Rising mortgage rates will expose housing momentum myth
As mortgage rates rise, home sales will decline, shattering the myth of escape velocity in residential real estate.
In rocketry, escape velocity is the speed required to propel an object into a stable orbit. In a housing market, escape velocity is a rate of price and sales volume increase necessary to sustain an increase in demand required to push prices higher for the long term. Escape velocity is the elusive dream of real estate pundits, a group who doesn’t understand what it was or why it disappeared (probably forever).
In previous real estate cycles (pre Dodd-Frank), as prices went up and buyers were priced out of the market, lenders responded by offering
affordability products toxic mortgage financing terms. As affordability products proliferated, prices kept rising, and many buyers accelerated their buying plans out of fear of being priced out and out of greed to capture appreciation. This unsustainable and self-reinforcing buying activity is escape velocity. All that was required to start the cycle was a period of rising prices — and a heavy dose of realtor bullshit.
For a housing market to embark on a long bull rally, it needs rising prices predicated on rising incomes and increasing household formation built on a stable foundation of steady interest rates and conventionally amortizing mortgages. For the last few years, the market has bounded from one unstable prop to another in the hopes fundamentals would improve. The reason prices rose is because inventories were so restricted by bank policy that the few active buyers in the market were forced to pay more. Sales volumes sputtered in 2014, and although they are better this year, momentum is clearly slowing down, a troubling sign considering mortgage rates are still below 4%.
Oct. 16, 2015, JONATHAN LANSNER
California home prices should continue to rise in the next two years, extending the state’s housing gains to a six-year winning streak, according to a new forecast by Wells Fargo Bank.
Does anyone place any faith in Wells Fargo’s ability to forecast market movements? Just curious.
Bank economists see the CoreLogic median selling price for the state finishing 2015 up 6.5 percent vs. a year ago; then rising 5.8 percent next year and up 5.5 percent in 2017. This index rose 13.4 percent in 2012, 20.5 percent in 2013 and 7.6 percent last year.
“Modestly higher interest rates should not present much of a direct challenge for the state, but with home prices rising and mortgage markets far less flexible than in the past, home sales might come under pressure if mortgage rates rise too quickly. That does not appear to be an immediate risk,” the forecast says. “Interest rates look like they will remain low for even longer than thought previously, which should allow the housing recovery to gain further momentum.”
While I agree with them that there is not an immediate risk, I think they’re wrong that the reflation rally will gain further momentum. Prices have reflated to the limit of affordability, and any change in mortgage rates will kill any sales momentum the market may exhibit.
Pushing home prices higher is the fact that California’s economy is outperforming the nation.
“We look for the Golden State to again add close to a half million net new jobs this year, which is a pace 1.5 times that of the nation as whole,” says the forecast. “Stronger growth is creating some strains, however. About 20 percent of the state’s new jobs have been created in the high-paying technology and life sciences industry.
“Hiring has also picked up in other higher-paying sectors, including construction, manufacturing, health care and logistics,” the report continues. “California, however, has also added plenty of lower-paying jobs as well, and many of these low-paying jobs are being created in the same geographic areas where higher-paying jobs are being added. These wage discrepancies have made finding affordable housing an even greater challenge than in the past.”
The California Association of Realtors last week predicted that the median price of a California existing, detached house will rise 3.2 percent to $491,300 in 2016. Its house price index rose 9.8 percent in 2014 and 6.5 percent so far this year.
realtors are even less reliable than bankers when it comes to predicting real estate prices.
So what happens when mortgage rates rise? Will job and wage growth overcome increasing borrowing costs and propel the market even higher?
The math says no.
Whatever illusions persist about escape velocity will perish when mortgage rates rise. Higher borrowing costs will reduce the amounts potential homebuyers can borrow. First this will impact home sales, which will surprise the pundits, then if rates rise high enough, it will impact prices.
It doesn’t really matter how many people have good jobs if they can’t finance prices sellers must obtain to close the deal. Perhaps some buyers will substitute down in quality, but not enough to sustain the mythical escape velocity everyone hopes for.
Escape velocity is a myth, a vestige of a bygone era, and rising mortgage rates will prove it was a fallacy better left in the dustbin of financial history.