This week’s Voice article, in addition to featuring a vaguely unsettling photograph, addresses the commonly-held belief that low interest rates should make homes more expensive.
The idea that an item’s long-term price should be affected by the rate at which you can finance it on any given day is not really sound. This applies both to financial assets (if the brokerage lowers the rate on your margin account, your stocks did not just become permanently more expensive) and to consumer goods (in the minds of most, a lower credit card rate doesn’t justify correspondingly higher grocery prices). So why do people accept that rates should affect the intrinsic value of housing, and only housing? Because logic doesn’t apply during speculative bubbles.
The article also has a look at historical data, which unsurprisingly belies the claim that lower rates correspond to more expensive housing:
As a matter of fact, rates and home valuations have tended to move in the same direction more often than not (62%, to be exact).
It’s important to emphasize that rates do matter very much in the current market, which has seen people lock themselves into enormous amounts of adjustable-rate debt. But the short-term stimulus provided by low rates should not be confused with a sustainable economic fundamental which should positively affect home prices.
Update: The commenters below raised a really good point about the lower cost of capital, as defined by low interest rates, raising the present value of an asset’s income stream and thus the asset’s "value." Whether this increased value is reflected in prices or not is another issue, as the second commenter points out.
They are correct… and I shouldn’t have used the term "value." I should have used "real price," which seemed unweildy at the time, but would have been more correct. I also should have made the point that lower cost of capital corresponds with harder economic times, and thus whatever increase in "value" is lent by low cost of capital is usually overridden by economic conditions in order to set the "real price."
This is what happens when you wait until the last minute and finish your article at 1:30AM the day it’s due.
Point well taken. I agree
Point well taken. I agree that we are dealing with an irrational and unsustainable bubble in housing prices. But there are two reasons why lower interest rates may increase the demand for housing. First, if interest rates fall, the present value of house rents will rise. In other words, if you plan to rent out your house, that stream of income is worth more. So you would be willing to pay more for the house. Second, if you are liquidity constrained (expecting large future salary increases or future inheritance, for example, and no one will lend you the money today) then falling interest rates and easier credit will make it easier to buy the home that you can afford.
The problem is, I’m not sure how many investors are calculating the present value correctly. With stagnant rents, housing demand should be flat. And I suspect that too many people are too optimistic about future salary prospects to justify buying such expensive homes.
I would rather have a 10%
I would rather have a 10% fixed 30 yr. mortgage on a 180,000 dollar home than a 3% ARM mortgage on a 880,000 dollar home.
All these clowns that say ” I need the tax break from ownership” are fools…usually you have to spend 3-4 dollars for EVERY ONE dollar saved in taxes..bad tactic, but hey, these guys know it all …. right ?
This article negates the
This article negates the relationship between an investment’s value and it’s cost of capital. I believe you may be speaking of Price, instead of Value. Cost of Capital has a direct relationship with an investment value, specifically a lower cost of capital will raise the net present value of an investment. Whether the price, set by the market, correlates with the increase in value depends on a myraid of exogenous factors.
I think this was a key
I think this was a key statement in your article:
If one treats a home as an investment — and it seems very clear that most San Diegans do view their homes as investments — then the cost of financing that investment is irrelevant.
This is the problem, that people are thinking of their homes as investments when that is completely inappropriate. If you think of your home as a means of shelter, then its cost is more of a budgetary issue than anything else, and financing costs play into that.
Of course, it does not follow that interest rates are the primary determinant behind price fluctuations.
It’s like when a car dealer
It’s like when a car dealer tries to sell a car. They always ignore the price and try to sell the payment.
I must warn you, this is a
I must warn you, this is a very long post but my perspective is a little different than most in this area. I believe Bugs comment was right on. He is very perceptive in looking at what drove the increase in home prices. (How many cars can you sell with 0% financing?) Buyers of cars and housing look at “Can I afford the payment?” before they look at the “price.” Heck, that’s why there is such huge credit card debt too. Consumers figure “Golly, it only costs me $ 60 a month to buy $ 3,000 worth of clothes, so why not look good, I can afford it.” If I can buy a bigger, more impressive house for the same payment I would have had to make for a smaller house five years ago, I am going to buy the bigger, more expensive home and the price will be secondary because the payment is “within my budget.” And, because most home buyers are short term in their perspective anyway and they see their home as an investment, they want to risk as little capital as possible. I have been a land subdivider for 30 years (I sell entitled land to merchant builders) and there is an old adage in this business that states “Price is a function of terms.” So, cost of capital (the interest rate on your home loan) has a direct impact on profit because it costs less to hold that asset prior to sale. Today’s home buyer figures “If my home is appreciating faster than the cost of capital, an interest only loan or a teaser loan would be fine because I’m only going to be in this home for five years or so and when I sell, I’ll just make the spread.” Bottom line: I believe low interest rates were the single biggest factor in causing the insane price increases in home sales. People weren’t making a whole lot more, initially land or construction costs weren’t up. So why the huge increases? People could “afford” more, relatively speaking. Here’s why interest rates impacted prices (from my perspective, being in the industry): Merchant builders try to anticipate need and build for what they think the market is going to want (there is a long lead time in home building and especially in getting buildable land to market). When interest rates started to fall and continued to fall (I believe this was done in part to stimulate the economy through construction, homebuilding and everything that follows it), builders figured that home buyers could now purchase more bang for the buck (a bigger house with lower payments, relatively speaking), and shifted their emphasis from entry level and first tier to “luxury housing” which is far more profitable due to the economies of scale. I remember when this happened. About eight years ago, nobody wanted to build “luxury” housing. Up until about six months ago, no one wanted to build “entry level” because high end was on fire. In the old days, a good profit margin on a home was 10%-15%. At the peak of the McMansion craze (and believe me, it’s over), some builders (especially super high end) were booking 25%-40% profit margins per home (some as high as 50%), because they had bought their land to build less expensive homes, when the land was priced in relationship to normal perceived margins. But when interest rates started to fall, builders began to deliver higher priced houses because they knew that capital was cheap and consumers could “buy more for less.” Builders knew buyers could pay less monthly (relatively speaking) and get more, meaning the builder could make a larger profit margin. (This is part of the reason you see huge houses on tiny lots – initially those lots were designed for smaller, cheaper homes). Now, margins are more back in line because land costs caught up with housing “prices” and in some cases margins are falling below “normal levels” because development costs and more importantly land costs, have increased dramatically (because land sellers could get them – lucky for me) and those McMansions got a lot more expensive to build. So, the better the terms (the lower the interest rates and smaller down payments), the higher the “price” one can afford to pay (and the more people who can pay it, reducing supply and increasing demand, which also hikes pricing), which means the higher the price the builder (or seller) is going to charge you (remember, your cost of capital does not impact the seller, except that they can charge you more, and, you can “afford” to pay it). And with zero to ten percent down and super low interest rates, prices went up, up, up (cheaper cost of capital, less equity risk, more perceived value via a larger home = higher prices). Salaries per se didn’t increase in line with housing prices but the ability to “afford” a more expensive home did (because capital costs decreased dramatically) and once new home prices started to increase, a domino affect was in place and it filtered down to existing home sales (real estate agents and sellers started raising their prices and were getting them because again, buyers could “afford” the prices, via the “livable” payments resulting from super low interest rates and crazy hybrid loans). The litmus test is this: What would happen to home prices if home loans were 0% financing for 40 years with zero down payments (feeding frenzy, anyone)…and conversely, what would happen to home prices if home loans were 18% amortized over 10 years with 50% down payments (stagnation, price dumping)? Price is definitely a function of terms. The better the terms, the higher the price (across the board, on just about any item). Back to Bugs, that’s why leasing a car costs more in absolute dollars than buying one (who looks at the “price” of a lease anymore — just get me in that new car!)
Word.
Word.
Thanks for sharing.
Thanks for sharing.
But still, we have to return
But still, we have to return to Rich’s charts, which show that interest rates and prices do not necessarily work in concert. I think it makes perfect sense that interest rates were one of if not the most important factors driving up house prices in this particular boom. It doesn’t necessarily work that was as a rule.
And in the recent price drive, it hasn’t been interest rates alone, it’s also been a buy now/pay later scheme.
I would also argue that strongly considering the financed monthly payment with respect to the price does make some sense to the homebuyer. It’s different from buying a car (which depreciates rapidly to a small fraction of its purchase price within several years) or consumables on your credit card. When you buy a home you are buying shelter, and an asset that is likely to retain most of its value, or if you’re lucky, appreciate, over your lifetime. One of the key problems is that people are gambling badly on the appreciation of that asset, which is far from assured even in the long-term when you consider the cost of upkeep, and downright unlikely to do anything but decrease in price in the short-term. But count me among those who made a decision to budget a certain percentage of my current monthly income to a financed mortgage payment, then went out and found the best house and financing I could in that neighborhood.
I’m not so sure it is the
I’m not so sure it is the rates that drove it, but the monthly payment and the number of people who could get loans. i.e. the availability of capital, and “createive” loas, not just “low rates”
Furthermore, we have some special market conditions. Right now, rising interest rates will have a significant impact on the market price. Rising rates will force alot of people into forclosure, and negatively impact prices.
I learned this from Rich, so I’d like to see how he reconciles “rates don’t really affect home prices” in his latest articles and “if rates go up, the bubble will burst” (both paraphrases).
Perhaps he would say “rates shouldn’t affect the market, but they have and now they must affect it again to undo the wrong-doing.”
The part I find interesting
The part I find interesting is the part about why house sizes have seemingly increased, ie zero lot line and monstrous houses on tiny lots. I would have thought that consumer demand for such things was what drove that decision. Your post seems to say that consumer demand is a secondary part of the equation. What I think you said is that builders can achieve better economies of scale on these houses. Low interest rates merely make this sort of calculus more reasonable for the end consumer. Even though its not directly tied to a housing boom or bust it has always interested me, the thought process that goes into development, esepecially residential.
Josh
I must say, I don’t like
I must say, I don’t like your analogies. They are static examples which ignore market forces.
Unlike houses, apples are not bought on credit so the analogy is not applicable. The apple vendor knows he cannot get away with incresing the price if rates are lower.
Lower rates may not lower the price of the stock you are purchasing, but you may purchase more of the stock than if rates were higher, thus increasing demand and the price after the purchase. If rates are lower for the whole market, and the stock is typically purchased with credit, the price will increase.
It is a market reality that people pay more attention to the monthly payment than value for cars and houses. Isn’t necessarily in their own best interest to do so, but they do.
Real estate agents know this and use it to drive the market price up. So, rates affect price, though not necessarily value.
It is impossible to see causality in your chart. Who knows how much higher prices would have been on any given date if rates were lower? You can’t tell. The chart does show there are larger forces at play in home valuation, though.
This, I love:
Where does the change in interest rates fit in with the idea that sky-high home prices were being supported by low rates? Now that rates have risen somewhat, and monthly payments with them, does this imply that home prices should have declined? If and when rates rise further, should homes prices drop even more? I haven’t heard any of these questions addressed by members of the “low rates beget expensive houses” school of thought, who apparently feel that interest rates are only a fundamental economic factor when they are extremely low.
Inflation may be important.
Inflation may be important. I’d like to make a suggestion here. Try redoing the 30 year mortgage graph by adjusting the 30 year rate for inflation. (i.e. subtract the inflation rate from the loan rate to get the actual yield realized by the lender.) The interest rate graph will take a different shape that may be more revealing with regards to the correlation to home prices.
Asterix
Here’s a good analogy. I
Here’s a good analogy. I have a boat, I keep it at a marina in San Diego, while sitting there drinking Jack Daniels after a long week, I often comtemplate the “Sur-real estate” scenario of lately here in SoCal, I have used some “boat Sense” to cut through the B.S. of human vanity and boasting that applies to both human nature and greed.
In my marina, (I have been there 12 years and have a 23 yr. old free and clear vessel that I have owned for the last 14 years) my new, mostly younger neighbors mostly all have new boats within 2-5 years old,and none of them hold jobs that I would consider “higher income positions” not bad jobs, but definitely NOT expensive yacht affording type jobs.
Their new boats come with a ball buster payment also. I talk with them occaisionally and here’s what I have discovered over the last 12 years. First it was the “virtual Dot-Com Millionaires” now its this “Real Estate Tycoon” group. Here’s the truth of the matter, as I see it:
NOBODY has a boat thats not exactly the absolute BIGGEST he can afford” Yachts are “statements to the world” for most people who own them, not all, but most.
Most of the time If somebody tells you otherwise, he’s probably blowing smoke up your a*s. Accept it.
People like to say this jive when they’re half lit on Saturday night sitting on the back of their boats, trying to make others admire their constraint, but I know otherwise, as I usually know the broker that sold it to them and sometimes I secretly know their financial situation. Its usually that they bought the MOST EXPENSIVE yacht (monthly payment) they could possibly afford. Mostly, they’re the “Monthly payment” crowd. Noveau Riche…as it were.
I feel like I have to throw the “Bull$hit flag” when they start talking like that. But I dont, I dont want to embarrass them, its comical to me anyways and they’re nice people, just in over their heads.
Yachts are JUST like 12,000 square foot homes, nobody needs them, but they are nice to have if you can comfortably afford it, AND if you can afford that type of largesse, why not get the biggest one you can ?
They didnt keep a sharp eye on the “total” sales price. People will buy the BIGGEST house they can possibly afford. Until the last 10 yrs. or so….People started buying the BIGGEST monthly payment they could afford, only problem is, its ADJUSTABLE usually. Somebody has to get “stuck” with an over priced house, its a law of economics. Nothing rises forever. Im afraid…its them…Do they really think people looking to buy are NOT reading the same articles the current owners are reading and the reason they are trying to sell ?? Who wants to get suckered ? Nobody I know.
The housing market in SoCal and nationally for that matter, is that these are no longer home dwellings or residences anymore. NO.. They are shrines to project the owners self image of wealth, know how and or maybe his creditworthiness, I guess?
In the next 10 years, he will wish to GOD he NEVER bought into such a HUGE price tag that will swallow him up.
He was watching the “payment”…not the “sales price”, Same reason they use “Chips” in Vegas and NOT cash, its not reality while your playing.
Our fearless leaders, and the FED, made it too easy for people to get tangled into this mess.
If banks would’ve loaned on boat’s for ZERO percent down and 2.2% interest on a 3-5 yr. arm like they did with houses,then boat sales would have skyrocketed. But they dont, they require 20-50% down, and they know full well its an emotional purchase and it will be tough for them to get their money back out of it, if they had to take it back. Just like the 12,000 square foot house, McMansion.
The money for these boats came from somewhere ? If not the banks ? then how did these people get the big down payments ?
A lot of those refi’s, 2nd.and 3rd. mortgage’s on their homes were FOR THEIR BOAT DOWN PAYMENTS !
They were living the dream Baby !!
This current disneyland ride does not take a ticket to get on initially, like we were all used too…no, This ride doesnt require the ticket Until AFTER you want to GET OFF the damned thing !
But not so FAST … it gets worse !….
While they were in Maui, sipping Mai-Tai’s for the 3rd. time in 2 years, paid for by that H.E.L.O.C Visa card, the NEW and improved bankruptcy laws went into effect favoring the lenders.
These people were spending like there was no tomorrow ! The govt originally was designed to protect people from themselves too! But they dropped the ball and even fostered this orgy of free money, to what end ? ..a Depression ? How will this end ? Debtors prisons ? I dont know.
Did somebody forget to tell ME back in 2001, that a meteor was going to crash into earth ?… and we’d all be dead in 2-3 years anyway so “live it up” now ? …I must have missed that memo……
Maybe the next “Memo” should say : “The meteor missed earth, I repeat, the meteor missed earth, go back to living your lives”.
..if you can afford to !
Lookoutbelow….that was
Lookoutbelow….that was awesome!! I could not have said it better myself. I believe your post just knocked the wind out of anyone reading it who was hoping that happy days would return anytime soon.
To which I say: F&k’em…it’s about they learn the errors of their ways…be it real or imagined–“debtors prison” awaits the vast majority of fools I have come to know.