How do we measure home values?

First off, tracking your home’s value in dollars is like measuring your height with a shrinking ruler. Dollars aren’t really a good long-term metric unless you adjust for inflation (a word everyone has become familiar with lately). Inflation is a term (often misused) that describes a currency’s loss of purchasing power over time.

Believe it or not, the private corporation that dictates US monetary policy (the Federal Reserve aka The Fed) wants inflation. In fact their stated target is 2% annually. Yes, the Fed’s stated goal is for your $1,000 savings to be worth $980 next year, then $960.40 the next year, then $941.20 the next and so on (1). The last 3 years have however seen that number average around 6% annually.

There is also a significant argument that government statistics are under-reporting reality, but I will leave that for another day. If you’re interested in this topic, John Williams has done a masterful job tracking the statistics at www.ShadowStats.org.  That said, we have to account for the dollar’s loss in purchasing power when we look at the cost of housing over time, otherwise the numbers are meaningless.

Who sets the interest rates?

This is such a complex question with so many factors, it would take a college level course to explain it. I will attempt to give you a 30,000ft view with a couple of the most significant factors explained. Once upon a time, interest rates were set by the free market. Lenders decided how much interest was needed to cover the perceived risk of an investment based on the merits of the borrower and their intended use of the funds. We have since become a centrally managed economy where a privately owned bank (the fed) has been chartered to control the United States money supply, including borrowing rates. This private central bank manipulates interest rates in multiple ways, but there are still some free market forces at play. The two main tools used by the fed are the federal funds rate and the buying/selling of debts.

The federal funds rate

The federal funds rate is the amount of interest the fed will pay banks to hold their dollars at the federal reserve short term, free of risk. The fed basically creates competition for bonds (debt) which drives bond rates up. The fed can also create dollars (out of thin air) and purchase debts in the form of US government bonds or mortgage backed securities. The purchase or sale of these debts is another tool the fed uses to manipulate rates up or down. If they want to reduce rates, they create dollars from nothing and buy real debts, if they want to raise rates, they stop buying or even sell these debts back into the market. This is where our beloved “money printer go brrrr” meme comes from.

The fed creates dollars out of thin air to pay banks interest or buy debts from banks. Banks in turn use your bank deposits to earn interest through bonds or fed funds. If they can buy a US bond that is perceived to be “risk free” then they must charge you the bond rate plus a premium to be worth the risk of lending to you.

Traditionally the 30-year mortgage rate tracks the 10-year US Treasury bond, almost exactly, with a premium of about +2.75%.  At the time of writing this article the US 10y treasury is trading at about 4.2% and the average 30-year mortgage is 6.96%. This is the highest mortgage rate since 2002 when (inflation adjusted) average home prices were 57% lower (3).

What do interest rates mean for home values?

A lot. The federal reserve admittedly uses interest rates to influence behavior in the markets. They say this is how they “control” inflation, by making it more costly to borrow, they drive down prices (2). Keep this in mind going forward, the goal of raising interest rates is to reduce asset prices. So, in effect, the fed reduces rates to fuel asset price inflation, then after we reach a point where inflation is out of control, they raise interest rates to pop the bubble.

Since the great financial crisis and housing bubble 1.0 popped in 2008, the fed has kept interest rates near zero most of the time. This was supposed to “help” us recover from the financial meltdown of 2008. What this has actually been, is an experiment in monetary policy creating the easiest lending and cheapest debt the world has ever seen.

How much do interest rates affect house payments?

As you know, interest rates directly affect your house payments. What you may not realize is how much. In July of 2021 the average 30-year mortgage rate was 2.79%. Just 15 months later, October 2022 the rate had increased to 7.08%. Rates have since leveled out with an average of 6.96% today (August 2023). We have never seen rates increase this much, this fast. Let’s crunch the numbers.

If we took a 2.79% 30y mortgage for $300,000 in July of 2021 the payment was $1,231. The same mortgage at 7.0% is $2,012. That’s almost $800 a month more for the same price house. (keep in mind this doesn’t include taxes and insurance, which also increase with housing prices). To look at it another way, if John Smith qualified for a maximum of $300,000 mortgage value at 2.79%, he only qualifies for $184,000 at 7.0%; You have reduced John’s buying power by 39%! A house must be 39% cheaper for John to afford it.

The vast majority of homes are sold with a 30-year mortgage, and almost all homes are bought with a mortgage. Cash purchases are a small percentage of the total housing market, and many of those made by institutional investors are packaged up and borrowed against later on to fund new purchases, so interest rates are a major factor in home values. What’s worse for institutional investors is they typically have adjustable rates that change every 3-5 years based on the market rate, so they are far from immune to rate increases.

A look at home appreciation

Assuming rates stay at this level for an extended period, will buyer’s 39% loss in purchasing power translate directly to a 39% reduction in prices? It’s hard to say but let me put something into perspective for you. Many homes appreciated 20% year over year from 2020-2023 (this is historically unheard of). So, a $200,000 house could have ballooned up to $345,000 in just three years. Okay, let’s say the price drops on that house by 38% from 2023-2026. That would reduce the value from $345,000 to $213,900 translating to an average yearly increase of over 1% which is a very normal price appreciation rate for Oklahoma. I am not saying this will happen, I am just showing you mathematically that it would actually put us in line with normal appreciation which is typically 1-2% per year in Oklahoma.

Where will interest rates go from here?

Isn’t that the $10 Million question? I have probably read, listened to and considered every possibly outcome to this question with all the arguments the greatest financial pundits can concoct, and I have come to the definite conclusion that no one knows. For every bulletproof argument that rates must come down, I hear another one justifying them staying this high or reaching double digits even. If we listen to the chairman of the federal reserve, Jerome Powell, we hear statements like “we need to keep rates higher for longer”. The question is, can the markets handle rates higher for longer?

We learned in 2000, 2007 and 2019 that as soon as there is financial panic, the fed cuts rates to zero. They have had to drop rates lower and lower for each calamity since 2000, but how much lower than 0.05% can they go? Ever heard of negative interest rates? It hurts the brain to even think about, doesn’t it? Well what if I told you that there have already been negative interest rate mortgages? No, not in the US, but Denmark led the way in 2019.

I do not think we will see this here soon, but I wouldn’t say never. What better way to stimulate the economy than to pay people to take out debt? What better evidence of a broken financial system could you have.

Won’t house prices shoot up when they drop interest rates again?

Not necessarily. As I’ve told you before, the housing market is a slow moving one, like a giant supertanker sailing full ahead, when you turn the rudder it takes time to feel the effect. Right now we have record low inventory, which we talked about in the past (link to article here).

This is keeping a floor on prices for the moment, partially because no one wants to sell their precious sub 3% mortgage (investors and homeowners alike). I hear this argument all the time, no one will sell because of their low locked in rate. It’s a good, valid argument but if we look back at the 2008 housing crash, rates were being lowered the whole way down. Once prices start to fall, people want out and will sell, especially investors who have accepted lower returns on rents hoping prices will continue to climb year over year.

Unfortunately, I don’t have a crystal ball, so all I can do is look at the past and assume the future will behave similarly. Or at the least, we can say it is historically possible for rates and prices to decline simultaneously. Eventually, yes the lower interest rates will re-inflate prices, but there is no telling how long that will take, there are so many other factors at play such as the health of the economy in general, unemployment rates, consumer price inflation and the banking sector’s willingness to lend (it was harder to get a loan from 08’-12’).

What if they keep rates this high or take them higher?

Honestly, this is the worst-case scenario for any asset typically purchased with credit, most notably houses. If the institutional house buyers we touched on earlier are forced to refinance their 3-5 year ARM loans at double or triple the rate they started at, they will have negative cash flow on their rental incomes. Supposing they are at negative cash flows and suspect stagnant or even declining real estate prices, they will be forced to sell these assets. Assuming this happens, we could see a dramatic increase in inventory, which as we discussed, is the limiting factory currently keeping prices stable.

The historically low rates we have experienced over the last decade have put individuals and institutions in a precarious situation with debt at all time highs in every sector; mortgages, credit cards, corporate bonds, you name it. Everyone thought low rates were here to stay. We are now about one year into “high rate” territory and the effects are just barely starting to show.

Remember, the federal reserve isn’t Federal, and it has no reserves.

Sources

1. https://www.federalreserve.gov/faqs/economy_14400.htm
2. https://research.stlouisfed.org/publications/page1-econ/2020/08/03/the-feds-new-monetary-policy-tools
3. https://fred.stlouisfed.org/series/CSUSHPINSA