Tuesday, September 29, 2015

Interest rates to rise this fall:

Janet L. Yellen, the Federal Reserve chairwoman, said on Friday that she still expected the Fed to start raising its benchmark interest rate later this year. Source: www.nytimes.com 
While I don’t expect a huge increase immediately, I do expect the start of a phase-in process to return to more sustainable levels. What impact will that have on mortgage rates and home values?
The chart below shows how interest rates for the Federal Reserve Board (FRB) and 30-year Fixed Rate Mortgages (30yrFRM) have moved over the past 42 years.  Note how they have moved together with the 30yrFRM showing less volatility.  The 30yyFRM appears (roughly) to be 1-2% points higher than the FRB. However, today it is more like 4% points. One thought is that the 30yrFRM has stayed higher assuming that the ultra-low FRB rate was only temporary. Therefore, maybe, the 30yrFRM will not rise very much when the FRB does make their move. Then again, the 30yrFRM is at it’s lowest point in 40 years. The 6-8% range for 30yrFRM appears to be more representative of a rate that is sustainable.
How might an increase in 30yrFRM impact the monthly mortgage payment? Here is the impact on a Buyer for a $1.0M home with 20% down, which means a $800,000 mortgage. The monthly mortgage payment for principal and interest for today’s rate (4%) and potential future rates of 6% and 8%:
8% = $5,870 (+54%)
6% = $4,796 (+26%)
4% = $3,819
Now most Buyers won’t be able to qualify for a higher payment. The assumed payment of ~$3,800 is at or near the maximum they can qualify for based on their monthly income. When rates do rise, the most likely option is to reduce the amount they borrow in order to keep the monthly payment the same, which in turn means lowering the purchase price. Here is what happens if we keep the $3,800/mo and 20% downpayment:
8% = loan of $520,000, purchase price of $650,000 (-35%)
6% = loan of $640,000, purchase price of $800,000 (-20%)
4% = loan of $800,000, purchase price of $1,000,000
Therefore, it appears if mortgage rates were to increase 2% points higher, to say 6%, then many/most of the Buyers would need to reduce their target purchase price by 20%. How might this impact home values?
Not dramatically over the next few years. First, the Fed is unlikely todo anything that would “shock” the market. Secondly, there is such strong demand that there is probably plenty of buyers to keep the market going. Lastly, buyers are likely to use lower cost mortgages to cover the initial increase in rates. Below is a chart that shows the current spread between 30yrFRM and lower-cost loans such as Adjustable Rate Mortagages (ARM). An ARM would buy some time, however in this timeframe rates will be expected to continue rising, making it more challenging if they refinance the loan.
The long-term impact may be a deliine on Buyer’s purchase power and downward pressure on home value appreciation. Here in Silicon Valley, the effect will be less than at the State or National level as long as some external event doesn’t slow-down high-tech growth and hiring. I do expect that rising rates will push our hyper-appreciation of 10-15% back to more sustainable levels of 6-10%. Really hard to imagine price going down, just not up so fast.
As to our current home prices – using Mountain View as an example, they are about 13% higher than the average of ~7% annual appreciation over the past 17 years. Doesn’t feel that far out-of-line (to me) given the hyper-growth of Google, LinkedIN and others and the significant reduction in the supply of New Listings.
The continuing decline in the supply of New Listings is also a key factor. It is amazing to me the nearly 40% drop in New Listings today from pre-Great Recession period of 2002-05. This factor alone would result in nearly a doubling in demand and significant upward pressure on prices. One explanation is that 2002-05 was higher than usual due to the bust of the Internet bubble (I remember people leaving Silicon Valley back then).  Maybe the supply of 1998-1999 is more representative of the norm.
For Buyers – homes are likely to be more expensive the longer you wait. Prices are expected to rise 10-15% a year for the next two years. On top of that, interest rates are likely to rise, forcing you to lower your target purchase price from today. A double whammy.  My belief is that you are best serve by owning a home that will rise and fall in value along with the rest of Silicon Valley real estate, especially if you intend to stay in the Bay Area for some time. The good news is that you can lock-in a mortgage rate that are still unbelievably low.
For Sellers – no immediate rush to sell as prices should keep rising. A word of caution, people are rarely able to “time the market”. If you intend to sell in the next 3-5 years, it may be advisable to sell in a Seller’s market. Media coverage of the Fed deciding to rise interest rates may also cause a mini-shock on market demand, that undermine’s the Seller market. Current tax laws may allow you to exclude up to $500,000 in gains and carry your existing Property Tax base to the next home (if 55+).