Real estate will suffer less than bonds when rates rise

House prices depend on debt. Of the four factors that determine house prices, three of them directly relate to financing terms. If mortgage interest rates go up, housing becomes more expensive even if prices don’t change. Wages must grow significantly to make up the difference in even a small increase in mortgage rates.

The prevailing view among economists is that the housing market would respond positively regardless of what happens with mortgage rates because house prices in the past have correlated poorly with mortgage rates. For example, during the 1970s, interest rates rose significantly, which should have caused house prices to drop, but instead California inflated a housing bubble. During the crash from the bubbles in the 1990s and the 2000s, interest rates declined, and so did prices.

Since the housing market went through significant periods when prices moved in opposition to mortgage rates, macro-economists reason that interest rates don’t impact housing. They fail to recognize that the new mortgage rules changed the way housing markets work.

According to the theory I postulated back in early 2013 — prior to the rate surge from 3.5% to 4.5% — rising mortgage rates should cause sales volumes to fall and falling mortgage rates should cause sales volumes to rise. The restricted inventory may cause prices to go up, but the changes in affordability caused by mortgage rate fluctuations would necessarily impact sales volumes by pricing out (or pricing in) marginal buyers.

In October of 2013 after the sudden mortgage rate spike pummeled sales, I wrote about the mounting evidence of the market’s sensitivity to mortgage rates.The mechanisms used to inflate previous bubbles — using teaser rates, allowing excessive DTIs, and abandoning amortization — these were banned by the new residential mortgage rules. Lenders can’t soften the impact of interest rate fluctuations or provide “affordability” when the market reaches its friction point. This is the main reason the market changed so dramatically and so suddenly when mortgage rates surged.

Since then, prices bounded against a ceiling of affordability, and although falling mortgage rates raised this ceiling over the last three years, prices can’t push through this barrier without toxic financing terms to boost them.

Economists at the Federal Reserve believed low interest rates in 2004 revived the economy, which is probably true, and they believe the interest rate policy that revived the economy also caused house prices to destabilize and become a bubble — which is not true.

The low mortgage rates of 2004 and 2005 were not the cause of the housing bubble. The low rates temporarily increased affordability, and these rates may have served as a precipitating factor to get the rally started, but mortgage rates only account for 10% to 15% of the huge runnup in house prices that was the Great Housing Bubble. The bulk of price inflation, 85% of the massive increase in price, was caused by toxic mortgage products like the option ARM that allowed borrowers to obtain loan balances eight to ten times annual income.

The real failure of the federal reserve — and there was a huge failure at the federal reserve — but the real failure was one of regulation and oversight. The federal reserve allowed the option ARM and other toxic mortgage products, and they allowed unrestricted credit default swaps on mortgage pools stuffed with toxic option ARMs. Investors pumped hundreds of billions of dollars into collateralized debt obligations insured by credit default swaps the ultimately found its way into millions of Option ARM mortgages at eight to ten times a borrower’s income. This greatly inflated house prices and set up an entire generation with debts too-big-to-manage and banks too-big-to-fail.

The Federal Reserve will raise interest rates. A higher federal funds rate doesn’t necessarily translate directly to higher mortgage rates. However, other real estate investments will be impacted by higher rates even if mortgage rates remain stable.

Higher rates don’t mean the death of housing, says Blackstone’s real estate chief

Matthew J. Belvedere, Tuesday, 18 Oct 2016

Concerns about the impact of what’s expected to be higher Federal Reserve interest rates on the property market are overblown, Jonathan Gray, global head of real estate at Blackstone, told CNBC on Tuesday.

“We’re later in the cycle, but some people are getting a bit too negative,” said Gray, who manages $103 billion of investor capital — nearly a third of Blackstone’s total assets under management. He controls more than $200 billion worth of real estate.

If anyone succumbs to the temptation to “talk their book,” it would be someone with a book worth $200 billion.

There’s too much of a focus on rates, he said. “There’s a [false] sense that owning real estate is the same as owning a bond.”

Bonds and real estate behave similarly because both investments provide periodic cashflow. Both investments exhibit sensitivity to interest rate fluctuations, but bond values fluctuate even more than real estate. Bonds pay a prescribed amount that doesn’t change. Real estate pays a variable amount based on rental income. Rent generally increases over time, so real estate investments provide benefits bonds do not. Of course, people who buy real estate know this, and they pay a premium for this potential growth.

Both bonds and real estate, along with every other asset class, will suffer in a rising interest rate environment. All investments value derives from a projected stream of income discounted to a current value. When the discount rate rises, which it does when interest rates rise, then the value of all investments tend to fall. Only those investments with superior growth potential shine when rates rise. That certainly isn’t bonds because the growth potential is zero. Real estate will perform marginally better because, despite slow growth rates, the growth rates are likely greater than zero.

Of course, this doesn’t mean that both bonds and real estate may not lose considerable value. If bonds lose 30% of their value and real estate only loses 20%, does that make investors feel better about owning real estate? Further, if real estate investors factored in 5% growth, and a recession knocks this growth back to 2%, real estate could actually fare worse than bonds because the premium would fall as the discount rate rises. This is the scenario Mr. Gray fears the most.

“Real estate, like stocks, can see earnings growth,” he argued. “And that’s what we’re seeing today because of favorable fundamentals.”

At least until the next recession when fundamentals weaken. 

In recent periods of rising rates — such as the early 1990s, the late 1990s and the mid-2000s — the property market “did OK,” Gray said.

LOL! That’s quite a stretch.

The property market in California in the early 90s was terrible. The previous bubble popped in 1990, and prices drifted slowly lower for seven years.

The property market across the United States experienced a massive bubble in the mid-2000s fueled by toxic mortgages and cheap debt. The only period of rising rates in the mid-00s occurred after Greenspan lifted rates from 1% in 2004. But by then the toxic mortgage financing proliferated and the bubble inflated rapidly.

Rising interest rates, and specifically rising mortgage rates, increase the cost of home ownership, pricing out marginal buyers, weakening demand. Nothing positive for real estate comes from rising rates.

“We don’t expect to see the growth in value in the next couple years that we’ve seen in the last four or five years,” he admitted. “But we don’t expect to see some sort of sharp decline in the near term.”

With new loss mitigation procedures (can-kicking), lenders will sustain high house prices even if nobody can afford them. Lenders will avoid foreclosure and losses on REO even if it means transaction volume falls to zero.

Blackstone, a diversified investment firm with specialties in real estate and private equity funds, also has a major holding in Invitation Homes, a nationwide home rental company.

“The housing market is definitely a bright spot in the U.S. [economy],” Gray asserted, saying home building is not keeping up with demand and population growth. “The result of that is you’re seeing rising rents and rising home prices. And we expect that to continue.”

“We own about 100,000 either multifamily homes or single-family homes for rent. And across the board, across the country, we’re seeing strength in that area,” he said.

Residential REITs took a haircut earlier this month as other investors see rising rates as a poor environment for real estate. Since real estate is illiquid, and since Mr. Gray has $200 billion worth, he can’t sell and get out so easily. Whatever happens to real estate, Mr. Gray will participate in the ups and downs.