Will rising interest rates cause house prices to crash?

The bearish arguments for real estate boil down to two points: (1) overhead supply will overwhelm demand, and (2) rising interest rates will lower loan balances. These are two very different arguments. The supply argument is is based on the total number of homes demanded through household formation. The interest rate argument is based on the total amount those new households can borrow.

I believe the first argument is compelling. There are too many houses to be absorbed by current demand. We know lenders are trying to match the rate they obtain foreclosures to the rate they sell them. In the process they have amassed a huge shadow inventory they are now planning to sell to private equity groups to hold as rentals. There is little doubt the overhead supply is much larger than the demand in the short and medium term. This may or may not push prices lower, but it almost certainly will prevent any substantive appreciation.

Today I want to focus on the second argument. Will rising interest rates cause house prices to crash? I want to start by saying there is no question that higher interest rates make for lower loan balances. If this were not true, the federal reserve wouldn’t be buying mortgage-backed securities to lower interest rates. The math is inescapable.

Interest Rate Table
$95,748 Irvine Median Income
$7,979 Irvine Monthly Median Income
31.0% Debt-To-Income Ratio
$2,473.49 Monthly Payment
Interest Rate Loan Amount Value Value Change
9.00% $307,410 $384,262 -41%
8.50% $321,686 $402,108 -38%
8.00% $337,096 $421,370 -35%
7.50% $353,753 $442,191 -32%
7.00% $371,784 $464,730 -28%
6.50% $391,333 $489,166 -24%
6.00% $412,557 $515,697 -20%
5.50% $435,635 $544,544 -16%
5.00% $460,766 $575,957 -11%
4.50% $488,171 $610,214 -6%
4.00% $518,100 $647,625 0%

At today’s 4% interest rates, borrowers can comfortably leverage over five times their yearly income. The 40-year average for interest rates is 9%. 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.

When the interest rate cycle reaches bottom, the value of the currency declines, and cost-push inflation becomes an issue. As Americans want to buy products from overseas, it takes more and more dollars to do it because the currency is declining in value. Unless we get a commensurate increase in our exports (or cheap money from China), our standard of living will decline. 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 Bernanke finally does start raising interest rates, we will be embarking on the next multi-decade rising cycle where inflation is a constant problem.

If interest rates go on a sustained rise, financing home purchases will become more expensive. That is the math. The real question then is whether or not these 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 Bernanke or a future central banker 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, a devalued currency, and steady house prices over a strong currency and falling house prices.

The housing recovery that wasn’t

By January 30, 2012: 5:00 AM ET 

The evidence for a recovery is compelling, but optimists should actually be watching rising interest rates.

FORTUNE — Over the past few months, a spate of good news about the U.S. housing market has led some to think a recovery is finally on the horizon.

The evidence is compelling. It now costs almost as much to rent as buy. Since the housing bubble burst in 2006, home prices have fallen by 33% nationwide — more than they did during the Great Depression. Waves of foreclosures and tighter lending standards have helped drive a surge in rentals. And during the third quarter, the median monthly mortgage payment totaled $698 compared to the median monthly asking rent of $700, according to Capital Economics, citing data from the National Association of Realtors and the Census Bureau. What’s more, the cost of borrowing has fallen to record lows, with interest rates for 30-year fixed rate mortgages hovering around 4%.

Even here in Orange County it is finally less expensive to own than to rent thanks mostly to four percent interest rates but falling house prices have helped too.

Builders are even building again. (Albeit, at a very modest pace and driven largely by construction of multi-family homes.) As a January report by CoreLogic shows, both single-family starts and permits rose at an annualized pace of 15% over the six months ending November 2011. The California-based mortgage data provider also notes that existing home sales nationwide have been trending up, rising 12% higher in November 2011 compared with January 2011. “While we cannot say with a high degree of certainty that 2012 has in store for us, indications based on the latter part of 2011 are that both the broad economy and the housing market are moving toward positive growth in 2012,” CoreLogic wrote in a research note.

That optimism is well-deserved, right? Not exactly.

Since the housing market imploded, analysts have predicted year after year that prices might at long last bottom out.

Will it finally happen this year? Perhaps next? Bottoming out necessarily precedes turning the corner — and until that happens optimists should be cautious. Economists widely cite the short-term obstacles weighing down prices. These factors range from high unemployment and household debt to the so-called “shadow inventory,” or all the properties that have yet to come into the market because of pending foreclosures or skittish homeowners delaying sales until prices improve.

These threats are very real. But there’s a bigger threat — and drag on any future recovery — that doesn’t get nearly the attention it deserves: rising interest rates.

Admittedly, rates probably won’t increase any time soon. In a sign that the economy is recovering slower than expected, the Federal Reserve announced last week that it would keep its record-low rate for another three years. The central bank has already kept its key rate at nearly zero for three years.

Does is seem plausible after the federal reserve’s recent behavior that they may chose to keep interest rates down to save housing no matter the cost? They have never openly committed to leaving interest rates low before.

And last summer, officials launched “operation twist,” whereby the central bank bought $400 billion in long-term bonds in hopes to give the economy a boost and, more specifically, lower the cost of taking out home mortgages.

Is there anything the federal reserve will not do to save housing?

Problem is, interest rates can’t stay low forever. Eventually they’ll have to rise, which could very well drive home prices down since the cost of taking out a mortgage becomes more expensive. Even if rates rise slowly over several years, prices could either fall much further or, at best, stagnate. This is partly why the Fed has been so obsessed with keeping rates down. “The market will look like a frog in boiling water once rates rise,” says Lance Roberts, CEO of Streettalk Advisors, a Houston, Texas-based investment advisory company. Roberts, who also contributes to Advisor Perspectives, which publishes newsletters and online articles focused on investment strategies, laid out his case in a recent post.

The post linked to above is well worth the time to read.

At some point, interest rates will start rising back toward the long-term median of 8.9% from the current 4%.

See table above for the impact of this increase.

Depending when and how quickly, the jump would make homes much less affordable for the average American family. Roberts notes that, back in 1968, U.S. households on average spent 7% of their real disposable income on their mortgage payment with a down payment typically at 20%. Assuming the same down payment, that share has more than doubled to 15% today or likely higher since many mortgages approved over the last decade required little or no money down. “With real disposable incomes stagnant as inflation pressures rise, that 15% of the budget is becoming much harder to sustain,” he says.

Say a family earning $55,000 a year (the U.S. median household income) wants to buy a home. They decide they can afford roughly a $600 a month mortgage payment after taxes and other expenses. At a 4% interest rate they can afford a $125,000 home. However, at a higher rate of 5%, they can’t afford as much and are looking at a $111,000 home. If rates rise higher to 6%, they’re looking at a $100,000 home. And so on.

So while the housing market may eventually overcome the immediate bumps of foreclosures, high unemployment and the like, real optimists should be looking at the direction of interest rates before they get their hopes up.

Interest rates and wage growth are the two most important variables impacting future house prices. Will they both go up? If so, it may be a wash. If wages go up and interest rates do not, house prices will rebound strongly. I don’t consider that scenario very likely given how low interest rates are today and how high unemployment is. If interest rates go up and wages do not — a probably outcome given the circumstances — then house prices will be weak for a very long time.