Historical Perspective: Int Rates & Inflation
Homebuilding and Real Estate: Those who fear a decline in the demand for houses in the immediate future, because of higher rates, are plain wrong. The housing sector will remain strong as long as mortgage money is available. Currently, mortgage lenders are still trying to finance everyone, even the family dog. Availability of money, not the cost of money, is what determines the health of housing. Analysts will tell you about a real estate bubble, the huge amount of increase in mortgage indebtedness, and that a housing collapse is inevitable. Yes, eventually there will be another housing recession, but that is probably a few years away. Housing is dependent on supply and demand. The demand is always there as long as money is available and people have jobs. If either one of these factors disappears, than housing has a big problem. Currently, the availability of mortgage money is as plentiful as we have ever seen. And the job market continues to improve. Conclusion: for now, housing will stay very strong. The supply factor has been interesting. We have not seen the huge increases in supply of houses that we saw during other housing booms, such as the 1960’s and the late 1980’s. Areas that have had the lowest amount of building have had the biggest price increases. And those with the greatest increases in supply have had the lowest increase in prices. As we have discussed here, I recognize the potential problem with ARM’s (adjustable rate mortgages). If long-term interest rates rise strongly, then homeowners with ARMS will see their monthly payments increase significantly, reducing their purchasing power for other goods. The entire U.S. mortgage market was a little over $7 trillion dollars in early 2004. Possibly 40%, or $3.2 trillion of that is in ARMS. This year that percentage has soared as ARMS are so much cheaper than fixed mortgages. I saw one estimate for California, which puts ARMS in California at 70% of all new mortgages. Obviously, if mortgage rates rise by 2-3% points, that will take a chunk out of consumer spending. But as consumer spending declines, so will long term interest rates, and soon things will be back in balance, with a lag effect. The big problems appear if we have an inflationary period, as we did in the late 1970’s, when interest rates tripled. Yes, the prime rate went from about 7.5% to 21%! That would bring massive loan defaults, bankruptcies of mortgage lenders who did not resell their mortgages, and a debacle in the mortgage derivative market, including FNMA and Freddie Mac. However, that may have to wait a couple of years. Currently the homebuilding sector is healthy. Mortgage delinquencies have actually declined over the past year. The ISI Group points out that since 1995 mortgage debt has increased 2.2 times. But household cash (money market funds, small CD’s, saving accounts, MMDA’s) has grown by the same multiple. That does not support the theory of a bubble. The pessimists will tell you about the record mortgage debt outstanding. They don’t tell you that household wealth is now at an all-time record high. Yes, there are two sides to a financial balance sheet. Consumer net worth is up 80%, or $20 trillion since 1995, to $45 trillion. But consumer liabilities are up only $5 trillion during the same time period. These numbers clearly show that we should ignore all the pessimists. Yes, there are big problems out there, and there always will be. In fact, experience shows that when all the problems are apparently solved, as in early 2000, its time for great caution. A bull market climbs a “Wall of Worry.” CONCLUSION: the real estate sector still offers good opportunities over the next 1-2 years. The unfounded fears that a small rise in interest rates would cause a housing collapse are overblown. These are the situations to take advantage of. Over the very near term, it remains to be seen if this sector will soften. If it does, it would only offer even better opportunities in a few months. Expect the Fed’s goal now must be to flatten the yield curve, i.e. raise short-term rates while hoping that long-term rates won’t rise as much, or not at all. A slowdown in the economy would help them achieve that goal. With plunging retail & auto sales, long term rates should remain attractive. IMHO
Just another .02
Sounds like you've got a good handle on it. In the beginning of a reflation, where we are at now, we should see some good appreciation over the next year or 2,3. However, I'm looking to refi & cash out to reduce debt & get a better LTV. We can probably expect rents to firm a bit and vancancies to go down. IMHO.
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Well Tom, to give some small whispers of doubt in a scenerio that I basicly find agreeable. . .
One of the reasons mortgage money is so readily available is that rates are low and capital demands in the rest of the economy are low. This means lots of people qualify and few default. If, on the other hand, rates were to climb more than I expect them to (let us say two points) then the default rate would also climb. Nothing scares lenders more than an increase in foreclosure rates. If we assume that the rest of of the economy picked up at the same time then lots of money would leave the mortgage business for rosier fields and the amount of money available would decline. This is, as you point out, the first step in a classic housing recession.
However there are other possible first steps and the possiblity of over-supply is a real one. Seen more often in commercial real estate than residential it is at least possible, especially in Hot markets, to actually build more houses than people want. Your post ignores that possiblity by over-simplyfiying the supply/demand equation as being about the supply of money only. You gotta have people to occupy all those houses or the value declines.
True on the supply/demand equation. Right now, at least in SFH & Multi's demands is high (in Illinois) and we are not seeing overbuilding. while the mkt itself based on pricepoints is adjusting with softness on the high end, I suggest that is normal. The bread and butter SFH are still in great demand. As far as rates go, I beg to differ on a rise in rates and it's impact. While a 2% rise in long rates would definitely slow things a bit, IMHO it is really the velocity or turnover of funds in the economy that will determine housing prices. If RE values are appreciating because of inflation and rates are rising, it will still be profitable to borrow at higher cost because your ROI will still be there. It's just a cost of Production like all other overhead. OF course for this to happen there must be a return..wheter in RE or Manufacturing, the cost of $ isn't the issue as long as price increases can be passed along. Until the Fed restricts the supply of $, which hasn't happened (yet), I expect we will see a robust housing mkt. Also, high gas prices and softening consumer demand also keep long rates soft for now. I do agree that "eventually" the balogney will hit the fan. It's just part of the market cycle. Remeber http://www.the.com thing. RE is not there "yet." but like all markets, it will be. HOwever, that may be several years away. Remember, tangible assets like RE are priced in $. As the "value" of the $ goes down, the "price" of RE must go up to off-set it. ERGO: Inflation Hedge.
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Quote: Nothing scares lenders more than an increase in foreclosure rates. This is the reason I see a moderating influence by the banks in future interest rates, and why I am happy to borrow at lower ARM rates. The banks do not wish to foreclose, and this will help to keep interest rates low. High increases in interest rates would lead to high default rates - not in banks' best interests.