Q. “Do Interest Rates Drive Home Prices?”
A. This is a common myth.
Interest rates are only a very small part of the equation, with home-prices primarily driven by other factors. This is how I think about the market: The key to housing is that homes are a leveraged asset, meaning that people do not pay the full purchase price of a home out of pocket. This gives home-owners the ability to “upgrade” homes as home prices increase – creating a self perpetuating cycle. This is easiest to see in an example:
Let’s say someone buys a $100k house with 20% down. This means they have $20k of equity in the home and an $80k mortgage. If home prices rise by 10%, the homeowner now has a $110k home, with an $80k mortgage, leaving $30k of equity. At the same 20% down, the home-owner can sell their home and “upgrade” to a $150k house (most homes are purchased with proceeds of a different home sale)! With mortgage insurance and low down payment requirements, this cycle becomes even more robust. At 5% down, that same 10% increase in home prices would allow the homeowner to move from their $110k home into a $300k home! As home prices continue to rise, this process is repeated, increasing demand at higher and higher prices.
This cycle will continue so long as the homeowner can 1) afford the new higher mortgage payment and 2) can get a mortgage. For this we track the National Association of Realtors Homebuyer Affordability Index (HAI), which tracks whether the median household has enough income to qualify for a mortgage on a median priced home (if it is above 100, the median homebuyer has more than enough income). Interest rates impact this measure, but so do housing prices, household incomes etc. The way I like to think about Homebuyer Affordability Index, is that it doesn’t drive the cycle, but it is a good barometer of whether higher costs will stall the cycle. (HAI Index attached).
So far I’ve talked about how rising home-prices are a self-perpetuating cycle where higher home prices increase the equity people have in their homes, increasing the demand for more homes, driving prices even higher. The same principal however holds on the way down. Declining home prices decrease the equity homeowners have, decreasing their ability to buy a home or move, decreasing demand for homes and driving prices even lower.
When we think about this principal in aggregate it’s clear that we have a cycle where home price appreciation drives more home price appreciation, until either access to credit, or costs are too high, then the cycle reverses and home prices fall for the same reason.
The decline in prices is ultimately slowed as people paying down their mortgages, and cash buyers begin to increase demand at the new low price levels… and the cycle repeats. Interest rates and mortgage rates are only a small piece of the cycle, driving a portion of affordability.
But there is more:
On top of the normal housing cycle is a credit cycle. What this means is that lenders typically are more liberal with their lending when loans are doing well. So as home prices are rising, you get very few defaults or losses to the mortgage owners as borrowers who are in trouble can simply sell their home at a profit. This entices lenders to make more loans at even more liberal terms, lower down payment requirements etc.
The same principal holds as home prices decline: borrowers can no longer “cash out” of trouble, meaning more mortgages go delinquent and lenders take losses. Lenders then tighten their lending standards, stop offering home equity lines, demand higher down payments etc. This credit cycle overlaid on what is a naturally cyclical asset exacerbates cycles making home price swings even greater and lending them even more momentum.
Today, home affordability is coming down, but remains well above historical averages, home prices have been increasing (hence increasing demand) and lenders are becoming more liberal with their lending standards. Hence we have a continued rise in home prices.
This housing theory gives us a lot of other interesting insights, for instance the price of ‘starter homes’ often leads the cycle both on the way up and on the way down. This is because a change in the price of starter homes drives demand for each market segment higher in the market. The price of starter homes is driven by both supply of these homes as well as incomes (and savings) of young first time home-buyers, and so the income of 25-35 year olds becomes an important leading indicator of housing (my personal theory is that this is why home prices in San Fran are outperforming the national average). Housing markets are of course very segmented and geographically independent, so while all of this makes sense in aggregate, different regions will be at different stages of the cycle, or being driven by overarching economic drivers that drown out the impact of the housing cycle (i.e. Detroit).
So, you see, there isn’t, necessarily, a strong link between rising home prices and rising interest rates. Because so much of the economy is housing dependent, rising home prices can drive economic growth (and falling prices slow it), this can in turn drive an increase in interest rates. But it is definitely not a direct relationship. At best it is a casual, not causal relationship.
Attached is a graph tracking the average 30-year Mortgage Rates versus the Case-Shiller Index
compared with the Home Affordability Index.
I don’t see any relationship, do you?
The Burch-Mudry Team
Private Offices at the Hawthorne Inn-Concord