I am very skeptical of the idea that lower interest rates justify higher home prices. Let me throw a couple of thoughts out there haphazardly — this is an article I’ve wanted to write for a while so this is a good opportunity to get feedback on my thinking.
1 – The historical record doesn’t support it
Check out this graph: http://piggington.com/images/primer/sdpricetoincome.gif The p/i ratio peaked and trough at the same place in the prior two cycles, despite vast differences in rates. This time around, the difference was not rates but incredibly (and unsustainably) loose underwriting due to the securitization boom.
Also I did a quick regression and there was no correlation between rates and inflation-adjusted home prices from 77-2000. If you include the latest bubble there was a mild positive correlation but again, i think that’s due to underwriting. Not sure how to prove that thesis, except for the fact that falling yields never before affected the p/i ratio, so it must be something else.
This is the part I’ve had trouble describing coherently. For the individual making a rent/buy decision, lower rates are definitely a consideration (as long as you will be in the house for long enough to reap the benefits of locking in a low rate. There’s always the argument that you can refi in the future, but what if rates only go up from here?).
However, think about the market as a whole and future rate/price direction. If rates rise, they will put downward pressure on prices (maybe? see above – but let’s say they do) in the future. Given that rates are low, and in specific that real yields are unusually low, there is a good chance of rates rising — shouldn’t this future pressure be priced into the justifiable home price?
Or let me try to explain it a different way. When you buy a house, the future value of that house will be influenced by FUTURE rates, not just current rates. So just because rates have spiked down, does that suddenly argue that prices should be higher? I’d argue not.
Or a third angle: the “justifiable” price may be influenced by rates, but it has to be influenced by the average level of rates over the holding period of the home, not just rates right now. Hmm, I think that may be a better way to describe it.
You can see why I haven’t written about this yet. 🙂 The concept is clear in my mind but I don’t know how to explain it. Thoughts?
