Interest Rates, Inflation and Home Prices

[XBoxBoy]

I’ve been thinking about the question of how much recent price rises are due to work from home narratives, people moving from other areas, and how much is due to record low interest rates. To answer this, I decided to make some charts that would show what I could reasonably expect to happen when interest rates change.

This first graph shows the relationship between interest rates and the size of a loan with a set monthly payment. To create this graph I used $2,500 a month payment. (Which might seem low for San Diego, but the amount of the monthly payment isn’t important, a larger payment simply moves the graph up.) I did not include taxes or mortgage insurance, or consider down payment. All examples I’m using are for 30 yr. fixed. The goal here is to just show how much more you can afford as rates change.

Two simple take-aways from this chart: 1) The obvious, that as interest rates go down you can afford a lot higher purchase price and 2) as interest rates go down the curve gets steeper and so prices increase more due to a .5 percent drop from 3 to 2.5 than from a .5 percent drop from 8 to 7.5.

Next, I wanted to add some historical perspective to this. Interest rates have changed a lot over the years, so how much of the change in home prices is due to change in interest rates? Here’s a graph that shows, given a monthly payment combined with the 30 yr. rate at a given time, what would be the purchase price you could afford. (Again, ignoring taxes, insurance, & down payment)

For this chart, I’m using a monthly payment of $2500, a starting date of January 1987 and mortgage rate data from FRED. I am not taking into account points paid. I’m not sure how important that is or isn’t.

Now, the problem with the previous chart is that it assumes that over time the monthly payment people could afford wouldn’t change. But over time inflation should cause wages to increase, thus increasing what people feel they can pay monthly. So, I’ve added a bit of code that increases the monthly payment by the inflation rate. Here’s the chart with a starting monthly payment of $2500 and every month I adjust that amount for inflation.

Note the above does not deal with the issue of location at all. The above merely looks at the impacts of interest rate changes and inflation on expected home price. These charts are not unique to San Diego, or any sub-area.(Which brings up a bunch of interesting questions about what has happened in areas where home prices haven’t risen over the years!)

But now, let’s introduce some data to see how the expected home price compares to actual home prices. To do this, we can use the Case Shiller Index. I’ll calculate the initial price based on what could be afforded on January 1, 1987 and then using San Diego Case Shiller Index, plot the Case Shiller price over the years.

In the above chart you can clearly see the housing bubble of the early 2000’s! (And note, the above chart uses San Diego Case Shiller, not national Case Shiller)

One last point, the above charts are all linear in both the x and y. But arguably the y (price) should be shown as a log scale. So here’s the final chart showing my interest rate and inflation adjusted expected price and the Case Shiller price with a log scale for the y.

So what to make of the above charts? First I think it’ll be really interesting to see how different people will interpret the charts differently and to see how people use the charts to argue differing points.

But for me, the biggest observation is that most if not all of the home price increases we’ve seen in San Diego are the result of interest rate changes and inflation. This isn’t a commonly held view, and one I would have doubted before doing these charts. The narrative that the home prices increases over the years are because so many people want to move here and that demand has grown while supply of houses hasn’t, just doesn’t hold up when I look at these charts.

The other thing is, if home prices increases are so strongly correlated to interest rates and inflation, what would happen if interest rates were to start rising? I’m not saying that’s going to happen but it’s worth keeping an eye on.

Sources of data:

Interest rate:
http://www.freddiemac.com/pmms/pmms30.html

Inflation data:

Historical Inflation Rates: 1914-2023

Case Shiller San Diego:
https://fred.stlouisfed.org/graph/?id=SDXRNSA,

[an]

You forget the key factor about RE (location, location, location). Not all area of RE increase at the same rate or decrease at the same rate. Also, not everyone’s salary increase at the same rate. Not everyone can afford/buy a home, so instead of looking at overall inflation, maybe you should look at wage inflation for the top 20%. Here’s an article about the migration pattern over the last year:

Pandemic Sparks a Rebound in Residential Migration, Survey Finds

[XBoxBoy]

[quote=an]You forget the key factor about RE (location, location, location). Not all area of RE increase at the same rate or decrease at the same rate. [/quote]

Actually, I haven’t forgotten this at all. My post isn’t meant to address anything about any specific location. In the last two charts I do compare expected house prices with Case Shiller for San Diego, but I don’t attempt to address anything more specific than San Diego in general.

[quote]Also, not everyone’s salary increase at the same rate. Not everyone can afford/buy a home, so instead of looking at overall inflation, maybe you should look at wage inflation for the top 20%. [/quote]
I’m not sure why we would want to limit to just the top 20% unless you are arguing they are the only ones who buy houses in San Diego. But, yes, using wage inflation instead of general inflation would be an improvement. I just didn’t find wage inflation data so instead used general inflation as a proxy. I’m assuming that over the course of 35 years the two remain reasonably correlated. Maybe I’m wrong about that though.
[quote]Here’s an article about the migration pattern over the last year:
https://candysdirt.com/2021/05/19/pandemic-sparks-a-rebound-in-residential-migration-survey-finds/%5B/quote%5D

Overall, I think you’re missing what I’m saying in my post. While I initially set out to try and answer how much of recent price changes are due to issues like people moving from out of town versus interest rates, what I ended up showing is that over the last 34 years almost all the rise in home prices in San Diego can be attributed to interest rate changes and inflation. Because my charts show 34 years of data, only a very small part of the charts are specific to the current situation. And the part that is for the last year is for San Diego overall, not a specific area.

But the bigger take away for me is that if I am correct that home price increases are largely correlated to interest rates and inflation, that means a lot of the narratives told in the past about why home prices are going up were false. Which leads me to be rather skeptical of the narratives I’m hearing now.

[an]

[quote=XBoxBoy]Overall, I think you’re missing what I’m saying in my post. While I initially set out to try and answer how much of recent price changes are due to issues like people moving from out of town versus interest rates, what I ended up showing is that over the last 34 years almost all the rise in home prices in San Diego can be attributed to interest rate changes and inflation. Because my charts show 34 years of data, only a very small part of the charts are specific to the current situation. And the part that is for the last year is for San Diego overall, not a specific area.

But the bigger take away for me is that if I am correct that home price increases are largely correlated to interest rates and inflation, that means a lot of the narratives told in the past about why home prices are going up were false. Which leads me to be rather skeptical of the narratives I’m hearing now.[/quote]
I understand what you’re trying to say. But I think you put more weight and correlation to rates than inflation. That’s what I’m trying to convey, is that wage inflation is probably a better correlation than rates.

This is why I’m trying to convey about the top 20% income inflation. 20% is some random number I pull from the sky, but the point is that someone making minimum wage would not be buying houses. They’re renters.

[XBoxBoy]

[quote=an]But I think you put more weight and correlation to rates than inflation. That’s what I’m trying to convey, is that wage inflation is probably a better correlation than rates.[/quote]

I’m not claiming any more weight or correlation to rates than inflation. I’m claiming that rates combined with inflation are the principle drivers of house price increases.

And I agree that wage inflation would be more appropriate than general inflation, and can see your point that low wage earners can probably be ignored. But I also doubt that there would be much difference in the charts. Maybe someone like Rich has wage inflation data we could use?

[sdrealtor]

Nice work but so tough to simplify something impacted by so many factors. Rising rates would only lock more people with sub 3% in place and further limit supply. On the demand side I would agree that inflation and rates were huge but don’t discount stocks, wealth transfers, stock based comp plans, work from home, higher awareness of SD worldwide, transforming from a tourist/military economy to tech/telcom/life science economy locally and of course crypto baby! They are all supercharging each other and I left out plenty Of others. In the current boom down payments have been huge on the whole which limits impact of wages and rates. There is no simple answer

[Rich Toscano]

xboxboy, this is awesome! Thanks for putting it together.

I’ve got to get on a meeting soon so very quick thoughts:

First, the steepening curve where as interest rates get lower, they exert a continually higher impact on affordability – that is something I had never thought about. That could be an important piece of the puzzle. I’d always observed that in the past, interest rates didn’t have such a big influence on valuations, but they seemed to have more of an impact more recently. This might be a result of the non-linear impact of rates — they didn’t matter so much when they were higher in the past, but matter a lot more now. Must think about it more.

Second, if you are inclined, I’d love to see a variation on the final graph that, instead of mapping both series, just shows the % difference between each series. That would give a more fine-grained look at how over- or under-valued SD housing is compared to your indicator.

Third, I’d be curious to see — what happens to the price model if rates go up to X? I guess I can do the math on that one based on the first chart. But for one example — rates got to the mid-4s in 2018. What would happen to your price model if they went to 4.5% again?

BTW I do have data that I’d be happy to share. To spare everyone the details on that, why don’t you PM me or email at [email protected].

[an]

[quote=XBoxBoy]I’m not claiming any more weight or correlation to rates than inflation. I’m claiming that rates combined with inflation are the principle drivers of house price increases.

And I agree that wage inflation would be more appropriate than general inflation, and can see your point that low wage earners can probably be ignored. But I also doubt that there would be much difference in the charts. Maybe someone like Rich has wage inflation data we could use?[/quote]
The reason why I think you’re put more weight on the rate than inflation because you assume price increase because rate goes down. In the 70s, rates went up and price went up as well. Maybe, if you have data as far back as 1970, you can use the same chart to see if your hypothesis still apply in a rising rate scenario.

[XBoxBoy]

[quote=sdrealtor]Nice work but so tough to simplify something impacted by so many factors.[/quote]

Actually, I don’t feel I’m trying to simplify. When I first set out to do this, I thought, maybe interest rates and inflation would account for about 50% of the rise in prices. I didn’t for one second think I would find that interest rates and inflation would account for pretty much all of the rise. When the charts first popped up, I was shocked how close they were. And then when I started to think about what I was seeing I realized that none of these other factors probably matters much at all. (At least not over the long term. Over the short term, we can see the actual prices (red case shiller) deviates from my expected prices during the mid-2000’s. So over the short term, prices can definitely be impacted by other factors!)

[quote] Rising rates would only lock more people with sub 3% in place and further limit supply. [/quote] Don’t misunderstand me here. I’m not making any prediction about what will happen. Not only would what you say potentially be true, but if interest rates do go up, there’s a good chance that they are going up because of higher inflation at the same time. Depending on the amount of inflation we could see very different paths.

[quote] On the demand side I would agree that inflation and rates were huge but don’t discount stocks, wealth transfers, stock based comp plans, work from home, higher awareness of SD worldwide, transforming from a tourist/military economy to tech/telcom/life science economy locally and of course crypto baby! They are all supercharging each other and I left out plenty Of others. In the current boom down payments have been huge on the whole which limits impact of wages and rates. There is no simple answer[/quote]

If we are talking short term (5 years?) maybe some of those factors will have a large impact. But looking back historically, it doesn’t look to me like any of those things have had a long term impact. I will certainly concede though that past performance is not indicative of future performance, so… who knows maybe in the future.

[XBoxBoy]

[quote=Rich Toscano]First, the steepening curve where as interest rates get lower, they exert a continually higher impact on affordability – that is something I had never thought about. That could be an important piece of the puzzle. I’d always observed that in the past, interest rates didn’t have such a big influence on valuations, but they seemed to have more of an impact more recently. This might be a result of the non-linear impact of rates — they didn’t matter so much when they were higher in the past, but matter a lot more now. Must think about it more.[/quote]

So mostly for amusement here’s the chart that shows what you could buy with interest rates from -10% to 20%.

This gives you a sense of just how unlinear the curve is. But if you think about it, realistically home loan rates are not likely to go into negative territory and even 10 and above seems extremely unlikely any time soon. So, we are only really interested in the 2-5% range which is comparatively flat against the overall curve.

[XBoxBoy]

[quote=Rich Toscano]Second, if you are inclined, I’d love to see a variation on the final graph that, instead of mapping both series, just shows the % difference between each series. That would give a more fine-grained look at how over- or under-valued SD housing is compared to your indicator.[/quote]

Here it is:

Most notably you can see the big overvaluation that was the 2006 bubble. It looks like currently we are overvalued but not significantly.

[sdrealtor]

Correlation is not the same thing as causation

[The-Shoveler]

IMO can’t discount the sugar high,

In the mid 80’s mortgage rates were in the 10’s housing was going up 15-20% a year in LA (defense spending boom sugar high).

[Anonymous]

[quote=XBoxBoy]
But the bigger take away for me is that if I am correct that home price increases are largely correlated to interest rates and inflation, that means a lot of the narratives told in the past about why home prices are going up were false. Which leads me to be rather skeptical of the narratives I’m hearing now.[/quote]

Yes, this pretty well debunks the non-sense narrative from the real estate crowd that “everyone wants to move to San Diego” blah blah blah.

The interest rate is key for multiple reasons. Yes obviously it pushes peoples ability to make mortgage payments. But in the bigger picture, it is this low interest rate environment that has enabled so many people to get wealthy in the first place. One example is through their corporate stock options and other pay packages that are killing it thanks to the fact that corporations have been borrowing money at near 0 rates and using it to buy back shares. All of this is induced by Fed easy money policies.

[sdrealtor]

It does nothing of the sort

[Author]

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