March 22, 2012, 2:01 p.m. EDT
Beware of Housing Prices
By Thomas H. Kee Jr.
The recent frenzy in the housing market is very interesting, although somewhat counterintuitive, and deserves consideration. In my neck of the woods, and I am sure in others, certain people are getting caught up in the sudden change in interest rates, but those same people are missing a very important relationship in the “home value” equation that I hope to reveal here.
Of course, the most important aspect in buying a home is location, but right next to that is affordability, and when interest rates begin to increase, affordability ratios decline. Everyone knows when interest rates increase the monthly mortgage payment increases, so if prices are held the same and interest rates rise, then the affordability ratio declines.
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However, the comparison above included an important assumption; it assumed that prices remain constant, and we all know that prices do not remain constant. In fact, the fluctuation in prices is a very important and dynamic variable in this same equation. I have argued many times that housing prices are a direct reflection of the amount people are able to pay, and nothing else. If that is true, the inverse relationship between price and interest rates that we all learned in economics 101 comes into play as well.
In school, we learned when interest rates increase, prices go down, but when interest rates decline, prices go up as well. This should be an eye-opening relationship given the direction of interest rates and prices over the past few years. Arguably, real estate prices would have declined much more than they have already if the level of interest rates was not declining alongside it.
There is not enough room in this article to include the findings, but the bubble was so exaggerated that even the steep decline in interest rates that we have seen since the bubble burst could not stop housing prices from falling.
Ultimately, housing prices are not a function of location, or interest rates, as much as they are a function of how much a person can afford. Of course, interest rates come into play in this determination, but people cannot change the amount they can afford at their whim, so that gives us a concrete starting point.
For example, if the average household could afford to pay $2000 per month (this is high), the maximum value of the home he could consider would fluctuate with interest rates. Assuming a 30-year rate of 4%, the maximum value would be $360,000 (CNN Calculator).
However, if interest rates increased from 4% to 5%, but the amount that person could afford to pay remained the same, the maximum amount that person could afford would be $320,000, or 11% less than he would have before. (I am including taxes and other related fees here.)
This relationship often plays a role in the affordability estimates, but when this is multiplied across millions of people, something interesting begins to happen. Assuming that people cannot change the maximum amount they can afford to pay at will — and assuming this is a fixed amount that can only fluctuate slowly over time — if interest rates increase, home prices will eventually need to decline, and that makes the future value of a home as an investment lower than it is today.
Think of the major homebuilders, as they determine prices. Lennar LEN -1.88% , PulteGroup PHM -2.88% , KB Home KBH -0.62% , they all compare the construction costs to the amount they can sell a home for, and those sales prices are always based on the amount people can afford to pay. If interest rates increase, people can only afford to pay less.
The best time to buy a house (assuming moderate inflation), is not when interest rates are at all-time lows, but instead when interest rates are high because prices and interest rates are inversely related. But the amount people can afford to pay does not change nearly as rapidly, in many cases, not at all. If you buy when interest rates are at or near all-time lows, and interest rates begin to increase, the inverse relationship between prices and interest rates will eventually influence prices lower.
If each home was a stock, and traded on an exchange, we would see an immediate correction in prices when interest rates increase, but instead this “hidden correction” is something real estate agents and brokers use to influence buyers to step up.
“Get in when rates are low” they say, but we never hear them say beware when rates go up because home prices decline. They might have a slight vested interest in making a sale, and on the surface, people like the idea of locking in a low rate. But it is much better to buy a home when rates are high and prices are low, and then when rates decline refinance into that lower rate instead. That is investment 101.
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