Rooting for Price Increases and Low Interest Rates

I've mentioned it in previous posts, but I'll say it here again: I purchased a house this year, against the advice of many (and to the delight of a select few). One of the things you will note if you undertake your own house hunt (or you'll recall if you've ever purchased a house) is the massive information disparity which exists between the house-hunter (or seller) and Realtor(s). Even though, with few exceptions, real estate purchases are the largest purchases most of us will make in our lives, transparency is non-existent and bad advice abounds. For starters, and the purpose of this article, I'd like you to consider two statements: "it's a good thing when home prices rise" and "It's a good time to buy now, interest rates are low". Let's consider those, shall we?

It's a Good Thing When Prices Rise...

Let's cut straight to the chase: if you are currently in the home of your dreams (note: this article is directed at the owner-occupant crowd, but the concepts apply to real estate investors as well) this statement is true.  There are two very important groups in the real-estate market who should think twice when they hear politicians talk about "stopping the free-fall in the housing market" or media figureheads talk about the need to attempt to raise home prices: first-time homebuyers, and move-up homebuyers.

Hopefully, you already can see why any increase in prices is detrimental to the first-time buyers in the market for new homes.  Any house price increases directly impact the amount of house they can afford (in the absence of mortgage rate fluctuations - addressed later).  If a homebuyer has a $400,000 budget and houses increase in price by 3% during his 6 month search, at the end of the hunt he is only able to afford what were previously $388,349 homes.

So what happened?  In January of 2003 the move-up buyer had $40,000 compared to a move-up house price of $450,000, a gap of $410,000.  Now, their situation has actually gotten worse, since the gap is up to $623,504.26.  So even though our fake homebuyer had appreciation north of 80%, so did the top of the market... and a high percentage of a higher number is an even higher number.  It's enough to make our fictional homebuyer want to rent.  (In June of 2011, S&P Case Schiller reports that the top tier houses in Vegas are at an index of 96.3 - if our buyer did sell the house and rent, he can afford the house now!)

Of course, other markets had higher rates of appreciation for lower tier homes, which would offset some of the problems portrayed in the scenario - including San Francisco... however, depending of the house price, move-up homes actually become more expensive from a reference point in most up markets.

It's a Good Time to Buy Now, Interest Rates Are Low!

This statement is an interesting one, because everything I'm about to type may actually be incorrect in the current environment.  However, historically, low interest rates 0n their own have not automatically meant that buying a home is a good thing.  Since the NAR only has existing home sales information from 2008 until the present, I've used a proxy in new home sales from the Census Bureau - which should track somewhat closely with existing sales.  For interest rate data, I've used the January 30-year mortgage numbers from the St. Louis Fed.  (Bear with me, this will take a few graphs).  You'll note that there is a very strong and significant correlation (at least through 2006.  '75-'06 it is -.76, '75 to '10 it is -.44!) between mortgage rates and the number of home purchases - what I'm trying to show is that low mortgage rates, at least before this most recent bubble burst, increase competition in the market.

Note that you can tell the negative correlation broke down in 2007.  It could be any number of factors: reduced access to credit, reduced risk tolerance, fewer qualified borrowers, fear, anticipated future price drops, or something else entirely.  However, my point is that generally a low interest rate environment actually increases competition in the market.  With increased buyers vying for homes, prices should increase - leading to lower interest prices on higher sales prices.  To verify that this is taking place, we need to come up with a metric which determines ability to pay.  The NAR has a slightly confusing metric to determine affordability - let's fabricate our own and call it the "Don't Quit Your Day Job Housing Affordability Index" (DQYDJHAI).  We will have multiple ratios - one based on average median household income and average selling price, one based on median household income and median home selling price, and one based on a made up measure of affordability.  In that third one - we will allow a front end debt to income ratio of 25%, a down payment of 20% and use the St. Louis Fed's reported mortgage rates from January, and Historic Median Incomes and Median and Average Home Prices from the Census Bureau.  We'll then compare those numbers to the actual prices!

And now for the same graph using average household income and average home price...

So, by both counts, in the current environment houses are affordable, and even low interest rates aren't enough to create the competition we usually see.  Now, I know a 25% front end DTI is nebulous, and you might argue people are willing to go to a 35% DTI... fine, I'll put a calculator together for you (Ed: I made the calculator).  Still, you should realize that until the last few years that lower interest rates did not mean (seemingly) good deals due to the increased competition.  You can see how closely prices tracked affordability in all interest rate environments (the above two graphs are not inflation adjusted, but in a future article maybe I'll review interest rates versus reported inflation versus prices).  Also, all markets are local, so using country-wide data means that you should remember that real estate is local... do your own research.

Anyway, the key takeaway from this article should be: take everything you hear on your house hunt with a grain of salt.  The only person who is 100% out for you is... you.