Property owners in coastal California have enjoyed some of the most impressive gains in value, historically speaking. Locally, we saw home prices fall to a low of $296,590 in March 2009 from a peak of $878,124 in July 2007, a drop of more than 66 percent (California Association of Realtors; median home prices for Santa Barbara County).
This low coincided with the low of the stock market following the implosion of the financial markets, when the Standard & Poor’s 500 Index fell to 666 during the same month. From the March 2009 lows, the S&P 500 has rallied an incredible 170 percent, while local home prices have advanced an even more impressive 225 percent, to $692,930 (CAR).
Although home prices are still a long way from the 2007 highs, one could argue that we are at least back to healthy valuations for local real estate. Here are three reasons why we should expect to see local real estate prices fall.
This is almost a no-brainer, but since changes in interest rates are fundamental to real estate valuations, the threat of rising rates must be any real estate investor/owner’s primary concern.
The chart below shows the 30-year fixed-rate mortgage rate for the past three years. We can see that rates bottomed in mid- to late 2012 around 3 percent and have rebounded somewhat to about 4.1 percent today. Historically, mortgage rates are still very low, so the recent rise has not had a material impact on real estate prices. Inventories remain very low, both locally and nationally, which has also contributed to the stickiness of real estate prices, despite this rise in rates.
Should rates continue to rise, however, we will certainly see real estate prices begin to fall. Rising rates directly affect the following two additional reasons why real estate prices are likely to fall.
Rising interest rates directly affect the affordability of real estate. According to CAR, as of the third quarter of 2013:
» For California overall, the affordability index is 32, the median home price is $433,940 (single-family home), the minimum qualifying income is $89,170 and the monthly payment would be $2,230.
» For Santa Barbara County, the affordability index is only 17, the median home price is $642,860 (note that the median home price is now $692,930 as of September, or $50,000 higher), the minimum qualifying income is $132,100 and the monthly payment would be $3,300.
With some quick calculations we can compare the affordability of a typical Santa Barbara home purchase using today’s 30-year fixed-rate mortgage rate, with higher rates:
» $1 million purchase price
» 20 percent down ($200,000; tough for most people to save this amount, and not too many have significant equity in their existing home)
» Loan Amount: $800,000
» Credit Score: 700 or so
As can be seen in the nearby table, the monthly payment for this mortgage would almost double if rates were to rise to 10 percent. While this may seem impossible, back in the mid-1990s, mortgage rates were between 8 percent and 9 percent, and for anyone with not so great credit, or those who did not have 20 percent for a down payment, rates were above 10 percent.
I would not expect rates to rise past the 6 percent to 7 percent range within the next two to three years, but even a rise to this level would still result in an increase in payments of more than 30 percent, assuming prices stay fixed. For those currently paying monthly mortgage payments, imagine how a plus-30 percent rise in your payments would affect you.
A rise in rates of this magnitude would certainly price many potential buyers out of the market. The typical response to rising rates is falling real estate prices, to maintain the same level of affordability. If we look at the same range of mortgage rates, and want to keep the payment at roughly the same level (around $3,900 per month), here are the corresponding loan amounts:
As we see in the nearby table, the amount of the loan would drop dramatically if we want to keep our payments at the same level. With a fixed down payment, this means that if rates rise to 7 percent from the current 4.1 percent, and if the buyer had $200,000 for a down payment, instead of a $1 million home, they could only afford a home priced at $780,000.
Loss of Investor Interest
The rapid rebound in home prices from the March 2009 low has drawn investors into the real estate market, especially along the California coast. The old adage “it takes money to make money” has certainly been true, as investors who can pay all cash to buy properties have been scooping up homes and flipping them for good profits as prices have increased. Besides the opportunity to make quick money, a lack of alternative investments has pushed many investors into real estate who otherwise may have placed their funds elsewhere. This is especially true with bond buyers, who have been unable to generate current income from the bond market, since interest rates have been so low for so long.
Unless we assume that real estate prices will continue to rise in a rising interest-rate market, we should expect to see many investors exiting real estate, looking for other places to put their money. As rates rise, bonds will look increasingly attractive. Bonds are liquid (easy to convert to cash), compared with real estate, which is illiquid and expensive to sell. Bonds do not require insurance, maintenance, tenant management, etc.
If we remove the upward pressure on prices that has supported the real estate market throughout the past five years, who have not been influenced or constrained by interest-rate levels, we will be left primarily with normal buyers who need a mortgage and are looking to live in the property, rather than to flip it for a quick profit. Should this occur, we would expect to see a much more elastic relationship between interest rates and home prices, meaning a much more direct, negative impact on home prices as rates rise.
To believe these arguments for lower real estate prices, one has to agree with my assumption that interest rates will rise. While anything is possible, we know that the Federal Reserve has been buying $85 billion in bonds each month for more than a year and is very close to removing this stimulus from the economy.
The purpose of this bond-buying program was to artificially force down long-term interest rates, including mortgage rates. When this stimulus is removed, we should expect long-term interest rates to rise significantly. In addition, as the economy improves, the Fed will eventually need to start raising short-term interest rates, as well.
Rising short-term rates and an improving economy should result in a steepening of the yield curve, meaning that long-term rates should move up at a faster pace and by a larger percentage than short-term rates. This would mean that long-term rates could be driven much higher in a relatively short amount of time. It is hard to imagine real estate prices holding firm in this kind of interest-rate environment.