It’s finally happening. Residential mortgage rates are moving up, as rates increased for the fifth week in a row. The Federal Reserve had hiked interbank lending rates four times last year, but, during that period, bank lending rates did not increase significantly. Now they are. Will this increase the cost of housing, erode demand and reduce value?
What’s happening now that did not exist before? Let’s first review the stock market, typically a good indicator of rate fluctuation. Last year the Federal Reserve rate increases did not dampen an ever-growing value in the stock market. Many wondered why. Pundits thought that rate increases were “baked in”, and thus not a factor which could hurt the market. Fast forward to last week, after new rate increases, when market volatility was like an Olympic snow boarder in the half pipe: high flying in one moment with twists and turns, and straight down in the next. The market was moving a thousand points per day. Clearly, increased rates were not all baked in.
In reviewing the literature and talking to bankers, I learned part of the reason why increasing rates may not dampen demand and thus value. Predominant among them is the fact that banks have loosened lending standards, and provided for more options that keep the cost per month of housing the same. Among the options is better “adjusted rate mortgages” (ARM), combined with longer amortization periods. As an example, I compared $600,000 of debt set up several years ago at 3.25% interest with 15 year fixed amortization, now being refinanced for $750,000 on a 5 year ARM at 4%, but over a 40-year amortization. The refinancing netted $150,000 excess dollars to the borrower, and reduced a $6,000 monthly payment to $3,000, despite the fact that the rate was almost 1 point higher. Genius, I thought. After all, in this society everything is based on credit, future payments and keeping costs level!
Related to monthly cost, the question around housing demand is answered partly by apartment rental versus purchase costs. In high rent areas, where rents for small units can easily be $3,000 to $4,000 per month, referring back to the $750,000 borrowing example, a nice condominium can be purchased potentially for less than the cost of rental. As long as mortgage monthly costs are less than monthly rentals, the market will be strong.
What are the other reasons as to why increasing rates may not decrease demand for housing? Besides better lending options, there continues to be growing consumer confidence. Some of it is buoyed by stock ownership in a highflying market. Some of it is the lowest unemployment rate almost ever, with companies vying for employees, and thus pushing salaries higher. Some of it is simple supply/demand, where housing construction has not kept up with the largest new population demographic demands for housing. It is also simply an understanding that rates move up when things are good.
With likely increase in salaries, the population will continue to buy, even at higher borrowing costs. Yes, there are some buying disincentives from the new tax law, with lower property tax deductions as well as capped mortgage interest deductions. However, that really isn’t a reason not to buy a house and start a family. 2018 should continue to be a good year for residential real estate. While the stock market will show volatility, it will also probably grind ahead slowly, producing money and confidence for buyers to move ahead. Despite all the peripheral noise around the market, fundamentally the companies that comprise it are doing well. Demand should also be increasing with continued family formation, one of the fundamental reasons why people buy housing.
Some experts believe that the rate or numbers of purchases will slow or flatten, but the prices will continue to go higher. The Mortgage Bankers Association, which tracks weekly mortgage trends, shows a modest recent decline in applications for loans. However, the majority of the drop is for re-fi, not new loans, which better reflect housing purchase demand.
All of that said, no one really knows. My sense is it depends on how far rates go, over what period of time. Short bursts of increase may actually push people to buy in order to avoid higher rates. But, too high a rate will ultimately have an impact on affordability, and thus value. You can be sure the Federal Reserve is keeping a close watch on all.
Daniel Calano, CRE, is the managing partner and principal of Prospectus, LLC, Cambridge, Mass.