Lead Story… Back when I first made the jump from commercial real estate finance to residential development finance, I had a view of the way that the housing market worked that was straight out of an economics textbook: namely that interest rates and housing prices have a predictable and consistent economic relationship. In particular, when rates fall and wages stagnate or do not go down, prices should rise and when rates rise quicker than wage growth, prices should fall. I was the guy who always scoffed at those who made a variation of the statement “it’s a good time to buy while rates are still low,” believing that it was an unsophisticated argument. Of course prices would fall to offset the increase in interest rates and home affordability as measured by monthly payment would remain relatively constant. Over the years, I’ve come to question my textbook economic logic, primarily because it never seems to actually work out that way in the real world.
The first time that I became acutely aware of the complicated relationship between rates and home prices was in the mid 2000s when the Federal Reserve began relentlessly raising rates in 2004, yet the housing market kept soaring through 2006. However, much of this could be written off to the fact that:
- Longer term rates didn’t go up much and the yield curve actually inverted; and
- Home owners and buyers increasingly took out risky pick-a-payment loans to keep (temporary) monthly payments un-naturally low as the market surged. Once the market stopped surging and the teaser rates adjusted, the resulting defaults, coupled with robust new construction flooded the market with inventory as financing dried up
Then you have our current cycle where rates have been rising (albeit in a choppy fashion) since July 2016, yet home prices have continued to rise as well. Why? Because, generally speaking, inventory has been falling as rates have risen. Rick Palacios, Jr of John Burns Real Estate Consulting covered this in a research note last week entitled Rising Rates Should Have Minimal Impact on Housing. Many of you may read this and think that it’s Pollyanna realtor talk. However, anyone familiar with JBREC would acknowledge that they are anything but perma-bulls. From JBREC (emphasis mine):
Mortgage rates have risen 1.0% or more ten times in the last 43 years, with little impact on home sales and prices when the economy was also strong. Here is the paper we shared with our clients a few years ago. Historically, rising confidence, solid job growth, and higher wages have more than offset reduced demand for housing resulting from higher mortgage rates. When rates rise during a weak economy, home sales and prices get crushed.
Today’s economic backdrop clearly supports continued home buying demand. Confidence among consumers and businesses continues to hit multiyear highs. Job and wage growth remains solid, with an increasing number of workers rejoining the workforce.
Home builders agree. In our survey of 300+ home builders this month, 85% said sales would decline less than 10% if rates were to rise all the way to 5.0%. 29% (generally luxury and active adult builders whose buyers are quite affluent) don’t believe sales will fall at all.
Builder stocks typically overreact very strongly to rising and falling rates, so don’t follow builder stock prices to assume what will happen to new home sales and pricing.
For perspective, mortgages rates have increased from 3.78% in September 2017 to 4.32% today, equating to a 6.7% increase in one’s mortgage payment. Rates rose even more last spring, jumping from 3.41% in July 2016 to 4.30% in March 2017 (11.5% spike in mortgage payment). Despite rising rates, housing had its best spring since 2013 last year, with a strengthening economic backdrop more than offsetting reduced demand from higher rates. All signals point to a similar scenario for builders as we kickoff spring 2018, with rising rates unlikely to ruin housing’s recovery.
Note what the author is saying above: all rate increase cycles are NOT created equal. If rates are rising because of good economic growth, the impact on housing demand is historically relatively benign. However, if rates increase due to an external shock in bad economic conditions, look out below. One of the major reasons that there is such a difference in rate increase scenario outcomes is the impact of inventory. In a weak economy with flat or falling real wages and rising unemployment, home owners may not have a choice as to whether or not they sell since their economic situation could dictate that decision. If such an economy is bad enough, it can lead to an increase in inventory at the worst possible time – when rates are high – eventually leading to lower prices. However, in a good economy, home owners are less likely to sell a home if rates increase substantially. Doing so would result in an increased cost of living, even when making a lateral move. As such, more resale inventory is kept off of the market at the margin. In an already tight market with suppressed new home construction like we have today, it could actually contribute to exacerbating an inventory shortage, leading to higher prices.
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Chart of the Day
Things that we need are getting more expensive. Things we don’t need are getting less expensive.
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