying short sales, modifying loans, and stopping foreclosures, lenders engineered a shortage of supply on the MLS. With buyers armed with mortgage interest rates as low as 3.35%, they bid up prices to a new, higher equilibrium based on these new rates.

Real estate market consultants attempt to make projections of future values based on what they believe will happen with the key market forces that drive house prices. Some of the better ones noticed the effect of low mortgage rates and warn their clients of the potential for future under-performance of real estate assets.

Finished Lot Values Well above Their Long-Term Intrinsic Value

by Sean Fergus June 23, 2016

In 2013, finished lot values (shown in navy blue below) spiked back to mid-2005 values. Since then they have climbed modestly. Today’s low mortgage rates support the high lot values, but lots are 26% overpriced if rates were to rise back to a long-term norm of 6.0%.

To fully understand the relationship between finished lot values and home prices, please read With house prices rising, the value of lots and raw land skyrockets or Development impact fees do NOT hinder construction of entry-level homes. In short, the values of finished lots correlate strongly with home prices.

BFLVI2

I stated on many occasions that the housing bust represented the restoration of market value from an artificially elevated condition. The above chart makes the same argument.

Back in 2013 I wrote the Housing market impact of 25 years of falling mortgage interest rates. In that post I noted, “House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.”

PriceRentJan2015

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 are still well below the 7.63% of the mid 1990s, and in all likelihood mortgage interest rates 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, which is what this consultant is warning his clients.appreciation-amortization

Methodology

To help our clients assess housing cycle risk, we calculate intrinsic finished lot values in 24 markets around the country and intrinsic home values in approximately 100 additional markets. Intrinsic values are those one would expect over a very long period. We assume that 6% is the normal mortgage rate over a long period like this. (6.45% is the median rate over the last 25 years.)

Valuation

Today’s finished lot values make sense in the current 4% mortgage rate environment (red line above) but won’t make sense if rates rise to 6% (green line above). Most home buyers are highly sensitive to mortgage rates, which is why the difference is so dramatic. …

Conclusions

Our analysis, which includes interviewing brokers and running cash flows, concludes that finished lots are 3% underpriced nationally as long as rates remain where they are. If rates rise to 6%, finished lots would be overpriced by 26%.

So which is correct? Is it better to measure value based on current rates or historic rates?

My favorite measure of value for individual properties and the entire market is the ratio of rent to home ownership cost. I prefer this method because it incorporates the effect of mortgage rates and more closely emulates the conditions people face when they decide whether to rent or own.

OCHN_SoCal_Housing_Market_Report_2016-06

Another method economists examine is the ratio of price to rent. It’s a blunt instrument because it doesn’t capture the impact of mortgage rates, but demonstrates the imbalances and distortions caused by record-low mortgage rates.

Home shoppers today are right to be concerned about another housing bubble. Relative to rent, house prices are similar to the stable period from 1993 to 1999. And the new mortgage regulations will prevent future housing bubbles because the “Ability to Repay” rules will prevent reckless lending. That being said, it’s always wise to be cautious.

cautiously_optimistic

[listing mls=”OC16132790″]